CORPORATIONS: FRIEND OR FOE?
By Joseph P Fullop III Ph.D.
Years of working with CEO's have brought me to one very profound conclusion. They don't understand the implications of forming a corporation. When you ask someone "Why are you incorporated? The answer is invariably the same; " I incorporated to protect my personal assets". In theory they are right but when it comes to the practical side of the issue they couldn't possibly be more incorrect! The modern corporation, if not structured properly, is a tax trap that has been carefully set to snare the uneducated. Personal bankruptcy more often than not goes hand in hand with corporate disaster. With careful structuring and professional help you can avoid the "big bullet". Before you run out and ask your attorney to help you it might be a good idea to understand the problems yourself. Unfortunately I have not found one single attorney that understands the real problems. Worse yet their advice to form LLC's as a cure all emphasizes their lack of expertise in the field of corporate financial planning.
Most corporations eventually borrow money in some form during their existence. Invariably the lease company, bank, or lender will require a personal signature as well as a corporate guarantee. If you guaranteed a note personally why did you bother to incorporate in the first place? If a financial disaster befalls you while this debt is outstanding everything you personally own could be in serious trouble. I'm sure there are some of you reading this to whom the above scenario does not apply, however, that does apply to about 80% + of businesses that are out there.
One solution that is practiced to a limited degree is to move all of your personal assets into a trust of some type and attempt to create a safe harbor to protect your assets. The problem with this is that banks won't make the loan in many cases because your financial statement will show you don't have any assets. If you subscribe to conventional financing you will invariably find yourself in a catch 22.
A CEO must get back to basics. The object of the game is to make money personally. Most consultants organize a business plan and make projections as to potential corporate profits. The consultant's job is but half-done. Once the corporation generates a profit how do you get the profits out of the corporation without double taxation? Bonuses you say! Salary increases! Dividends! Within certain limits you can reap some of the fruits of your labor through these. The IRS has limits however as to the amount these can be before additional taxes are levied. So what can a person do?
The answer constitutes a paradyne shift in the way you view a corporation, and the way you structure debt and taxes within the corporation. Furthermore you must come to the simple conclusion that the entire reason you are working yourself to death is to make money personally. A Corporation is a piece of paper. It is a tool of business. It must be used properly if the desired affect is to be achieved. Unfortunately a corporation alone cannot accomplish all of the things you want to achieve by itself. It takes a combination of at least two business tools to do this. I personally utilize a Limited Partnership and a corporation to achieve all the things my client's desire.
The Limited Partnership is used to raise money from investors. If you sell stock in a corporation you give up control and you repay the investors by declaring a dividend. This can dilute returns to the investors by as much as 39%. The sale of stock dilutes control and creates stockholder liability. The Limited Partnership is a pass through tax vehicle, which means any profit or loss or form of depreciation is passed through directly to investors. One person, the Operating General Partner, controls a Limited Partnership. Investors are passive. The investors in a Limited Partnership don't have a vote in management decisions. The Limited Partnership is used as a safe harbor for assets that have been purchased with investor dollars.
Control ceases to be an issue when you use a Limited Partnership, therefore you can raise all the money you need to fully capitalize the project without incurring conventional debt. The Limited Partnership rents the assets to the corporation for a percentage of gross sales. The corporation is not intended to realize a profit. It is being used precisely for what it was intended. The Corporation is a shield for financial disasters. The corporation is a shell. It produces a widget or service and pays for insurance, taxes, labor, and utilities. No more, no less.
The Limited Partnership receives under the terms of the USE contract the percentage of gross income that exceeds the corporation's absolute needs. The Limited Partnership proceeds can now be divided between the investors and the Operating General Partner without incurring dividend or corporate taxes. If constructed properly the percentage of gross income for the use of the Limited Partnership assets is 100% tax deductible as a cost of doing business. If you already have stockholders you may convert them to the Limited Partnership. After all, what would you rather have- a quarterly stock report - or a monthly income based directly on performance of the company?
Historically this structure will dramatically increase the income to the principals of a business and return usually a 30% ROI per annum to investors. Sound crazy? Stop and think. What percentage of your business revenues does it take to pay for labor, insurance, taxes, and utilities? The Limited Partnership raises enough money to enable you to purchase all your raw materials at maximum volume discounts, paid for 100% of the best equipment money can buy, and all of the buildings and land is paid for in full. The only debt you have is when you sell something. You are now operating at maximum efficiency! You have complete control of the assets and the operations. The corporation can be bankrupt without effecting the Limited Partnership assets or its investors. You have no personal liability because you have no personal debt. The monies inside the Limited Partnership can be divided many different ways in order to be fair to all parties involved. Problem solved.
Planning the way you expend money from a family or a corporation in important under present day tax laws. A little thought can save you a fortune. The structure I described should not be tried without the guidance from a professional. Solid documentation is critical.
Raising money from investors is extremely important in order to achieve "minimum risk" for all concerned. Many CEOs that I have consulted with reject the idea of using investors. This attitude is foolish and in most cases it smacks of the worst trait a CEO can possibly posses - greed. It makes much more sense to make the pie bigger with little or no risk to all concerned than owning 100% of a business that puts at risk all you own. Decision-making is the CEOs job. It is not always easy. The decisions you make will ultimately affect the outcome of your working life.
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