One of the first decisions that potential business owners must confront is how their busi¬ness should be structured and operated. This crucial decision must be made even before the business has actually begun operations. The legal documents that will generally accompany the formation of a business can follow many different patterns, depending on the particular situation and the type of business to be undertaken.
Initially, the type of business entity to be used must be selected. There are many basic forms of business operating entities. The five most common forms are:
• Sole proprietorship
• Limited liability company
The choice of entity for a particular business depends on many factors. Which of these forms of business organization is chosen can have a great impact on the success of the business. The structure chosen will have an effect on how easy it is to obtain financing, how taxes are paid, how accounting records are kept, whether personal assets are at risk in the venture, the amount of control the “owner” has over the business, and many other aspects of the business. Keep in mind that the initial choice of business orga¬nization need not be the final choice. It is often wise to begin with the simplest form, the sole proprietorship, until the business progresses to a point where another form is clearly indicated. This allows the business to begin in the least complicated manner and allows the owner to retain total control in the important formative period of the business. As the business grows and the potential for liability and tax burdens increase, circumstances may dictate a re-examination of the business structure. The advantages and disadvantages of the five choices of business operation are detailed below.
A sole proprietorship is both the simplest and the most prevalent form of business organization. An important reason for this is that it is the least regulated of all types of business structures. Technically, the sole proprietorship is the traditional unincorporated one-person business. For legal and tax purposes, the business is the owner. It has no Corporation.
existence outside the owner. The liabilities of the business are personal to the owner and the business ends when the owner dies. On the other hand, all of the profits are also personal to the owner and the sole owner has full control of the business.
Perhaps the most important factor to consider before choosing this type of business structure is that all of the personal and business assets of the sole owner are at risk in the sole proprietorship. If the demands of the creditors of the business exceed those assets which were formally placed in the name of the business, the creditors may reach the personal assets of the owner of the sole proprietorship. Legal judgments for damages arising from the operation of the business may also be enforced against the owner’s personal assets. This unlimited liability is probably the greatest drawback to this type of business form. Of course, insurance coverage of various types can lessen the dangers inherent in having one’s personal assets at risk in a business. However, as liability insurance premiums continue to skyrocket, it is unlikely that a fledgling small business can afford to insure against all manner of contingencies and at the maximum coverage levels necessary to guard against all risk to personal assets.A second major disadvantage to the sole proprietorship as a form of business structure is the potential difficulty in obtaining business loans. Often in starting a small business, there is insufficient collateral to obtain a loan and the sole owner must mortgage his or her own house or other personal assets to obtain the loan. This, of course, puts the sole proprietor’s personal assets in a direct position of risk should the business fail. Banks and other lending institutions are often reluctant to loan money for initial small business start-ups due to the high risk of failure for small businesses. Without a proven track record, it is quite difficult for a small business owner to adequately present a loan proposal based on a sufficiently stable cash flow to satisfy most banks.
A further disadvantage to a sole proprietorship is the lack of continuity that is inherent in the business form. If the owner dies, the business ceases to exist. Of course, the assets and liabilities of the business will pass to the heirs of the owner, but the expertise and knowl¬edge of how the business was successfully carried on will often die with the owner. Small sole proprietorships are seldom carried on profitably after the death of the owner.
The most appealing advantage of the sole proprietorship as a business structure is the total control the owner has over the business. Subject only to economic considerations and certain legal restrictions, there is total freedom to operate the business however one chooses. Many people feel that this factor alone is enough to overcome the inherent disadvantages in this form of business. Related to this is the simplicity of organization of the sole proprietorship. Other than maintenance of sufficient records for tax purposes, there are no legal requirements on how the business is operated. Of course, the prudent businessperson will keep ade¬quate records and sufficiently organize the business for its most efficient operation. But there are no outside forces dictating how such internal decisions are made in the sole proprietorship. The sole owner makes all decisions in this type of business.
