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Legal Structures for Your Business
Before you have any discussions with your professional advisors,
it is useful to understand the basics of the various legal
structures available to you: sole proprietorship, partnership,
and various forms of corporations.
SOLE PROPRIETORSHIP
This is the most popular form of small business and, as the name
implies, ownership is totally vested with one person. It is the
easiest to establish since no legal formalities are necessary.
The only business requirement may be a license from your local
jurisdiction to allow you to conduct the type of business you
are planning. For example, you may need a license to sell food
to the public.
Sole Proprietorship Advantages:
1. Easy and quick and usually the least ex-pensive to establish.
2. You have total ownership and control of the business.
3. All the profits of the business belong to you, the owner.
4. No additional Federal taxation on business profits (No double
taxation).
5. No periodic business reporting to the IRS or other government
agency is required.
6. Income tax filing is simply part of your annual personal tax
return (Schedule C).
Sole Proprietorship Disadvantages:
1. The owner is personally liable for all business debts and the
liability is not limited to the value of the business. You are
personally liable for any and all business debt you incur.
2. It is generally more difficult to borrow money or obtain
outside investment than with other types of legal structures.
3. If the owner is incapacitated for any reason, the business is
likely to fail.
4. All management responsibility is with the owner which can be
a heavy burden.
5. You must pay self-employment tax on the business net income.
IMPORTANT NOTE A "home business" is frequently a sole
proprietorship and offers a number of unique ad-vantages.
However, just because you are con-ducting business from your
home does not exempt you from possible legal or other
liabilities. See Appendix III for a listing of the advantages of
a home-based business.
PARTNERSHIP
This type of business is just what the name implies: Business
ownership is divided between two (or more) partners. The general
partnership is the most common and is formed to conduct a
business with two or more partners being fully involved in the
operation of the business. All the partners share both profits
and liabilities. A limited partner-ship, as the name implies,
provides for limited liability of the partners. (This liability
can be no greater than the partner's investment in the
partnership). In a limited partnership there must be at least
one general partner who remains liable for all the debts of the
partnership.
Forming a partnership is complex and legal advice is very
important. The kind of partnership and the type of partner you
will be determines your potential personal liability.
Partnership Advantages:
1. Synergy as a result of pooling partners' different areas of
expertise.
2. The partnership does not pay Federal in-come taxes. An
informational tax return (IRS Form 1065) must be filed which
shows the pass-through of income/loss to each partner.
3. Liability may be spread among the partners.
4. Investment can come from the partners in the form of a loan
which creates interest income for the partners and a business
deduction for the partnership.
Partnership Disadvantages:
1. Formation and subsequent changes in structure are complex.
2. Problems with partner(s) as the result of misunderstandings,
different goals, etc., can weaken or destroy the partnership.
3. Limited partners are liable for debt if they are active
managers in the business. General partners have unlimited
liability. You may also be liable for the commitments of your
partners.
CORPORATION
There are three major types of corporations, the C-corporation
("regular corporation"), the S-corporation (or "S-Corp"), and
the Limited Liability Corporation (or "LLC"). All of these forms
of the corporation are complex legal entities. Their detailed
structure may vary from state to state (incorporating a business
in a given state allows you to conduct business only in that
state). It is essential for you to obtain legal advice if you
are thinking about forming a corporation. Since each state has
its own set of corporation laws, you should contact the
appropriate state office in your state (usually the office of
the Secretary of State) for additional material and procedures.
Most offices can provide a guide for new businesses to follow
for incorporation and doing business in their state. Call or
write for a copy.
Most people immediately think of incorporating in order to
minimize their personal liability. Indeed, the liability of
stockholders (owners) in a corporation is limited under certain
and complex conditions. Today, with the Tax Reform Act of 1986
and other legislation, there are really few good tax reasons to
incorporate (with the exception of dividing corporate profits as
noted below). The best reason for incorporating is, in fact, the
limited liability. However, there is no such thing as total
insulation from liability resulting from doing business as a
corporation. Record keeping and tax matters with a corporation
are difficult and time-consuming tasks usually requiring the
services of an accountant. You need to keep this in mind when
considering operating costs for your business.
Avoid the "do it yourself" incorporation guides. Incorporating
is a complex process and you should not take on the task
yourself. You cannot afford any mistakes at this point in your
new business, so if you decide incorporation is for you, do it
right and spend the money required to have it done
professionally. Legal fees for setting up a corporation can run
between $350 and $1,500 (assuming it is relatively
straightforward).
REGULAR CORPORATION
The corporation is a taxable entity and, as such, pays taxes.
