“How to Determine the Legal Structure of Your Business”

WHAT TO EXPECT

This Business Builder will provide you with the information you need to help determine the best business structure for you.

WHAT YOU SHOULD KNOW BEFORE GETTING STARTED [top]

Going into business requires not only the knowledge of your trade but the understanding of the laws on a local, state, and federal level. There are many reasons today for owner-managers of small businesses to look at the legal business structure of their firms. Changing laws and the need for capital are just two of the many factors which require owner-managers to carefully evaluate which legal structures best meet their needs. This Business Builder will provide you with the information you need to help determine the best business structure for you.

As a small business owner, you must play many roles in order to keep the business functioning smoothly and properly. However, there are times that you shouldn’t try to be lawyer, accountant, marketing specialist, foreman, salesman, etc. Instead, take advantage of the professional advice that is so readily available. A good attorney or CPA can help you interpret the many legal and technical issues which pertain to any one or all of the legal structures for business. Your savings in time and money for utilizing a professional advisor can far outweigh the possible expense of missteps and wrong turns when selecting the business structure for your firm. Because laws are constantly changing, it is best to consult an attorney or accountant for the latest in regulations and requirements before you decide on the right business structure for you.

WHAT ARE MY ALTERNATIVES? [top]

In order to intelligently select the legal structure of your business, you must be knowledgeable about the alternatives from which you may choose. A business venture can be structured in several ways; however, the law classifies businesses so that most fall into one of three legal forms. They are:

• Sole Proprietorship
• General Partnership
• Corporation

There are also variations on some of these basic legal forms — the S corporation, the limited partnership, and the limited liability company (LLC), a relatively new form of business organization, which has gained legal status in a majority of states.

Each business structure you are about to review has its advantages and disadvantages. There is no good or bad structure. The optimum choice depends solely on your personal situation. Read through each section carefully. Then, decide which structure is best suited to your business needs.

Sole Proprietorship

The simplest (and least amount of paperwork) of any of the legal business structures is the sole proprietorship. To establish a sole proprietorship, you will need a good idea, a lot of determination, and an endless supply of energy for the hard work ahead. However, the only paperwork you’ll need is that required for filing a fictitious name (if you decide not to use your own) and whatever licenses you’ll need to begin your operations. You are not required to perform any formal action to set up a sole proprietorship. Consequently, there is no need to hire professionals to file required government documents to get you started. You do it all yourself!

With nearly three quarters of all businesses operating as sole proprietorships, this business structure is by far the most popular of any of the structures. In fact, many businesses that are partnerships and corporations today, initially started out as sole proprietorships and changed when it became advantageous to do so.

As a sole proprietorship, the business is owned and operated by one person — you! You don’t have any partners to confer with or boards to answer to. The law recognizes you and the business as one in the same. The business is you; you are the business. And it’s this single entity status that is responsible for the advantages of setting up as a sole proprietor and the disadvantages, as well.

Advantages

• Easy to form — As mentioned, this is the easiest business structure to set up. Minimal amounts of paperwork and red tape are associated with this type of business format.
• Least expensive to set-up — Costs vary depending upon where you live, but typically all you’ll need to pay is a nominal business license fee and maybe a business tax. Contact your city or county government offices for their requirements.
• Ease of dissolution — Just as easy as setting up this type of business is ending it. As sole owner, you can dissolve your business at any time. There is no legal waiting period or formal paperwork involved.
• Sole recipient of profits (and losses) — You, as owner, receive all of the profits and losses from the business. Profits and losses are reported directly on your individual income tax return. In the event that you suffer business losses, you can deduct them against any other income you may have to reduce your overall tax burden.
  

  For example, Gina has decided to start up her own advertising firm on a part-time basis. Her plan is to continue her job as Director of Advertising for her town’s leading newspaper until she is making enough money on her own to go it alone full-time. In the first years of operating her part-time business, Gina is able to off-set her income from the newspaper with the net losses from her part-time business to reduce the overall income tax she must pay as an individual.

• Maximum authority — No need to worry about organizational maneuvering and management manipulation here, you, and you alone, make all the business decisions.
• Tax-free asset withdrawal — You can shift funds in and out of your business accounts or withdraw assets from the business with few tax or other legal ramifications.

Disadvantages

• Unlimited personal liability — This is by far the major disadvantage to this type of business structure. As the sole proprietor, you are responsible for all debt incurred by the business. Since the law recognizes you and the your business as one, your business AND personal assets can be confiscated to satisfy your business obligations. After your business assets are depleted, creditors can seek payment of the remainder of your outstanding debt by coming after your personal assets such as your home and car.
  