As was mentioned earlier, the sole proprietorship is the least regulated of all businesses. Normally, the only license necessary is a local business license, usually obtained by simply paying a fee to a local registration authority. In addition, it may be necessary to file an affidavit with local authorities and publish a notice in a local newspaper if the business is operated under an assumed or fictitious name. This is necessary to allow creditors to have access to the actual identity of the true owner of the business, since it is the owner who will be personally liable for the debts and obligations of the business.
Finally, it may be necessary to register with local, state, and federal tax bodies for I.D. numbers and for the purpose of collection of sales and other taxes. Other than these few simple registrations, from a legal standpoint little else is required to start up a business as a sole proprietorship.
A final and important advantage to the sole proprietorship is the various tax benefits available to an individual. The losses or profits of the sole proprietorship are considered personal to the owner. The losses are directly deductible against any other income the owner may have and the profits are taxed only once at the marginal rate of the owner. In many instances, this may have distinct advantages over the method by which part-nerships are taxed or the double taxation of corporations, particularly in the early stages of the business.
A partnership is a relationship existing between two or more persons who join together to carry on a trade or business. Each partner contributes money, property, labor, and/or skill to the partnership and, in return, expects to share in the profits or losses of the business. A partnership is usually based on a partnership agreement of some type, al¬though the agreement need not be a formal document. It may even simply be an oral understanding between the partners, although this is not recommended.
A simple joint undertaking to share expenses is not considered a partnership, nor is a mere co-ownership of property that is maintained and leased or rented. To be considered a partnership for legal and tax purposes, the following factors are usually considered:
• The partners’ conduct in carrying out provisions of the partnership agreement
• The relationship of the parties
• The abilities and contributions of each party to the partnership
• The control each partner has over the partnership income and the purposes for which the income is used
The disadvantages of the partnership form of business begin with the potential for conflict between partners. Of all forms of business organization, the partnership has spawned more disagreements than any other. This is generally traceable to the lack of a decisive initial partnership agreement that clearly outlines the rights and duties of the partners. This disad¬vantage can be partially overcome with a comprehensive partnership agreement. However, there is still the seemingly inherent difficulty many people have in working within the framework of a partnership, regardless of the initial agreement between the partners.
A further disadvantage to the partnership structure is that each partner is subject to unlimited personal liability for the debts of the partnership. The potential liability in a partnership is even greater than that encountered in a sole proprietorship. This is due to the fact that in a partnership the personal risk for which one may be liable is partially out of one’s direct control and may be accrued due to actions on the part of another person. Each partner is liable for all of the debts of the partnership, regardless of which partner may have been responsible for their accumulation.
Related to the business risks of personal financial liability is the potential personal legal liability for the negligence of another partner. In addition, each partner may even be liable for the negligence of an employee of the partnership if such negligence takes place during the usual course of business of the partnership. Again, the attendant risks are broadened by the potential for liability based on the acts of other persons. Of course, general liability insurance can counteract this drawback to some extent to protect the personal and partnership assets of each partner.
Again, as with the sole proprietorship, the partnership lacks the advantage of conti¬nuity. A partnership is usually automatically terminated upon the death of any partner. A final accounting and a division of assets and liabilities is generally necessary in such an instance unless specific methods under which the partnership may be continued have been outlined in the partnership agreement.
Finally, certain benefits of corporate organization are not available to a partnership. Since a partnership cannot obtain financing through public stock offerings, large infusions of capital are more difficult for a partnership to raise than for a corporation. In addition, many of the fringe benefit programs that are available to corporations (such as certain pension and profit-sharing arrangements) are not available to partnerships.
A partnership, by virtue of combining the credit potential of the various partners, has an inherently greater opportunity for business credit than is generally available to a sole proprietorship. In addition, the assets which are placed in the name of the partnership may often be used directly as collateral for business loans. The pooling of the personal capital of the partners generally provides the partnership with an advantage over the sole proprietorship in the area of cash availability. However, as noted above, the partnership does not have as great a potential for financing as does a corporation.
As with the sole proprietorship, there may be certain tax advantages to operation of a business as a partnership, as opposed to a corporation. The profits generated by a partnership may be distributed directly to the partners without incurring any “double” tax liability, as is the case with the distribution of corporate profits in the form of div¬idends to the shareholders. Income from a partnership is taxed at personal income tax rates. Note, however, that depending on the individual tax situation of each partner, this aspect could prove to be a disadvantage.
