Small Business Entity Structures

For someone who is starting a business, there are many different things to consider. One of the first things to decide when starting a business is which business entity, or entities, the business should operate as. There are five main types of business entities: sole proprietorships, partnerships, limited liability corporations, S-corporations, and corporations (also known as C-corporations). When looking into further detail at the different types of businesses, there are many things to consider about each: How big will the business be? What will the nature of the business be? What level of control should the owner have? What is the business’ vulnerability to lawsuits? What are the different tax implications? What is the expected profit of the business? How will capital for the business be raised? Each of these questions is critical to ask during the process of selecting the right business entity.

 

Sole Proprietorship

Whenever someone first starts a small business, they are most likely planning to operate it as a sole proprietorship. The vast majority of small businesses in the United States start out as sole proprietorships. Sole proprietorships are the oldest and most simple forms of business. A sole proprietorship is a good entity to operate a business if the owner does not expect a massive amount of growth, or if there is an estimated low amount of liability exposure. Also, if the business itself does not justify the extra regulations and formalities associated with corporations, a sole proprietorship is advantageous. The most distinct characteristic of a sole proprietorship is the fact that the owner and the business are one in the same; a single legal entity. Because of the sole proprietorship’s status of having no legal distinction between the business and the owner, the owner is free to use his personal credit and capital to invest in the business. This being said, all the profits or losses incurred are accrued to the owner himself, and are subject to taxation. Since all the assets of a sole proprietorship are personally owned by the business owner, the business owner is legally liable for any debts or lawsuits that are created by the sole proprietorship. Being personally liable for a sole proprietorship means that not only are business resources and assets at risk, but personal resources and assets as well. This is due to the fact that the business and the owner are one in the same under the law. To operate a business as a sole proprietorship, an owner may use a “doing business as” or a trade name instead of his name. By creating a trade name, an owner can open up a separate bank account to use strictly for the sole proprietorship. In order to create a “doing business as” name, an owner can visit a local courthouse to officially register the name. According to the IRS, the owner of a sole proprietorship is responsible for the following taxes: income tax, self-employment tax, estimated tax, Social Security, Medicare, income tax withholding, federal unemployment tax, and excise taxes.

There are clear advantages to operating a business as a sole proprietorship.  A sole proprietorship is the easiest and most inexpensive form of business to organize, with a lack of corporate formalities and regulations. If an owner has the capital needed to start the business, then he can hit the ground running as soon as the business is registered with the courthouse. Due to the lack of regulation, sole proprietors have the greatest range of control within their businesses. As long as they operate within the parameters of the law and pay the required personal taxes, owners of sole proprietorships can make any business decision as they see fit. Because the owner of a sole proprietorship personally receives all the income generated from the business, the owner has full say in what to do with the profits. A sole proprietor may choose whether or not to reinvest or keep profits for personal use. While some businesses, such as S-Corporations, have strict regulations on how profits are distributed, the legal simplicity of a sole proprietorship allows for the maximum amount of flexibility in allocating profits and dealing with losses. This simplicity of running a sole proprietorship is also apparent for taxation purposes, where all profits flow directly into the owner’s personal tax return. The sole proprietor’s taxes include personal and business. This legal classification makes tax season relatively simple for sole proprietors. Another major advantage of having a sole proprietorship is the ease by which a sole proprietorship can be dissolved. If an owner decides to stop running the business, the dissolution of the sole proprietorship is easier to dissolve than any other type of entity. There are no legal battles with a partner or shareholders.