  For instance, let’s say your widget business has suffered a significant loss in market share due to increased competition from the Pacific Rim. You’ve done everything in your power to hold on, but you’re left with no other alternative but to liquidate. Unfortunately, after your "going out of business sale" you still have some outstanding debts, and these creditors are unwilling to work out any kind of extended payment plan whatsoever to satisfy the debt. Therefore, you are forced to sell your house and auction your belongings to cover the debt. Both you and your business are ruined.

• Limited ability to raise capital — Quite often until your business grows and has gained a good credit rating, you may find it difficult to get business loans which would otherwise help your business grow. Bankers grant loans based on the strength of the owner(s)/investor(s). Going solo may prolong the time it takes to raise capital for your business.
• Growth of business limited to personal energies — There is only so much you can do as owner, administrator, marketing representative, billing clerk, etc. on an daily basis. New business might have to wait until your schedule allows you the time.
• Limited tax savings for fringe benefits — As a sole proprietor, you are not qualified to receive the tax benefits that corporations get for offering certain fringe benefits such as group-term life insurance benefits, long-term disability insurance coverage, and medical insurance or medical expense reimbursements.
• Termination of business upon owner’s death — Since the individual and business are a single entity, the business ceases to exist once the owner dies.

General Partnership

According to the Uniform Partnership Act (which most states have adopted), a partnership is an "association of two or more persons to carry on as co-owners of a business for profit." Frequently, you may decide to take on a partner because he has skills or expertise that you may lack. However, take special care in choosing a suitable partner. Don’t select the first person that offers to make an investment in your company. A partnership is a marriage in many ways; however, few take the time and put in the effort to pick a partner that they would in choosing a spouse. Nevertheless, many a business has had to close its doors because the business union did not work.

In many ways the partnership structure is very similar to the sole proprietorship. For instance, there is unlimited liability for partners and a limited life of the business. Where it differs, however, is that you can share the work, financial pressures, decision-making, and everything else that goes along with the business with a trusted colleague. If you’ve selected your partners well, you can expect to reap synergistic benefits.

There can be many different variations on the partnership theme, depending upon how active your partners are. You can have general partners who share in the managing, financing and liability of the company, or you can have limited partners, who do not take an active role in the managing of the business but whose liability is limited to their investment. More on limited partnerships will be discussed later in the Business Builder. Also, partnerships don’t necessarily have to be divided up equally, either. It is perfectly legitimate for one partner to have majority ownership.

For example, Larry’s Limited, a wholesaler of farm equipment, was structured as a general partnership with Larry, Harry, and Barry as co-owners. Because of the various levels of experience and capital that each owner brought to the business, it was decided that each partner’s share of the business would directly relate to his contribution. Since Larry had formerly run a similar company and was providing the majority of seed capital for startup, it was decided that he would retain 50% share of the business while Harry and Barry each would have 25%.

Now, let’s look at some of the major advantages and disadvantages of a partnership.

Advantages

• Easy to establish — Like the sole proprietorship, there is no formal paperwork or waiting period. If you operate under a fictitious name, you’ll need to file a "Certificate of Conducting Business as Partners." It’s recommended that you draw up an "Articles of Partnership" agreement (discussed later) which will be an additional cost. More than likely, you’ll also need to obtain a business license to get you started.
• Synergistic — Draws upon financial and managerial strength of all of the partners. Generally speaking, "Two heads are better than one" when you’ve recruited the right partners. A good partnership will be one whose partners complement one another’s skills and expertise.
• Stronger growth potential — Your chances for acquiring a loan will increase when there’s more than one of you. Bankers look upon partnerships more favorably than sole proprietorships. There are more than a single credit rating to research and if something should happen to an owner, there are other owners that can step in and take over. Also, with more than one owner, you’ll be able to take advantage of additional talent and expertise needed to grow your business.
• Direct rewards — Partners reap the benefits of their efforts by directly sharing in the profits.
• Freedom from government control and special taxation — While a partnership must file federal (Form 1065) and usually state information returns, it generally pays no income tax. Instead the partners report each their share of income or loss on their own individual income tax return.

Disadvantages

• Unlimited personal liability for the firm’s debts — As is the case with the sole proprietorship, you and each of your partners have personal liability for the debts, taxes and other claims against the partnership.
• Business terminates upon death of a partner — Unless a partnership agreement provides otherwise, a partnership usually terminates when any partner dies or withdraws from the partnership.
• Any partner can commit the business to obligations — Any partner is considered an agent for the partnership and can make decisions which might commit the partnership beyond realistic expectations. Difficulty of disposing of partnership interest-unless specifically arranged for in the written agreement.