For a business in which two or more people desire to share in the work and in the profits, a partnership is often the structure chosen. It is, potentially, a much simpler form of business organization than the corporate form. Less start-up costs are necessary and there is limited regulation of partnerships. However, the simplicity of this form of business can be deceiving. A sole proprietor knows that his or her actions will determine how the business will prosper, and that he or she is, ultimately, personally responsible for the success or failure of the enterprise. In a partnership, however, the duties, obliga¬tions, and commitments of each partner are often ill-defined. This lack of definition of the status of each partner can lead to serious difficulties and disagreements. In order to clarify the rights and responsibilities of each partner and to be certain of the tax status of the partnership, it is good business procedure to have a written partnership agreement. All states have adopted a version of the Uniform Partnership Act, which provides an outline of partnership law. Although state law will supply the general boundaries of partnerships and even specific partnership agreement terms if they are not addressed by a written partnership agreement, it is better for a clear understanding of the business structure if the partner’s agreements are put in writing.
A corporation is a creation of law. It is governed by the laws of the state where it was incorporated and of the state or states in which it does business. In recent years it has become the business structure of choice for many small businesses. Corporations are, generally, a more complex form of business opera¬tion than either a sole proprietorship or partnership. Corporations are also subject to far more state regulations regarding both their formation and operation. The following discussion is provided in order to allow the potential business owner an understanding of this type of business operation.
The corporation is an artificial entity. It is created by filing Articles of Incorporation with the proper state authorities. This gives the corporation its legal existence and the right to carry on business. The Articles of Incorporation act as a public record of certain formalities of corporate existence. Preparation of Articles of Incorporation is explained in detail in Chapter 9. Adoption of corporate bylaws, or internal rules of operation, is often the first business of the corporation, after it has been given the authority to conduct business by the state. The bylaws of the corporation outline the actual mechanics of the operation and management of the corporation. The preparation of corporate bylaws is explained in Chapter 10.
There are two basic types of corporations: C-corporations and S-corporations. These prefixes refer to the particular chapter in the U.S. Tax Codes that specify the tax con¬sequences of either type of corporate organization. In general, both of these two types of corporations are organized and operated in similar fashion. There are specific rules that apply to the ability to be recognized by the U.S. Internal Revenue Service as an S-corporation. In addition, there are significant differences in the tax treatment of these two types of corporations. These differences will be clarified later in this chapter under the heading “S-Corporations.” The basic structure and organizational rules below apply to both types of corporations, unless noted.
In its simplest form, the corporate organizational structure consists of the following levels:
• Shareholders: who own shares of the business but do not contribute to the direct management of the corporation, other than by electing the directors of the corporation and voting on major corporate issues
• Directors: who may be shareholders, but as directors do not own any of the business. They are responsible, jointly as members of the board of directors of the corporation, for making the major business decisions of the corporation, including appointing the officers of the corporation
• Officers: who may be shareholders and/or directors, but, as officers, do not own any of the business. Officers (generally the president, vice president, secretary, and treasurer) are responsible for day-to-day operation of the corporate business
Due to the nature of the organizational structure in a corporation, a certain degree of individual control is necessarily lost by incorporation. The officers, as appointees of the board of directors, are answerable to the board for management decisions. The board of directors, on the other hand, is not entirely free from restraint, since it is responsible to the shareholders for the prudent business management of the corporation.
The technical formalities of corporation formation and operation must be strictly ob¬served in order for a business to reap the benefits of corporate existence. For this reason, there is an additional burden and expense to the corporation of detailed recordkeeping that is seldom present in other forms of business organization. Corporate decisions are, in general, more complicated due to the various levels of control and all such deci¬sions must be carefully documented. Corporate meetings, both at the shareholder and director levels, are more formal and more frequent. In addition, the actual formation of the corporation is more expensive than the formation of either a sole proprietorship or partnership. The initial state fees that must be paid for registration of a corporation with a state can run as high as $900.00 for a minimally capitalized corporation. Corporations are also subject to a greater level of governmental regulation than any other type of business entity. These complications have the potential to overburden a small business struggling to survive. The forms and instructions in this book are all designed to lessen the burden and expense of operating a business corporation.