While a sole proprietorship offers many advantages, the disadvantages are also good to consider before deciding to start a sole proprietorship. Since the owner and the business are one single entity, the owner of a sole proprietorship can be in for some serious trouble if the business acquires a lot of debt or has a lawsuit filed against the business. The owner’s personal belongings and money can be taken away to rectify the lawsuit or business debt owed. Unlike a corporation, a sole proprietorship cannot simply go out and sell stock in the company, which makes raising capital more difficult. Often, sole proprietors are limited to using funds from personal savings or loans. A sole proprietorship can be viewed as a source of “unstable employment” as well as a job that does not offer impressive compensation or benefits. For this reason, it can be very difficult to attract high-caliber employees to work in a sole proprietorship. On top of that, a sole proprietorship does not have the internal resources to find, recruit, or hire new employees like many corporations and other large companies do. Another employee-related issue that arises in sole proprietorships is that employee benefits such as owner’s medical insurance premiums are not directly deductible from the business income. Therefore, it can be more expensive for a sole proprietorship to provide benefits for both the owner and employees.

 

Partnerships

Partnerships are comparable to two sole proprietors joining together to share their resources and work together in a common business. When talking about partnerships it is important to consider the external and internal relationships that are taking place. External relationships for a partnership are the business activities that occur with the rest of the world. On the other hand, the internal relationship refers to the relationship between the partners within the business. In explaining limited liability, partnership formation, operation of a partnership, taxation, and business termination you will begin to see why these relationships are important when considering whether or not to form a small business in the form of a partnership.

Partnerships have full unlimited personal liability for anything within their own business. This concept is exactly the same as a sole proprietorship except that in the case each partner is fully responsible for the actions of the other. Therefore, all partners are taking on the liability of all other partners in the business and the employees. Many times partners will develop partner agreements stating the limitations of the partners such as withdrawing money or making purchases. Should the partner decide to violate the partnership agreement, the other partner is still liable for the actions unless the third party involved in the transaction was aware of the partnership agreement. The unlimited liability of the partners only applies to situations that pertain to the business itself. Should the partnership be sued or found liable in a situation, the assets of the partnership and personal assets of the partners would be used to pay the damages being brought against the business.

Forming a partnership requires no legal action, the only requirement is that two or more people come together to partake in a common business activity where they share management roles, profits, and responsibilities. Nothing has to be filed for a partnership to be formed, but there could be some legal requirements such as registering the name of the partnership.

When it comes to the operation of a partnership the partners within the business serve as managers, owners, and also employees. The element of control can be difficult when running a business on a collective basis. In order for partnerships to operate more successfully, the partners are encouraged to draw up a partnership agreement in which the responsibilities of each owner are addressed. Should the partnership not adopt its own policies, the partnership will be required to adhere to the state’s partnership agreements. Some common issues that are good to put in this document are voting rights, decision making processes, and the addition or dismissal of a partner. It is highly advisable to consult an attorney when starting a partnership.

Taxation of a partnership does not usually include the transfer or contribution of assets for the business from each partner, but this can change depending on state laws and requirements. Bartering is a transaction within a partnership that is taxable and must be included in a partnership’s records. With matters such as these it is recommended to consult an accountant. Otherwise, partnerships are not taxed as a separate entity but as two sole proprietors combining together for a common business purpose. The partnership is required to fill out a partnership tax form which reports collective income and expenses for the business. The taxes are not distributed here but rather from the total profit or loss among partners in proportion to their interest in the partnership. The partners are held responsible for reporting any profits or losses on their individual returns.

There are a couple of ways to plan for the termination of a partnership. One way is to set a specific date of termination for the partnership. Another common way to deal with termination within a partnership is to enter an “at-will” partnership agreement. Similar to at-will employment, at-will partnerships allow partners to remove themselves at anytime for any reason.  When a partner dissolves, the partnership does not cease to exist as a business, but rather must close down, liquidate and pay creditors unless otherwise mentioned in the partnership agreement.

If a partnership decides not to continue as a business then the assets are distributed among the partners. This distribution is based upon the amount of interest each partner invested in the business. If the partnership decides to sell, however, the amount of gain or loss on each asset will be divided among partners based on their interest and must be reported on their individual tax returns. A partnership can continue being a business by selling one partner’s interest in the business to a third party.