Partnership Agreement

Although not legally required, a Partnership Agreement, also known as Articles of Partnership, are often drawn up to outline the contribution of each of the partners into the business. These articles determine the roles of the partners in the business relationship, whether financial, material, or managerial. Following are some you might want to include in your "written articles of partnership" to protect the best interest of your partnership.

• Capitalization — This provides for the initial capitalization of the business, turning what is usually a moral obligation into a legal one. A business cannot promote its ideas without adequate funds to back them up. Since there is no way to adequately predict the future financial needs of the business, this is a one-shot provision rather than a continuing obligation.
• Authority/Dispute Resolution — This provides for arbitration of disputes among the partners. Arbitration is a much simpler and less expensive method of settling disputes between parties, as there is no outside litigation required. Because this agreement is written by and for its own participants, and are, therefore, sometimes viewed with skepticism by the courts, the participants should decide whether certain or all disputes concerning the business be arbitrated.
• Management — The method of management for the business should also be covered by the partnership agreement. The agreement may limit or enhance the normal powers of partners. This agreement may also provide for non-competition between the owners and the business. as well as provide the method for computing salaries and bonuses. Also included here is a provision for continuing the business in the event one of the owners becomes so disabled that he or she is unable to help manage the business.
• Sale of Partnership Interest — This is one of the most important provisions in the agreement. It is a restriction on the participant’s right to sell their interest to third parties. The partners chose each other because of their personal qualities, therefore, permitting one to sell his or her share to a third party would defeat the intent of both partners. On the other hand, it is unfair to force a partner to continue in a business. The agreement should provide for a method by which the dissatisfied partner can dispose of his or her interest in the business without forcing the other partner to take in a stranger. One method is a right for the business or other partner to buy the interest before it is offered to outsiders. The provision must cover the method of determining the price and the terms of payment for the dissatisfied owner’s interest.
• Death of Partner — In the event that one of the partners dies or becomes permanently disabled, this provides for a mandatory buy-out of the dead partner’s interest in the business. Failure to provide for these contingencies could lead to tremendous difficulties for the business. In the absence of such an agreement, the death of a partner automatically dissolves partnership.

Limited Partnerships

In a limited partnership, the law provides for a special kind of arrangement whereby certain partners have limited personal liability. The limited partnership is more regulated than the more common general partnership, but it allows investors who will not be actively involved in the partnership’s operations to become partners without being exposed to unlimited liabilities of the business’ debts if it should go out of business.

A limited partner risks only his or her investment but in exchange for this must allow one or more general partners to exercise control over the business. In fact, if the limited partner becomes involved in the operations of the partnership, he or she may lose his or her protected status as a limited partner. The general partners in a limited partnership are fully liable for the debts of the partnership.

There are state laws requiring certain formalities in a limited partnership that are not required in other partnerships. To qualify for their special status, limited partnerships must usually file a Certificate of Limited Partnership with the secretary of state or other state and county offices. Establishing a limited partnership also requires a written partnership agreement.

Corporation

This type of business structure is considered the most formalized and complex form of business organization. It is costlier, more difficult and requires more paperwork.

A corporation is a separate legal entity which is organized in accordance with state and federal statutes. Ownership is divided into shares of stock. The business activities are dictated by a charter stating the powers and limitations of the particular business. Corporations which do business in more than one state must comply with the Federal laws regarding interstate commerce and with the state laws, which may vary considerably.

Now, let’s look at some of the advantages and disadvantages of a corporation.

Advantages

• Liability is limited to the amount owners have paid for their share of stock. Generally, stockholders in a corporation are not personally liable for claims against the corporation and are, therefore, only liable for their personal investment.
• Life of the business is unaffected by death or transfer of shares by and of its owners. The business will continue as a corporation indefinitely. Creditors, suppliers, and customers often prefer to deal with an incorporated business because of this continuity.
• Easier to raise capital in larger amounts and from many investors.
• Delegated authority. Centralized control is secured when owners delegate authority to hired managers.
• Draws upon financial and managerial strength (expertise) of all of the owners.

Disadvantages

• More expensive to form. There are many forms to file, such as articles of incorporation charters, permits. The legal fees to file these forms can be substantial.
• Power limited by charter and various laws. Once established, the charter dictates all decisions, activities, etc. of the business.
• Extensive record keeping. Because of the various forms involved with a corporation and continuous filing schedules with the government, both state and federal, ongoing record keeping is a must.
• Manipulation. Minority stockholders are sometimes exploited.
• Double taxation. Taxes on profits of the business and taxes on dividends are paid to the owners. The last item listed under Disadvantages, Double taxation, can be avoided by filing as an "S" Corporation.

