Legally Organizing a Restaurant

According to the National Restaurant Association (www.restaurant.org), there are about 935,000 eating and drinking establishments in the U.S. and more than seven out of 10 of these are independent operations (not franchises). These businesses average $1.5 billion in sales daily and account for 4% of the gross national product. The industry is the largest employer in the U.S., besides the government and forecasts for 2007 look good.

With all this positive information about the food service industry, one might think that it is well settled how, from a legal perspective, to set up a new restaurant, bar or take-out business. It’s not and the debate among restaurant owners and legal advisors persists. Here are the options--you decide.

Legal liability
Running an eating or drinking establishment can be a risky proposition. Rich Stytzer, member of the Board of Directors of the New York State Restaurant Association and president of the Westchester-Rockland Chapter of this Association, notes that the threat of lawsuits is always present, including the potential for frivolous claims by staff and patrons.

Work-related injuries to staff, from burns and falls on slippery floors, to sprained muscles and wrenched backs, are not uncommon. According to the Bureau of Labor Statistics, in 2003 there were 4.6 work-related injuries for every 100 full-time employees (www.bls.gov/oco/cg/cgs023.htm). And there are risks related to patrons as well. The InjuryBoard.com reports that in the U.S. alone, over 350,000 people are hospitalized for food poisoning each year, and more than 5,000 die (www.injuryboard.com).

While taking safety measures and carrying adequate insurance is the first line of defense against claims from injured people, it is impossible to fully protect against lawsuits in excess of insurance claims. Here’s where the importance of legal entity comes into play. An owner can gain personal liability protection in this situation if the business is set up in a form that affords such protection. This means that business creditors, including successful litigants, can only look to the assets of the company to satisfy their claims; an owner’s home, personal savings and other personal assets are insulated from these claims. There are two choices for achieving personal liability protection: Incorporate or form a limited liability company (LLC).

Corporation or LLC?
Most eating and drinking establishments are formed as corporations or limited liability companies in order to obtain personal liability protection for owners. Which alternative is preferable? There is no fixed answer; ask 10 restaurateurs or their legal advisors and you probably will receive answers favoring each alternative. Both the corporation and LLC format can be used if there is only one owner or multiple owners. The cost for formation, which includes state filing fees and other charges, is roughly the same for each alternative, so cost should not a determining factor. Here is an explanation of what each type of entity is all about and some other factors to help in making a selection.

Limited liability companies
A limited liability company (LLC) is a legal entity formed under state law. As mentioned earlier, this legal status gives personal liability protection to owners (called members).

Taxwise, an LLC is taxed just like a partnership if there are two or more owners, or like a sole proprietorship if there is only one owner. This means income and expenses of the business are reported on the owner’s personal income tax return; in the case of partnership treatment, each LLC member reports his or her share of the business’ income, losses and credits.

When it comes to Social Security and Medicare taxes on an owner’s net income from the business, the LLC owner is not an employee of the business. There is no FICA tax on wages because there is no such thing as wages for an LLC owner, who is treated the same as a sole proprietor or partner. He or she pays self-employment tax on net earnings from the business, which effectively amounts to what would be the employer and employee shares of Social Security and Medicare taxes. An owner’s withdrawal of funds from the business bank account, usually as a draw, has no impact on his or her income taxes or self-employment tax.

Corporations
There are two types of corporations: Regular (called “C”) corporations and S corporations. A corporation is a separate legal entity set up under state law that fully protects the assets of its owner (shareholder) from the claims of creditors; both a C and an S corporation provide the same personal liability protection for owners.

The distinction between the two types of corporations is how they and their owners are taxed. Incorporation automatically makes the business a C corporation, which is a separate taxpayer. The corporation reports its income and expenses on a separate tax return, Form 1120, U.S. Corporation Income Tax Return. The owner reports on his or her personal income tax return only compensation and other taxable amounts received from the corporation.

Owners of a corporation can opt, instead, to report the business income and expenses on their personal returns. (The corporation cannot have more than 100 shareholders but this is rarely an issue for most restaurants.) Obtaining S corporation status is done by electing it--the federal election is made by filing Form 2553, Election by a Small Business Corporation (there may be a separate state election required to achieve S status for state income tax purposes). There is no government fee for making the election. The election can be made as soon as the business is incorporated. Making the election means that, as in the case of the LLC, income, losses and other tax items pass through the corporation to the shareholder and are reported on the shareholder’s personal tax return (the corporation does not pay tax).

The S corporation files a return, Form 1120S, U.S. Income Tax Return for an S Corporation, which acts as an information return, telling the IRS about the business’s income and expenses. The owner reports the net amount on his or personal return.

Unlike LLC members, corporate shareholders who work for their businesses are employees. This means that wages and other taxable compensation are subject to FICA taxes--the corporation pays the employer share and the shareholder-employee pays the employee share.

Making a choice
Because it is possible to obtain pass-through tax treatment with both the LLC and the S corporation, these are the most frequently used forms of entity in the food industry. However, there are some distinctions that may favor one or the other:

Lower employment taxes for S corporations. LLC members may pay self-employment tax on all of their net earnings from the business. In 2007, this means that earnings up to $97,500 are taxed at 15.3%, with excess earnings taxed at 2.9%. For example, say a restaurant owned by one LLC member, who actively runs the show, nets $200,000 in 2007. Whether or not some or all of this is distributed to the owner, he or she must pay self-employment tax of $17,446.30 (one half of which is deductible on the owner’s personal return).

In contrast, the S corporation shareholder only pays FICA on wages received from the business. Say the owner takes a salary of $75,000. The owner and the corporation would each pay FICA tax of $5,737.50; the corporation could deduct its share of the tax from the net income passed through to the shareholder. Caution: The shareholder must receive reasonable compensation for work performed for the business; the IRS has placed the failure to do this on its audit watch list.

Greater tax basis for LLCs. An owner of an LLC or S corporation can deduct losses (expenses in excess of revenue) passed through from the business only to the extent of “basis.” The way in which basis is figured for purposes of this limitation favors LLCs over S corporations.

A shareholder’s basis is comprised of investments in the corporation and loans to it from the shareholder. Third-party loans to the corporation do not impact a shareholder’s basis.

In contrast, a member’s basis includes his or her share of certain third-party loans to the LLC. For example, if the corporation borrows $100,000 from a bank to refurbish its eating area and kitchen, such amount can be included in the member’s basis.

Distribution flexibility for LLCs. An S corporation can have only one class of stock and distributions to shareholders must be in proportion to their ownership interests. Thus, a 50% shareholder must report 50% of the corporation’s income, etc.

An LLC is not subject to this restriction and can make disproportionate distributions and allocations to members. For example, profits can be allocated more heavily to one member than another without regard to their ownership interests.

Conclusion
Each situation is unique, so the choice of entity should be custom-tailored to meet the needs and aims of owners. State law may also influence entity selection, so the location of the restaurant should be taken into account.

This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.

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