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Legal Advice at the Speed of BusinesSTM from a Licensed Attorney – Right here in Colorado

Business Entity Selection

 

INCORPORATE IN COLORADO 

Choosing the appropriate legal structure for a business venture is a critical decision which requires careful analysis by the entrepreneur. The legal form of a Colorado business can have a significant impact on the success and profitability of the business. Therefore, a general understanding of the fundamental aspects of the basic types of business structures is an important first step. The options typically include one of the following four categories: Sole Proprietorship, Partnership, Corporation (C or S), and Limited Liability Company (LLC).

Sole Proprietorship Back to the top

A sole proprietorship is a business owned directly by one individual. The enterprise is merely an extension of the individual owner. This is the default business form for one person engaged in a trade or business. Agents and employees may be hired, but the owner carries all of the responsibility. Additionally, all of the profits and losses of the business are directly attributed to the owner.

Advantages

  • Control: Owner has complete control over the actions of the business.
  • Inexpensive Creation: No filing fees or legal fees are required to form.
  • Ease of Formation and Operation: Very few legal requirements are necessary for formation. Owners simply need to obtain a business license and/or permit from the city and county.
  • No Double Taxation: The sole proprietorship is simply a conduit to the individual taxpayer, therefore, there is only one level of taxation.

Disadvantages

  • Unlimited Personal Liability: The sole proprietor is exposed to unlimited liability regarding his or her business and personal assets. Owner is subject to all debts and legal liabilities of the business.
  • Fringe Benefits: Fringe Benefits are not typically tax free to the sole proprietor, however, hiring a spouse as an employee and providing tax advantaged health benefits to the spouse/employee with coverage then applying to the whole family is an option.
  • Capitalization: The ability to raise capital is limited to the individual's personal assets or assets the individual can secure personally.
  • One Owner: Entity is limited to only one owner.

Taxation

  • Pass-Through Federal Taxation: Business income is reported on owner's personal tax return on Schedule C of Form 1040. Business income is only taxed once.
  • Self Employment Tax: Federal Self Employment Tax is imposed on net earnings from self employment income at a rate of 15.3%. Schedule SE of Form 1040 is required.
  • Payroll Tax: If you have one or more employees, you must deduct the employee's part of Social Security and Medicare taxes from their wages (7.65%) and report these deductions, along with payment of the employer's part of these taxes (7.65%) and all deductions of income taxes made from the employee's wages to the IRS. Each employee must fill out an IRS Form W-4. In order to avoid costly mistakes in payroll processing, hiring a payroll service is highly recommended.

General Partnership Back to the top

A general partnership is a business enterprise, entered into for profit, that is owned by more than one person. The persons in the business are called partners. A general partnership may be created by a written agreement, an oral agreement, or by a simple handshake. No express agreement is necessary to create a general partnership. The general partnership is the default business form when two or more persons carry on a business for profit. Each of the partners is an owner and has a right to share in the profits of the business. As with a sole proprietorship, each partner is personally liable for any losses suffered by the partnership business. Therefore, partners are subject to unlimited legal liability regarding the debts and obligations of the business.

Advantages

  • Inexpensive Creation: No filing fees or legal fees are required to form.
  • Ease of Formation and Operation: Very few legal requirements are necessary for formation or operation. Owners simply need to obtain a business license and/or permit from the city and county.
  • Unlimited Number of Partners: A partnership can have any number of partners.
  • Capitalization: Because there are two or more persons who can contribute assets to the business, it is easier to raise capital for a General Partnership compared to a Sole Proprietorship. However, the LLC and Corporate forms offer even greater ability to raise capital than a partnership.
  • No Double Taxation: The partnership is simply a conduit to the individual taxpayer, therefore, there is only one level of taxation.

Disadvantages

  • Unlimited Personal Liability: Each partner's personal assets are exposed to unlimited liability regarding the debts and obligations of the business.
  • One Partner Can Legally Bind the Others: When one partner takes action in the name of the business, the other partners are legally bound by such action. Therefore, each partner is personally responsible for the acts of other partners who act in the name of the business.
  • Fringe Benefits: Owners can take advantage of fewer tax-favored and tax-free benefits than those that would be available as fringe benefits for employees of a C corporation. However, some fringe benefits are still available to partners in partnerships on a tax-free or tax favored basis. Even if the fringe benefit is included in the partner's taxable income, deductions may apply on the partner's individual income tax return Form 1040. The double taxation disadvantages of a C Corporation often outweigh its fringe benefit advantages.
  • Accidental Formation: two or more persons who want to be involved in business together may not intend to be partners, however, if they meet the definition of a partnership, then they are bound by Colotado Partnership Laws.

