Legal Structures for the Design Firm

by: Leonard DuBoff
from: Professional Practices: June 18, 2002

Every graphic design business has an optimal structure that will provide it with the maximum

possible benefits. These may include tax benefits, protection from liability, continuity of existence, and the like. It is important for small business owners to determine which business form will best serve their needs and whether their business objectives can legally be achieved.

Sole Proprietorships

The simplest form of business is a sole proprietorship. This is the name given to a business that is owned and controlled by a single individual. Little need be done to create a sole proprietorship. All you have to do is obtain a business license if it is required in your jurisdiction and, if you are using a name for your business other than your own, register that as an assumed business name or fictitious name. This simple business form has a major downside, though. Sole proprietors have full personal liability for all debts of the business. This means that your house, car, personal bank accounts, and the like will be exposed to the risks of your business. Certainly you can obtain insurance, but insurance policies have limits and some risks are not insurable.

If a sole proprietor hires an employee and the employee commits a wrongful act within the scope of the business, then the sole proprietor will have full personal liability for the employee’s wrongful conduct. In addition, if the employee contracts on behalf of the sole proprietorship business and the contract is within the scope of that business, the sole proprietor will be liable on the contract, even if it was not authorized or approved.

Sole proprietors pay income tax on their earnings at their individual rates. While most sole proprietors segregate their business bank accounts from their individual bank accounts for a number of reasons, the IRS lumps all of the sole proprietor’s earnings together for tax purposes. That is, the sole proprietor’s personal tax return will reflect business earnings as well as investment or bank interest.

Partnerships

When two or more individuals join together for purposes of engaging in a business, then the relationship between them is known as a partnership. No formal acts are necessary to form a partnership, although it is always a good idea to put all of the parties’ understandings regarding the business into writing so misunderstandings can be avoided.

A partnership is defined as an arrangement whereby two or more persons act as co-owners and engage in a business for profit. Note that the individuals need not be equal partners, although, if they have not specified a particular relationship, the law presumes that they are equal. Because there are numerous presumptions which attach to the relationship under state laws, it is important for individuals who become partners to specify the terms of the partnership with some particularity in order to avoid confusion.

Each partner has full personal liability for the debts and wrongful acts of any other partner when they occur within the scope of the partnership business. In addition, partners have full personal liability for the acts and the contracts of all partnership employees. For example, if one partner engages in acts of copyright infringement, all partners will be liable for the wrongful conduct, even though only one of the partners was the wrongdoer.

Each partner pays tax on his or her distributable share of partnership profit and may deduct his or her share of partnership losses. Note that tax liability is imposed on the partner even if there is no actual distribution of profit. If, for example, two graphic designers have an equal partnership that earns $50,000 per year and decide to retain those earnings for purposes of expansion, then each partner has a tax liability of $25,000, even though the money was not distributed.

Limited Partnerships

A type of partnership that can afford some partners’ limited liability is known as a limited partnership. This business form is a partnership comprised of one or more general partners who have full personal liability and one or more limited partners who may enjoy limited liability so long as they are not actively involved in running the business. A limited partner may receive financial information and, in some states, retain the right to elect or remove general partners, but the limited partner may not, under any circumstances, conduct the day-to-day operations of the business.

If a limited partner becomes actively involved in determining policy and running the partnership’s business, then the active limited partner will have full personal liability as if he or she were a general partner.

Partners in a limited partnership, whether they are general or limited partners, are taxed on distributable profits and may deduct distributable losses. The limited partnership entity is not taxed as such, though an informational return is filed; rather, individual tax returns of the partners reflect partnership profits and losses. The partnership does file an annual return, but it is for informational purposes only.

One method by which business owners may be shielded from liability for business obligations is to have the business structured as a corporation or some other business form with limited liability.