An S corporation is like any other corporation in terms of corporate law requirements, limited liability of shareholders, and all other corporate aspects, except tax treatment. An S corporation is a regular corporation which has essentially elected to be treated somewhat like a partnership for federal income tax purposes. S corporations do not pay tax at the corporate level. Instead, taxable income, losses, deductions, and credits are passed through to the corporation’s stockholders. Tax law changes enacted by the Tax Reform Act of 1986 have caused many businesses currently taxed under corporate tax rules (known as "C" corporations) to reexamine their tax options.

When operating as an S corporation, individuals are taxed at a top tax rate of 28%. Corporations, on the other hand, are taxed at a maximum rate of 34%. (These figures are subject to change. Consult your tax advisor for the current rates.) Obviously, paying taxes as an S corporation may be more desirable under the new law.

In certain instances, an S corporation may be subject to tax on "built-in gains." Built-in gains are untaxed gains on the assets of a corporation that would have been recognized as taxable if the assets had been sold at fair market value on the day a corporation became an S corporation.

Profits of the corporation are scheduled to be disbursed to the shareholders on the last day of the corporation’s tax year, whether or not the profits are actually distributed. Consequently, if an S corporation’s profits are distributed as dividends, the distribution itself is usually not taxable, so there is not double taxation of distributed profits.

In addition to the income tax advantages, an S corporation status can eliminate accumulated earnings tax problems because all earnings, whether distributed or not, are taxed to the stockholders each year. In addition, S corporation stockholders can apply their deductible personal losses against their pro rata share of the company’s taxable income. They can also deduct their pro rata share of an S corporation’s net operating loss from their personal gross income.

In order to qualify as an S corporation, your business must meet the following requirements:

The corporation must be created under the laws of the U.S. or one of the 50 states.

The corporation must have 35 or fewer stockholders. (A husband and wife will be considered a single stockholder.)

All stockholders must be individuals, decedents’ estates, bankruptcy estates, or certain types of trusts.

The corporation must have only one class of stock issued and outstanding. Differences only in voting rights do not mean shares of stock are of different classes.

An S corporation election should not be made without the advice and assistance of a tax professional, since it is a very complex and technical area of the tax law.

Electing S corporation status for a corporation is usually most favorable in these situations:

Where it is expected that the corporation will experience losses for the initial year or years of doing business and where the shareholders will have income from other sources the business losses can shelter from tax.

Where, because of the low tax brackets of the shareholders, there will be tax savings if the anticipated profits of the business are passed through to them rather than being taxed at corporate tax rates.

Where the nature of the business is such that the corporation does not need to retain a major portion of profits in the business. In this case, all or most of the profits can be distributed as dividends without the double taxation that would occur if no S corporation status were in effect.

Where a business is in danger of incurring an accumulated earnings penalty tax for failure to pay out its profits as dividends.

Possible disadvantages of S corporation status must also be considered. The taxable income of an S corporation is taxed to stockholders even if the income is not actually distributed to them. Consequently, if the cash flow of a business is uneven or uncertain, S corporation status may not be the wisest choice. Finally, certain items that are tax deductible for a C corporation, such as the costs of certain fringe benefits, are not deductible for an S corporation.

Limited Liability Companies

In addition to the three major forms of business structures discussed, many states have adopted a new type of entity called a limited liability company (LLC). An LLC is similar to and taxed as a partnership, and it offers the benefit of limited liability like corporations and S corporations.

In 1988, a Wyoming limited liability company was permitted to be classified as a partnership for federal income tax purposes, despite its limited liability, due to the short-term life of the business. In some states, LLCs are required to terminate in a specified period of years, usually 30 years or less. LLCs offer the corporate benefits of limited liability, while retaining the flexible flow-through tax treatment of a partnership.

As in all other business structures, there are disadvantages to the LLC. Because not all states have adopted a limited liability company law, if you set up an LLC in one state which allows LLCs and you do business in another state, which does not, your LLC may not provide any limited liability protection from creditors in that state. This is a severe risk, and one you won’t face if your business is incorporated.

As your business matures, the initial choice of a business structure, no matter how well it performed in the startup phase, may require adjustment or alteration.

Ask yourself the following questions as an aid in determining what business structure may best suit your business plan.

• What would the continuity (life) of the firm be if something happened to me?
• What are the costs and procedure in starting? Licenses?
• What is the ultimate goal and purpose of the business, and which legal structures can best serve its purpose?
• What is the size of the risk (i.e., what is the amount of the investors’ liability for debts and taxes)?
• What legal structure would insure the greatest adaptability of administration for the business?
• What are the possibilities for additional capital?
• What are the needs for and possibilities (if any) of attracting additional expertise?
• What is the influence of applicable laws?

RESOURCES [top]

U.S. Small Business Administration

Delaware Small Business Development Center

Writer: Lynn Phillips

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