Taxation

  • Pass-Through Federal Taxation: Partnership income and losses pass - through the partnership to the partners individually. IRS Form 1065 must be filed with a Schedule K-1. Partners report income or loss on their individual income tax returns. Therefore, business income is only taxed once.
  • Self Employment Tax: Federal Self Employment Tax is imposed on net earnings from self employment income at a rate of 15.3%. Schedule SE of Form 1040 is required.
  • Payroll Tax: If you have one or more employees, you must deduct the employee's part of Social Security and Medicare taxes from their wages (7.65%) and report these deductions, along with payment of the employer's part of these taxes (7.65%) and all deductions of income taxes made from the employee's wages to the IRS. Each employee must fill out an IRS Form W-4. In order to avoid costly mistakes in payroll processing, hiring a payroll service is highly recommended.

Corporation (C)Back to the top

A C Corporation is an entity separate and distinct from its owners. It is an organization formed with state government approval which is designed to act as an artificial person to carry on a business. A corporation can acquire, hold, and convey property in its own name. It can also sue and be sued in its own name. Ownership interests in a corporation are represented by shares of stock, therefore, the owners are called shareholders. The shareholders periodically elect a board of directors who oversee the affairs of the business. The board acts under the leadership of a chairman and elects corporate officers who manage the business. Colorado requires corporations to have at least two corporate officers, those being the offices of president and secretary. For small business corporations, one individual may act as the sole shareholder, chairman of the board of directors, and president of the corporation. However, one individual may not act as president and secretary simultaneously. One benefit of a C Corp is that its liability for damages or debts is generally limited to its assets, so that shareholders and officers are protected from personal claims. Corporations are typically divided into publicly held and close corporations. A close corporation only issues shares to family members or persons who know one another, whereas, a publicly held corporation sells shares to public investors.

Advantages

  • Limited Liability: Because the corporation is a separate legal entity, the shareholders are not personally liable for the debts and obligations of the corporation, assuming corporate formalities are properly followed.
  • Separation of Powers: Power and control of a corporation is shared amongst the officers, shareholders, and board of directors.
  • Attracts Investors: The issuance of corporate stock to investors may allow the corporation to add much needed capital to the business.
  • Employee Stock Options: Employees can be offered stock in the company as an incentive.
  • Unlimited Shareholders: An unlimited number of shareholders may be owners in the corporation.
  • Filing Fee: A $50 filing fee payable to the Colorado Secretary of State is required upon formation. 
  • Multiple Classes of Ownership Interests: A corporation may offer multiple classes of stock, for example: common stock, preferred stock, voting stock, and non-voting stock.
  • Fringe Benefits: Corporations can deduct fringe benefits for its employees such as group life insurance, medical plans, and deferred compensation plans. Therefore, the employee is not personally taxed for the value of the employment benefits.

Disadvantages

  • Double Taxation: The business income from a Corporation is subject to "double taxation". First, the corporation must pay income tax on its earnings, and then shareholders and employees must pay tax on their dividends and wages. Employee wages are typically a tax deductable expense for the corporation while shareholder dividends are subject to taxation. A tax professional can help a corporation minimize its corporate income tax liability by paying the owners/employees additional wages and compensation as opposed to dividends. However, IRS rules and limitations must be strictly followed when doing so.
  • Corporate Formalities: In order to maintain its status as a separate legal entity, a corporation must strictly adhere to corporate formalities such as annual shareholders meetings, formal board of directors meetings, and documentation of meeting minutes. In general, the corporate form includes more paperwork and accounting requirements than an LLC. For many businesses, the complexities of corporate formalities are cumbersome and impractical.
  • No Capital Gains Treatment for Real Estate: Gains from real estate owned by Corporations will be subject to corporate tax rates. Whereas, gains on real estate for LLCs will be taxed at the more favorable Capital Gains Rates (currently 15%-20% for Long Term Capital Gains).