Limited Liability Company

When choosing a business entity, many small businesses often choose a more flexible structure such as a Limited Liability Company. An LLC combines the advantages of a corporation and a partnership or sole proprietorship without their disadvantages. For this reason LLCs are often referred to as hybrid companies. One of the benefits of LLCs include limited liability protection which is similar to the protection a corporation receives but with fewer formalities. Pass-through taxation is also a benefit in an LLC that can be seen as a benefit in a partnership. Owners of an LLC are called members, as opposed to stockholders in a corporation; there is no maximum number of members for LLCs and most states also allow single member LLCs. Members, just like shareholders in a corporation, are the owners of the LLC. These members can be persons, corporations, partnerships, or other LLCs.

The federal government does not recognize an LLC as a classification for tax purposes; therefore LLCs have the choice of being taxed as a corporation, a partnership, or a sole proprietorship depending on the number of members. Multiple member LLCs can choose to be taxed as either a corporation, which includes S-Corporations, or a partnership. An Entity Classification Election form must be filed with the federal government; if this form is not filed then the multiple member LLC will automatically be classified as a partnership for taxation purposes by the Internal Revenue Service (IRS). A single member LLC also has the option of being taxed as either a sole proprietorship or a corporation. Just like a multiple member LLC, if a classification form is not submitted then the LLC will automatically be classified by the federal government as a “Disregarded Entity” which is taxed as a sole proprietorship for income taxes. Taxable income earned by the entity is passed through to individual members. Members then report any earnings or losses on their individual tax return. This allows an LLC to only be taxed at the member level, and therefore avoid the double taxation that corporations have to deal with. Double taxation means the corporation is taxed on its earnings and losses and the individual shareholders are taxed on these again when filing their individual return. Such flexibility in taxation has led to increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.

There is limited personal liability in an LLC therefore protecting the owner’s personal assets in case of a lawsuit, similar to a corporation. This is not to imply that a member of an LLC is fully protected of personal liabilities. Many times courts are able to pierce the veil of LLCs when misrepresentation or fraud is involved. In order to better protect one’s assets an owner can also choose to combine equity and debt funding. An example of this protection can be seen when a corporation purchases an LLC and they combine. The owner takes back a membership interest as a “member” in the LLC and as common stock as a “shareholder” in the corporation. Where there is an especially high risk of injury, the assets should be contributed to the operating entity, and then encumbered with liens in favor of the holding entity or owner. Any liability would then run only to the operating entity, while the assets would still be protected. In a situation where assets are especially valuable, and of only moderate risk, the holding entity may be a more appropriate owner of these assets. These assets can then be leased to the operating entity.  The duration of the LLC is usually determined when the organization papers are filed. If the members wish to expand its duration they may choose to do so by a vote at the time of expiration. Continuity of life is also possible if a member dies or decides to sell his interest in the company.

One of the major problems with an LLC is the difficulty to raise financial capital. This is due to the fact that investors may be more comfortable in investing in a better understood corporate form with the possibility of an initial public offering (IPO) in the future. For this reason LLCs are not suitable for companies planning to attract venture capital or pursue multiple rounds of funding.  Even though an LLC may have an unlimited number of members, just like a corporation, transfer of ownership in an LLC is not as flexible as that for a C-corporation. In an LLC a member needs the approval of other members before being able to sell an interest in the LLC just like in a partnership. There are also many states that prohibit businesses such as banks, insurance companies, and non-profit organizations to use an LLC as their business structure. Another great disadvantage in using an LLC as a business entity is that the owner has to be very cautious in the similarities between and LLC and a corporation. If an LLC shares more than two of the four characteristics that define a corporation then corporation forms must be used for tax purposes. The four characteristics that define a corporation are: limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.

