When starting a new restaurant, choosing the menu, buying equipment and designing the dining space are probably some of the more interesting tasks facing a restaurateur. But before any of the fun begins, one chore that should be faced is deciding what kind of business the restaurateur wants to operate. Whether the restaurant is a new concern or an existing one that is undergoing changes, the first question to answer should be whether incorporating the operation would be the best, easiest and most economical form of conducting business.

Myriad options

Business organizations generally take the form of sole proprietorship, general partnership, joint venture or corporation. A sole proprietorship has maximum flexibility and no operational formalities such as the need to keep minutes of meetings. Unfortunately, personal liability is limitless, corporate tax benefits are nonexistent and sharing of The outer limits The courts have historically upheld the principle that a corporation is separate from its shareholders, officers and directors. Shareholders risk their capital investment, but their personal assets are beyond the reach of business-related creditors and lawsuits. Provided the incorporated restaurant is sufficiently capitalized and treated as a separate entity, personal assets are usually shielded from attacks on the corporation.

Corporate ownership offers a number of advantages, including limited financial risk for the owners, increased availability of capital and easy transferability of ownership. Possible dissolution of the restaurant business is among the strongest arguments for incorporating.

The ability to readily value and sell a restaurateur's share in the incorporated business at the time one wants to leave it is invaluable. It is one means of assuring that the restaurant will go on — even if one or more of the principals should leave.

Incorporating a restaurant business usually protects individual assets from lawsuits should financial problems arise. However, even when a restaurant is incorporated, pockets of personal liability are still present. But if someone — an employee, an officer or a director of the incorporated restaurant — signs a loan individually or guarantees anything personally, the restaurateur's personal assets are at risk.

Learning to share

Although limited risk is the most significant advantage of the corporate type over other forms of ownership, many restaurateurs rank expanded financial capability a close second. That expanded capability may allow the incorporated restaurant to grow and become more efficient than it would if the business were set up as a sole proprietorship or partnership.

Many lenders prefer to deal with corporations because of the usury laws in many states that restrict the amount of interest that can be charged to sole proprietors and other individuals. The fact that corporate ownership is divided into many small units, or shares, makes it easier to attract capital. People with both large and small amounts of money can invest their savings in the corporation by buying stock.

Not too surprisingly, large financially stable corporations can often borrow money at lower rates than smaller businesses. Of course, not all corporations are large. Many small restaurants are also set up in the corporate form. The sale of shares by the corporation is also an attractive method of raising needed capital.

Ad infinitum

A corporation can have a perpetual existence; that is, theoretically, a corporation can last forever. That may be a great advantage if there are changes in the ownership of the restaurant business in the offing. The continuity can also be an important factor in establishing a stable business image and a permanent relationship.

Unlike a partnership — in which no one may become a partner without the consent of the other partners — a shareholder of corporate stock may freely sell, trade or give away stock unless the right is formally restricted by reasonable corporate decisions.

The new owner of such stock is then a new owner of the business, in the proportionate share of stock obtained. That freedom offers potential investors a liquidity to shift assets that is not present in the partnership form of business.

Taxation can be both an advantage and a disadvantage when incorporating an operation in the restaurant industry. Depending on many factors, the use of a corporation can increase or decrease the actual income tax paid. However, corporations are able to offer a much greater variety of fringe-benefit programs to employees and officers than any other type of business entity.

The high cost of incorporating

Some disadvantages are also inherent in corporate ownership. Corporations are the most difficult and costly form of ownership to establish. They are usually at a tax disadvantage, and often they face a multitude of legal restrictions.

Each state has different incorporation laws, some of which are quite technical and complex. Establishing a corporation usually requires the services of an attorney and thus legal fees — despite some advertisements that promise easy do-it-yourself any-state incorporation.

States also charge incorporation fees that add to the cost of setting up this type of business entity. Delaware, however, has traditionally attracted corporations because it has relatively easy requirements and low costs for incorporating.

As separate legal entities, corporations are subject to federal and state income taxes. Corporate earnings and any dividends (payments to shareholders from earnings) are taxed on an individual basis.

From the viewpoint of stockholders who receive dividends, this is effectively double taxation of corporate earnings — once at the corporate level and then again at the shareholder level, when those already-taxed earnings are distributed as dividends.

Relief for S corporations

The federal government provides tax relief to corporations meeting certain size and stock-ownership requirements by recognizing them as Subchapter S corporations. Many states also give relief to such corporations. The S corporations can elect to be taxed as partnerships while retaining the advantages of incorporation.

The S corporation has all of the advantages and disadvantages of the traditional corporation except in the area of taxes. For tax purposes, the S-corporation shareholders are treated similarly to partners in a partnership. The income, losses and deductions generated by an S corporation are passed through the corporate entity to the individual shareholders. Thus there is no double taxation of an S-type corporation. In addition, shareholders of S corporations can personally deduct any corporate losses.

Stepping up the corporate ladder

In order to incorporate, the first step should always be to consult an attorney. While it is possible and quite economical to incorporate a restaurant business yourself, most restaurateurs hire a lawyer so they can be assured that all necessary requirements are met.

The second step should be to select a state in which to incorporate. This is an extremely important decision, because regulations, incorporation costs and other fees, taxes and ownership rights vary widely among the 50 states.

If you intend to operate primarily within the Commonwealth of Massachusetts, for example, you should probably incorporate in that state. But if your principal business will be in Harris County, Texas, you should probably establish a Texas corporation. Aside from the convenience of incorporating in your home state, if the business involves state-awarded contracts, many state governments specify that local firms must be given preference.

An incorporated restaurant operation is considered a domestic corporation in states where it is incorporated. If a restaurant expects to do business in states other than the state of incorporation, it must register as a foreign corporation in those states.

Stockholders are the people who acquire the shares of the incorporated restaurant; they are its owners. Some corporations, such as family businesses, are owned by relatively few stockholders. In those firms — known as closed corporations — the stockholders also control and manage the corporation's activities. In larger corporations (sometimes described as open corporations), however, the ownership is widely diversified.

Stock is usually classified as either common or preferred. Owners of preferred stock have the first claim to the corporation's assets after all debts have been paid, but they usually do not have voting rights at the annual stockholders' meeting. Owners of common stock have only a residual claim (after everyone else has been paid) to the restaurant's assets, but they do have a say in the operation of the business.

Weighing the pros and cons

Deciding whether to incorporate can often hinge on whether adequate insurance is available. If insurance coverage is available, a restaurateur may decide not to incorporate. In situations where insurance protection is not available or affordable, incorporation and the limited liability it provides might be advisable.

The incorporation decision depends on factors other than simply minimizing personal liability, of course. There are tax consequences, such as the double taxation of profits and dividends, as well as the extent to which certain deductions can be taken.

Of course, many restaurateurs are discovering one of the newest business entities, the limited liability company (LLC), which was created to allow more investors to participate in a venture than are allowed in an S corporation. An LLC offers the same advantages of limited liability and tax treatment as a partnership. State laws differ regarding the business flexibility of LLCs, and an LLC that does business outside of the state in which it was created must register in those other states.

Each year, states create new entities like LLCs and pass new acts of legislation that affect how companies do business. Restaurateurs who stay informed and know which questions to ask their tax preparers and legal advisers will be able to make the best decisions. No one would willingly pay more taxes, take on more liability or receive fewer dividends than necessary, so get as many facts as possible before inking out an incorporation application.

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