Taxation

  • Double Taxation: The business income from a Corporation is subject to "double taxation". First, the corporation must pay income tax on its earnings and file its own tax return on Form 1120. Secondly, the shareholders and employees must pay tax on their dividends and wages. Shareholder dividends are taxed at capital gains rates, which are currently 15%-20% for long-term capital gains and ordinary income tax rates for short-term capital gains. Employee wages are subject to ordinary income tax rates. Current corporate income tax rates are as follows: $0-$50,000 is taxed at 15%, $50,000-$75,000 is taxed at 25%, $75,000-$100,000 is taxed at 34%, $100,000-$335,000 is taxed at 39%, and $335,000-$10M is taxed at 34%.
  • Personal Services Corporations: When a corporation has employee-owners performing services in the fields of law, health, engineering, architecture, accounting, performing arts, or consulting, then the corporation income is subject to a 35% flat tax rate rather than the graduated rates above.
  • Payroll Tax: If you have one or more employees, you must deduct the employee's part of Social Security and Medicare taxes from their wages (7.65%) and report these deductions, along with payment of the employer's part of these taxes (7.65%) and all deductions of income taxes made from the employee's wages to the IRS. Each employee must fill out an IRS Form W-4. In order to avoid costly mistakes in payroll processing, hiring a payroll service is highly recommended.
  • Filing Fees: $50 upon formation.

Corporation (S) Back to the top

An S Corporation, or Subchapter S corporation, is a small corporation whose owners have elected to be treated as a partnership for federal tax purposes. An S Corporation election is made by filing Form 2553 with the IRS. Unlike a C Corporation, an S Corporation does not pay taxes at the corporate level. Instead, the S Corp files a Form 1120S and then passes its income, losses, deductions, and credits to its shareholders for inclusion on their personal income tax returns. S Corporations must strictly adhere to IRS regulations in order maintain S Corp taxation status.

Advantages

  • Limited Liability: Because the corporation is a separate legal entity, the shareholders are not personally liable for the debts and obligations of the corporation, assuming corporate formalities are properly followed.
  • Pass-Through Taxation: Taxed as a partnership or sole proprietorship on the federal level, therefore, corporate profits are taxed at the owner level only and avoid double taxation (unlike a “C” Corporation).
  • Attracts Investors: The issuance of corporate stock to investors may allow the S corporation to add much needed capital to the business.
  • Filing Fee: A $50 filing fee payable to the Colorado Secretary of State is required upon formation. 

Disadvantages

  • Corporate Formalities: In order to maintain its status as a separate legal entity, a corporation must strictly adhere to corporate formalities such as annual shareholders meetings, formal board of directors meetings, and documentation of meeting minutes. In general, the corporate form includes more paperwork and accounting requirements than an LLC. For many businesses, the complexities of corporate formalities are cumbersome and impractical.
  • Payroll Taxes: An S Corporation must withhold Social Security and Medicare from its employees pay and timely file payroll tax returns with the IRS. The owners of the S Corporation are considered employees, therefore, payroll applies to them as well, even if the S Corporation does not have any non-owner employees. Payroll taxes typically mean added expenses for the business as well.
  • Limited to One Class of Stock: Only one class of stock is permitted and the owners of the stock are entitled to their pro-rata share of the corporation’s profits.
  • Limited Number of Shareholders: There can be no more than 100 shareholders.
  • Shareholder Limitations: The S Corporation cannot have shareholders who are not individuals, with the exception of estates and certain trusts, and there can be no nonresident alien shareholders.
  • Ineligible Corporations: Certain financial institutions, insurance companies, and domestic international sales corporations cannot be S Corporations.
  • Fringe Benefits: Owners can take advantage of fewer tax-favored and tax-free benefits than those that would be available as fringe benefits for employees of a C corporation. However, some fringe benefits are still available to substantial (more than 2%) shareholders of S corporations on a tax-free or tax favored basis.