This results in the "double taxation" you may have heard about.
The corporation pays corporate taxes on its profits, and then,
you the owner (shareholder), pay personal taxes on the dividends
your corporation pays you. (The dividends are not deductible by
the corporation). This is one of the biggest disadvantages of a
corporation.
On the other hand, incorporating your business usually makes it
easier to establish credit with suppliers and borrow from banks.
If you expect to use outside investors for business capital, a
corporation is a must.
Regular Corporation Advantages:
1. Shareholders (the owners) enjoy personal limited liability.
2. It is generally easier to obtain business capital than with
other legal structures.
3. Profits may be divided among owners and the corporation in
order to reduce taxes by taking advantage of lower tax rates.
4. The corporation does not dissolve upon the death of a
stockholder (owner) or if owner-ship changes.
5. Favorable tax treatment for employee fringe benefits
including medical, disability, and life insurance plans.
6. 70% of any dividends received by the corporation from stock
investments are deductible (unless you purchased the stock with
borrowed money).
Regular Corporation Disadvantages:
1. More expensive and complex to set up than other legal
structures.
2. Completing tax returns usually requires the help of an
accountant.
3. Double taxation on profits paid to owners (corporation pays
corporate taxes on profits and owner pays personal taxes on
dividends from the corporation).
4. Recurring annual corporate fees.
5. Tax rates are higher than individual rates for profits
greater than approximately $75,000.
6. 28% accumulated earnings tax on profits in excess of
$250,000.
7. Business losses are not deductible by the corporation.
S-CORPORATION
The S-corporation offers the limited liability advantages of a
corporation but does NOT pay Federal taxes. All the earnings and
losses of an S-corporation are passed through to the
share-holders. It is a popular form of incorporation in the
startup years of a business but there are some subtle
disadvantages that need to be taken into account as you grow.
Again, because of the complexities involved, talk with your
attorney and accountant.
S-corporation Advantages:
1. Owners enjoy personal limited liability as in a regular
corporation.
2. No Federal income tax liability, and in most cases, no state
income tax.
3. Profit/losses are passed to owners ... no double taxation.
4. The S-corporation does not dissolve if one of the owners dies
or otherwise leaves (like a regular corporation).
5. Wholly owned subsidiaries are permitted.
S-corporation Disadvantages:
1. Legal assistance is required to set up.
2. Maximum of 75 shareholders.
3. Only one class of common stock is permitted (no preferred
stock).
LIMITED LIABILITY CORPORATION (LLC)
This type of corporation blends the tax advantages of a
partnership and the limited liability advantages of a
corporation. Owners of an LLC are referred to as "members." As
you might expect, it also has some limitations but is definitely
worth considering. Ask about the LLC when you contact your
appropriate state office for incorporation information.
LLC Advantages:
1. Limited personal liability for the owners (like a corporation
and unlike a partnership).
2. No Federal taxes (like a partnership).
3. No limit on the number of stockholders (un-like an
S-corporation).
4. More than one class of stock is permitted (unlike an
S-corporation).
5. Business losses may be deducted on your personal tax return
(like a S-corporation).
LLC Disadvantages:
1. Legal assistance is required to set up. The paperwork is
complex.
2. No "continuity of life" as in a regular corporation. The LLC
dissolves if one of the owners dies or otherwise leaves.
However, other formal agreements between the owners can overcome
this.
3. Some states require than an LLC have more than one member.
MAKING YOUR CHOICE
As already noted, it is difficult to give specific advice as to
the choice of legal business structure since every situation
will be unique. The ad-vantages and disadvantages noted above
should be assessed based on your particular situation. In any
case, it is important to discuss your plans with advisors
including both an attorney and an accountant prior to making
your final decision. The various tax consequences for
corporations and partnerships are complex and must be carefully
considered for each specific situation.
When discussing your plans with your advisors, keep in mind the
following points:
* The LLC is well worth looking into.
* Saving taxes is one of the most important reasons to consider
when selecting your structure. Keep in mind that there are
generally few tax advantages with a corporation if your total
taxable business income is more than $75,000.
* Don't select the corporation structure based on possible tax
advantages of profit-sharing plans since the Keogh, SEP, and IRA
plans available to a sole proprietorship are equally beneficial.
* If you consider a partnership, be certain to have a complete
partnership agreement drawn up by your attorney.
* Consider an S-corporation if you expect business losses for
the first year or two of your business. These losses can be
passed through to the owners as tax relief whereas they provide
no current benefit in a regular corporation.
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About the author:
Eran Salu, JD,MBA,CPA is the Founder and CEO of
TotalBusiness.com