Finally, the profits of a corporation, when distributed to the shareholders in the form of dividends, are subject to being taxed twice. The first tax comes at the corporate level. The distribution of any corporate profits to the investors in the form of dividends is not a deductible business expense for the corporation. Thus, any dividends that are distributed to shareholders have already been subject to corporate income tax. The sec-ond level of tax is imposed at the personal level. The receipt of corporate dividends is considered income to the individual shareholder and is taxed as such. This potential for higher taxes due to a corporate business structure can be moderated by many factors, however.
One of the most important advantages to the corporate form of business structure is the potential limited liability of the founders of and investors in the corporation. The liability for corporate debts is limited, in general, to the amount of money each owner has contributed to the corporation. Unless the corporation is essentially a shell for a one-person business or unless the corporation is grossly under-capitalized or under-insured, the personal assets of the owners are not at risk if the corporation fails. The shareholders stand to lose only what they invested. This factor is very important in attracting investors as the business grows.
A corporation can have a perpetual existence. Theoretically, a corporation can last for¬ever. This may be a great advantage if there are potential future changes in ownership of the business in the offing. Changes that would cause a partnership to be dissolved or terminated will often not affect the corporation. This continuity can be an important factor in establishing a stable business image and a permanent relationship with others in the industry.
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 his or her stock unless this right is formally restricted by reasonable corporate decisions. The new owner of such stock is then a new owner of the business in the proportion¬ate share of stock obtained. This freedom offers potential investors a liquidity to shift assets that is not present in the partnership form of business. The sale of shares by the corporation is also an attractive method by which to raise needed capital. The sale of shares of a corporation, however, is subject to many governmental regulations on both the state and federal levels.
Taxation is listed both as an advantage and as a disadvantage for the corporation. De¬pending on many factors, the use of a corporation can increase or decrease the actual income tax paid in operating a corporate business. In addition, corporations may set aside surplus earnings (up to certain levels) without any negative tax consequences. Finally, corporations are able to offer a much greater variety of fringe benefit programs to employees and officers than any other type of business entity. Various retirement, stock option, and profit-sharing plans are only open to corporate participation.
The S-corporation is a certain type of corporation that is available for specific tax purposes. It is a creation of the Internal Revenue Service. S-corporation status is not relevant to state corporation laws. Its purpose is to allow small corporations to choose to be taxed, at the Federal level, like a partnership, but to also enjoy many of the ben¬efits of a corporation. It is, in many respects, similar to a limited liability company. The main difference lies in the rules that a company needs to meet in order to qualify as an S-corporation under Federal law.
In general, to qualify as an S-corporation under current IRS rules, a corporation must meet certain requirements:
• It must not have more than 75 shareholders
• All of the shareholders must, generally, be individuals and U.S. citizens
• It must only have one class of stock
• Shareholders must consent to S-corporation status
• An election of S-corporation status must be filed with the IRS
The S-corporation retains all of the advantages and disadvantages of the traditional corporation except in the area of taxation. For tax purposes, S-corporation sharehold¬ers are treated similarly to partners in a partnership. The income, losses, and deduc¬tions generated by an S-corporation are “passed through” the corporate entity to the individual shareholders. Thus, there is no “double” taxation of an S-corporation. In addition, unlike a standard corporation, shareholders of S-corporations can personally deduct any corporate losses. For information on setting up an S-Corporation, please see Nova Publishing Company’s S-Corporation: Small Business Start-up Kit.
The decision of which business entity to choose depends upon many factors and should be carefully studied. If the choice is to operate a business as a S-corporation, this book will provide an array of easy-to-use legal forms that will, in most cases, allow the business owner to start and operate the corporation with minimal difficulty while meeting all of the legal paperwork requirements.
© Nova Publishing Company, 2005