Taxation

  • Pass-Through Federal Taxation: S Corporation income and losses pass - through the corporation to the owners individually. The S Corporation files Form 1120S and distributes K-1’s to its shareholders. The shareholders then report their pro-rata share of income or loss on their individual income tax returns. Therefore, business income is only taxed once, unlike a C Corporation.
  • Self Employment Tax: S Corporations owners do not pay self employment taxes. However, S Corporations do not avoid paying into the Social Security and Medicare system (see Payroll Tax immediately below).
  • Payroll Tax: If you have one or more employees (including S Corporation owner-employees), you must deduct the employee’s part of Social Security and Medicare taxes from their wages (7.65%) and report these deductions, along with payment of the employer’s part of these taxes (7.65%) and all deductions of income taxes made from the employee’s wages to the IRS. A shareholder who is actively engaged in the business is treated as an employee and must be paid a reasonable salary which is subject to payroll taxes. However, the employer’s part of the taxes (7.65%) is deductible by the S Corporation before it is distributed to the shareholder as income. In an LLC, half of the 15.3% self employment tax (7.65%) is deductible by the member, but only after the LLC income is reported on the members personal tax return. Each employee must fill out an IRS Form W-4. In order to avoid costly mistakes in payroll processing, hiring a payroll service is highly recommended.
  • Filing Fees: $50 upon formation.

Limited Liability Company (LLC) Back to the top

The Colorado Limited Liability Company ("LLC") has become the dominant form for newly-created small businesses in Colorado. In fact, there are now 3 LLCs formed each year in the state for every 1 Corporation. It is clear that LLC is the entity of choice for Colorado's entrepreneurs.

The CO LLC has become so popular due to the fact that it gives business owners several advantages of the various business forms in one package. It is a hybrid which combines the flexibility and taxation benefits of a partnership with the limited liability protection of a corporation. Much like a corporation, a CO LLC is a legal entity which exists apart from its individual owners. The individuals therefore are not personally liable to creditors of the business, nor are they personally liable for torts which arise from the business. 

Financially, this effectively limits an individual member’s financial liability to no more than their investment in the Colorado LLC (which would include any assets owned by the LLC). This limit on financial liability for the business owner is very attractive considering that his or her personal assets cannot be touched in order to satisfy the debts of the LLC (assuming business formalities are correctly followed). Only the CO LLC itself is liable for its financial obligations.

From a risk standpoint, an LLC offers similar protection from tort law suits to the individual owners or members as a corporation does. This simply means that the members of an LLC are not held liable in legal suits for the wrongs that his fellow member(s) commit against third parties. Additionally, an LLC limits the liability of an individual from lawsuits brought by fellow members, directors or managers of the LLC.

Advantages

  • Limited Liability: The members of the LLC and their personal assets (house, car, personal property, etc.), are protected from liability for the acts and debts of the LLC. However, liability protection will not extend to situations where: loans or debts are made with a personal guarantee, the owners fail to operate the LLC as a legitimate business apart from their personal affairs, an owner commits a criminal act, or an owner commits a tort (negligent or intentional act or omission) which injures another’s person or property.
  • Organizational Flexibility: LLC owners can choose whether they want the operations of the business to be flexible and informal like a general partnership or rigid with formal procedures like a corporation. For the small or medium sized business, the formalities of a corporation such as formal board meetings to make decisions, minutes taken at board meetings, and annual shareholder meetings may not make much sense. The formalities may be simply impractical to apply to the daily operations of an LLC consisting of only a few individuals. A Colorado LLC may choose one of two forms of government: (1) member-managed, in which case the management of the LLC will be vested in its members; and (2) manager-managed, in which case the management of the LLC will be vested in a manager or managers. In sum, the LLC owners choose to create a business entity that is either formal or informal in its operation and the owners can tailor the conduct of the business to their liking.
  • No Double Taxation: Assuming the owners of the LLC choose to be taxed as a partnership or sole proprietorship, profits are taxed at the member level only (via pass-through taxation) and avoid double taxation (unlike a corporation). LLCs by default are treated as pass-through entities, therefore, the entity itself is disregarded for tax purposes. Under the “check the box” regulations, an LLC can elect to be taxed as an S Corporation or a C Corporation. However, choosing S or C Corporation taxation is not typically advantageous in Colorado.
  • No Corporate Formalities/ Streamlined Operation: Assuming the owners choose to be taxed as a partnership and operate under a member-managed or manager-managed structure, the LLC will generally require far less administration recordkeeping and paperwork compared to a Corporation. LLCs are not required to adhere to corporate formalities such as annual shareholders meetings, formal board of directors meetings, and documentation of meeting minutes (Although not required, an annual meeting of the members and minutes are encouraged for every LLC in order to legitimize the separate nature of the entity). The streamlined day to day operation that an LLC offers is one of the many reasons entrepreneurs choose the CO LLC.
  • Attracts Investors: Venture Capitalists and Investors have traditionally preferred to purchase corporate stock. However, with the popularity of the LLC, savvy investors are accustomed to purchasing ownership interests in LLCs.
  • Multiple Classes of Ownership Interests: An LLC can create multiple classes of ownership interests with both voting and non-voting rights. The majority of LLCs only need one class of ownership interest which includes voting rights. However, if desired, the LLC has the flexibility to assign various ownership interests and various voting rights in its Operating Agreement. An S Corporation, however, is prohibited from having more than one class of stock.
  • Single or Multiple Members: A Colorado LLC can be a single member entity or a multiple member entity. There are no restrictions on the number of members permissible. Members can be individuals, partnerships, C Corporations, S Corporations, trusts, or other LLCs.
  • Unlimited Duration: LLC owners can choose for the LLC to exist perpetually, even after the death of the owners.
  • Interstate Business: All 50 states have statutes that permit businesses to operate as LLCs. Additionally, other states recognize the limited liability of foreign LLCs operating within their state.
  • Professional Image: A legal business structure, such as a Limited Liability Company, can enhance the professional image of a business in the eyes of its investors, customers, and others in the marketplace.