S-Corporations and Corporations

When small business owners are deciding to start up a business or restructure an existing business, the most common options would be to form a standard corporation, better known as a c-corporation, or an s-corporation. The s-corporation is a more prominent choice among small business owners. All corporations consist of shareholders, directors, and officers and are characterized by the issuance of shares of stock given to the owners of the company, as well as limited liability. The shareholders are the owners of the company, and they elect a board of directors. The directors oversee the affairs of the corporation and can make major decisions affecting the corporation. The directors appoint officers who take care of the day-to-day operations of the business. The requirements to form both a c-corporation and an s-corporation are also the same in that owners have to pay the necessary filing fees, and the formation documents must be filed with the appropriate state agency. A business owner would choose to create one of these business entities in order to give the company separate legal standings from its owners while protecting them from being personally liable if the company were to be sued. The main difference between the two entities is that standard corporations can be subjected to double-taxation on the entity level as well as the individual level. S-corporations elect to have a special tax status with the Internal Revenue Service (IRS) where they use pass-through taxation. With this taxation, business’ profits go to the individual tax returns of the owners where they are taxed at the individual tax rate and thus avoid double taxation. The business’ losses also go down to the individual. Double taxation would occur in the c-corporation by the business’ profits first being taxed at the corporate level when the profits are reported to the state and then taxed again at the individual level when shareholders have to report their dividends as personal income.

There are several advantages to restructuring a small business into an s-corporation. The most obvious advantage, as was mentioned earlier, is that s-corporations are not subject to double-taxation on their profits and shareholders are not held personally responsible for debts and liabilities of the business. This would be very appealing to an investor who is looking to safely make some money while having limited liability. Another advantage of the s-corporation is that ownership can be easily transferred and additional capital can be raised through the sale of stock. This is also true of c-corporations. Unlike sole-proprietorships and partnerships, S-corporations are also very stable in that they have unlimited life expectancy after the illness or death of an owner due to the many shareholders investing in the business. Another great advantage of s-corporations is that they can look more professional and stable to potential customers than sole-proprietorships or partnerships, which will make them more likely to want to invest in the business. A final advantage to forming an s-corporation is that they are less frequently audited by the state than a sole-proprietor entity is.

Although there are many important advantages to creating an s-corporation, there are also several disadvantages that should be considered. S-corporations, as well as c-corporations can be costly to set up and both have to follow corporate formalities. Also, because s-corporations elect to have special tax status with the IRS, the IRS has to impose several restrictions on who can be owners of the business. There has to be fewer than 100 shareholders, and the owners cannot be non-resident aliens. However, this is different for c-corporations. C-corporations can have an unlimited number of shareholders, and the shareholders do not have to be residents of the United States. Another restriction on the ownership of an s-corporation is that it cannot be owned by c-corporations, other s-corporations, limited liability companies, partnerships or many trusts. Shareholders also suffer from no flexibility in the allocation of the business’ profits because all profits are distributed in proportion to each shareholder’s ownership interest in the business. S-corporations also cannot deduct the cost of fringe benefits such as health or accident insurance granted to shareholders whose ownership interest in the corporation is more than 2%. Another disadvantage is that s-corporations can only have one class of stock, whereas c-corporations can have multiple classes of stock.

While sole proprietorships, partnerships, limited liability corporations, S-corporations, and corporations all have different advantages and disadvantages in the business world, it is important to weigh all of the options to make the most informed decision.

Works Cited:

http://www.irs.gov/businesses/small/article/0,,id=98202,00.html

http://www.sos.state.ia.us/business/sole.html

http://www.sba.gov

http://www.investorwords.com/1140/corporation.html

http://www.bizfilings.com/products/scorp.asp

http://www.bizfilings.com/Learn_About/C_Corporations_vs_S_Corporations

http://www.allbusiness.com/business-planning/business-structures-corporations/2516-1.html

http://www.expertlaw.com/library/business/s_corporation.html#4

http://www.toolkit.com/smallbusiness_guide

http://resources.lawinfo.com

http://www.startupcompanylawyer.com/2009/03/12/what-type-of-entity-should-i-form/

 

 

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