Corporations

One of the most popular business forms is the corporation. It is considered a separate legal entity apart from its owner(s), even if the owner is one individual. The corporation is responsible for all of its business activities and the owner generally is not. If an employee engages in wrongful conduct within the scope of the business or if the employee involves the corporation in an unfavorable contractual arrangement, the corporation, not the owner, will be liable. With few exceptions, the owner’s only exposure when engaging in business in the corporate form is for the assets placed in the corporation.

A corporation is a taxable entity, and it must, therefore, file its own corporate tax return. There is, however, a special type of corporation which may elect, for tax purposes, to be treated as if it were not incorporated. This is the so-called “S” corporation. Unfortunately, “S” corporations do not truly pass through profits and losses as if the business were unincorporated, and there are a number of restrictions imposed on businesses with an “S” corporation status. This form of business is unavailable if any of the shareholders are not American citizens or are other for-profit corporations. Until just recently, if there was more than one class of stock, the “S” form was then also unavailable. In addition, the number of shareholders was limited. However, new legislation has expanded the applicability of “S” corporations. Certain tax-exempt organizations will now be permitted to hold stock, and the number of permitted shareholders will be increased from thirty-five to seventy-five.

Those who conduct business in the corporate form and desire to provide medical, dental, or prepaid legal insurance for employees may do so by adopting a plan permitting them to fund these benefits with pre-tax dollars. In addition, the benefits are not taxable to the employee recipients. This is available only for corporations that are considered taxable entities, not “S” corporations. A properly structured contract between the corporation and its shareholders could provide for a tax-deductible life insurance program. This type of arrangement is also available only for regular or “C” corporations, which are taxable entities.

A “C” corporation must retain its losses and carry them forward until it has earned profits. The individual owners may not personally net those losses against their individual earnings. In addition, if money is paid to shareholders on account of their stock interest as dividends, then that money will be taxed to the recipient and may not be deducted by the corporation. Essentially, then, this money is taxed twice.

There are a number of methods by which a business attorney can structure a graphic arts business in order to maximize liability protection while minimizing tax. If, for example, the parties have conducted their business under a particular name or logo, then they can protect that trademark and continue to use it when they set up their business form. The trademark could be owned by the business, or a more sophisticated plan could be implemented. For instance, if the owners personally retain ownership of that mark and register it in their own names, they can license the mark to their graphic design business and obtain some benefits, including royalty payments. Royalty income is known as passive income and is exempt from certain income-related taxes. There are, thus, some tax benefits in having a licensing arrangement between the business owners who are also owners of the trademark of the business they own.

It is common for owners of small businesses, including graphic design businesses, to be employees of their businesses. The money paid to employees is known as earned income, and that income is subject to all employment taxes. Earned income is also deductible by a corporation, which is a taxable entity. This means that even though the corporation earned considerable money, it may pay that money out in reasonable salaries and payroll withholding expenses so long as the salary is reasonable, and, thus, have no taxable income at year-end.

Limited Liability Companies

There is a new business form known as a limited liability company (LLC). This business form allows the individual owners to achieve the same kind of liability they would have in a corporation, while the business organization is ignored for tax purposes. Essentially, the owners of the graphic design firm would be taxed as if they were sole proprietors or partners, even though the business organization could not qualify as an “S” corporation.

“S” corporations and LLCs are not taxable entities, and the owners must pay tax on their distributable profits and may deduct their pro rata share of business losses. It would, therefore, be important for you to determine whether your graphic design business is likely to lose money during the formative years. If so, it may be in your best interest to create an “S” corporation or an LLC. In this way, your business losses may be netted against your personal earnings from other sources.

If a corporation retains profits of up to $50,000 for purposes of expansion, it will be taxed at 15 percent on that $50,000, while sole proprietors, partners, or those who conduct business as “S” corporations or LLCs that retain any money in the business for expansion will be taxed on those retained profits at the individual’s rate of 15 to 28 percent.

There are numerous other considerations that affect the determination of what business form will best serve your interests and maximize your business security. A skilled business lawyer can assist you in making that determination and helping you realize your objectives.

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