Disadvantages

  • No Corporate Stock: LLCs are not able to issue corporate stock through a public offering or offer stock options to employees as an incentive. Ownership in a LLC is represented by Membership Interests and not corporate stock. If the owners are looking to go public on the stock exchange or offer employee stock options, then corporate formation is necessary. However, forming a Colorado LLC in the start up phase and converting to a C Corporation prior to going public is also an option. LLCs can also give equity interests (membership interests) to its employees as an incentive in the form of a 1) profit interest, 2) capital interest, or 3) a future option to acquire a capital interest. Offering employee stock options is more straightforward than offering employee equity interest in a LLC.
  • Fringe Benefits: CO LLC Owners can take advantage of fewer tax-favored and tax-free benefits than those that would be available as fringe benefits for employees of a C corporation. However, some fringe benefits are still available to LLC members on a tax-free or tax favored basis. Even if the fringe benefit is included in the member’s taxable income, deductions may apply on the member’s individual income tax return Form 1040. The double taxation disadvantages of a C Corporation often outweigh its fringe benefit advantages.
  • Filing Fees: The required filing fee payable to the Colorado Secretary of State for a LLC is $50. 

Taxation

  • Pass-Through Federal Taxation: For Single Member LLCs, business income is reported on owner’s personal tax return on Schedule C of Form 1040. Business income is only taxed once. Multi-Member LLCs are treated like Partnerships for federal income tax purposes. The Member’s income and losses pass through the LLC to the members individually. IRS Form 1065 must be filed with a Schedule K-1 issued to the members. Members then report income or loss on their individual income tax returns on Form 1040. Therefore, business income is only taxed once, unlike a C Corporation.
  • Self Employment Tax: Federal Self Employment Tax is imposed on net earnings from self employment income at a rate of 15.3%. Schedule SE of Form 1040 is required. Members who are actively involved in the LLC business are not treated as employees of the LLC and avoid paying Social Security/Medicare through their paychecks, therefore, they are required to pay a 15.3% Self Employment Tax on the LLC profits. The 15.3% Self Employment Tax is a combination of 12.4% OASDI and 2.9% Medicare tax. The 12.4% is paid until the members income is above $106,800 (in 2010; adjusted annually for inflation) and the 2.9% is paid regardless of income level. Up to half of the members self employment tax paid (i.e. 7.65%) is deductible on their personal tax returns. S Corporations avoid Self Employment Tax, however, the owners are treated as employees and their wages are subject to Payroll Taxes.
  • Payroll Tax: If you have one or more employees, you must deduct the employee’s part of Social Security and Medicare taxes from their wages (7.65%) and report these deductions, along with payment of the employer’s part of these taxes (7.65%) and all deductions of income taxes made from the employee’s wages to the IRS. Each employee must fill out an IRS Form W-4. In order to avoid costly mistakes in payroll processing, hiring a payroll service is highly recommended. LLC owners are not treated as employees, therefore, they are not required to pay payroll taxes on themselves. However, if the LLC hires employees, payroll taxes are necessary regarding such employees.
  • Filing Fees: $50 

Series LLC Back to the top

Please Note: Colorado statutes do not allow Series LLCs at this time. However, real estate investors whose home state is not Colorado often use this structure according to their home states laws in order to invest in real property in the state of Colorado.

A Series LLC is limited liability company whose Members and/or Holders desire to divide the business, business assets, and financial interests of the Company into one or more Series. A single LLC entity is formed which defines various Series of asset ownership, with each Series operating independently from the other Series. According to the statutes in other jurisdictions, the debts, liabilities, obligations and expenses incurred by, contracted for or otherwise existing with respect to a particular Series shall be enforceable against the assets of such Series only, and not against the assets of the LLC generally, or any other Series of the LLC. Traditionally, when entrepreneurs wanted to keep the debts and liabilities of one property or business separate from another they would form several separate LLCs. The Series LLC allows the owner to form one company and have the assets separated into each Series, while saving the owners from paying annual filing fees and administrative costs for each separate LLC. The Series LLC is fairly new, therefore, its tax treatment and asset protection advantages are somewhat unproven. Due to its recent statutory creation, there is very little case law interpreting the scope and validity of Series LLCs. Creating multiple LLCs to hold separate assets is still the most proven method to spread risk. However, if multiple assets are going to be held by the company, and multiple LLC filings are cost prohibitive, the Series LLC can be a flexible tool for the entrepreneur.

Single Member LLCBack to the top

The formation of a single-member LLC is permissible under the LLC Act in Colorado. In fact, all 50 states now recognize single-member LLCs. A single-member LLC is a disregarded entity for federal tax purposes. Therefore, if the single-member is an individual, the business income is reported on the member's personal tax return on Schedule C of Form 1040. In theory, the single-member LLC provides the owner with the same limited liability protection available to a multi-member LLC. However, there is some concern that liability protection identical to that of a multi-member LLC will not be extended to single-member LLCs. There are a couple of reasons for this. First, when an LLC is sued for an amount above and beyond its insurance coverage, the plaintiff will typically try to pierce the "corporate veil" in order to reach the member(s) personal assets. When a LLC has only one member, it's an easier argument to claim that the LLC is simply an alter ego of its owner and not a separate entity. Secondly, although the state statute clearly allows for a single-member "Limited Liability" Company, there is limited case law regarding the liability protection of single-member LLCs. 

So, is a multi-member LLC the better choice? Yes. Forming a multi-member LLC is the better option for liability protection. A single entrepreneur should consider adding another member to their LLC such as a spouse or relative. However, the added member must be a legitimate member of the LLC, meaning they must have a right to share in the profits and losses of the LLC. Also, a 1% owner may not be viewed as legitimate. It is unclear what % is necessary for a legitimate owner, however, a very small % of ownership will not suffice. If the entrepreneur is faced with the choice of remaining a sole proprietor or forming a single-member LLC, several factors should be considered. First, if the business involves inherent risks, has employees, or invites the public to its storefront, the single-member LLC is likely the better choice. Secondly, the entrepreneur must consider that the single-member LLC offers potential liability protection (taking into consideration a clear state statute with limited case law regarding the liability protection), while the sole proprietorship form offers no liability protection (outside of its business insurance coverage). Thirdly, a single member LLC must pay a filing fee of $50, whereas, a sole proprietorship does not have filing fees. Lastly, a single-member LLC may portray more trust and professionalism to potential customers vs. a sole proprietorship. The entrepreneur should carefully weigh the cost-benefit of entity formation. If a single-member LLC is chosen, the member should do the following in order to build a stronger argument for the separateness of their business and personal assets: have a written operating agreement signed both by the member in their personal capacity and by the LLC through its member, follow the provisions in the operating agreement, have an annual meeting with minutes, document major decisions in writing , keep excellent accounting books, keep a separate bank account for the LLC and never co-mingle personal and business funds, sign all documents in the name of the LLC as its member, and buy and sell LLC property in the name of the LLC.

Visit our CO LLC Key Terms section for more insight.