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Incorporating Your Business : LLC, Corporation, Partnership, Sole Proprietor



Another AHBBO Article
What's In A Name?

© 2013 Elena Fawkner

How's business?  Humming along nicely?  Good ... glad to
hear it.  Take a seat.  We're going to talk about what you need
to start thinking about now that your business is off the ground,
so to speak.

When you started your business, you may have done so on
a part-time basis while you continued with your full-time job.
Perhaps you're still doing double duty. If so, it's possible that
you haven't really given too much thought about the tax and
legal ramifications of the legal entity you have chosen for your
business.  After all, it's hardly something to worry about when
you're just starting out.  After all, who knows whether this
thing's going to fly, right?  At some point, though, once your
business begins to get off the ground, you do need to turn your
mind to such things.  Now that your bird is in the air, it's time
to give some serious thought about the entity you're using for
your business.

In this article, we'll discuss the main forms of legal business
entities and the advantages and disadvantages of each so you
can begin thinking about which one is best suited for you, your
business and your circumstances.

Of necessity, we're only concerned with general issues here.
Each state/province/country is different and you will need to take
the advice of your own professional adviser (lawyer or
accountant) before making a final decision that's right for you.

While this discussion will be focusing on entities most
commonly used in the United States, most of them exist, in
some fashion or another, all around the world (although some
of the finer details will vary).  For this reason, this article is only
intended as an issue-spotter and thought-starter and should
not be used as a substitute for independent professional advice.
 

SOLE PROPRIETORSHIP

The most simple form of business entity, the sole proprietorship,
is just that ... one person who is the sole owner of the business.
If you're running your business under your own name or under a
fictitious business name that you have filed with the state (and
that fictitious name has not been filed by a partnership of which
you are a member or by your company) you are a sole proprietor.
You are required to file a fictitious business name if your
surname does not appear in the name of your business or the
name of your business suggests the existence of other owners.

Under this form of business entity, the owner and the business
are legally inseparable.  In other words, the business does not
have an existence separate and independent from its owner.

=> Advantages

The advantages of a sole proprietorship are that it is simple and
inexpensive to set up (you've probably done it without even
realizing just by signing up for and promoting an affiliate program,
for example); the owner reports the business's profit/loss on his
or her personal income tax return (the business doesn't have to
file a separate tax return); the owner may offset a business loss
against other income; and the owner has total management and
control of the business.

=> Disadantages

The disadvantages of a sole proprietorship are that the owner has
personal, unlimited liability for the debts of the business; the
owner may find it difficult to obtain finance; community property
is at risk if the owner is married and the owner is personally
liable for the acts and omissions of agents and employees.

A sole proprietorship may be a good choice for you if you are in
sole control of your business (i.e. you don't use agents or
employees) and where personal liability for business debts is
not a major concern.  When your business starts to grow,
however, and you begin adding employees, incurring significant
debts or need to source venture capital of any substantial
amount, it may be time to consider another form of entity for
your business.
 

PARTNERSHIP

The next step up from sole proprietorship is a partnership.  A
partnership is a business with more than one owner that is not
incorporated and that is not a limited liability company
(corporations and LLCs are discussed below).  In a partnership,
each partner shares in the management of the business and in
the liability for the acts of fellow partners.

The internal workings of the partnership are governed by a
partnership agreement which should include issues such as the
authority of the partners, the name and purpose of the
partnership, each partner's respective contribution to the
partnership (whether in the form of money, time, expertise
or other services); payments to be made by the partnership to
the partners in the form of profits and drawings; the management
duties of the respective partners and how to handle the addition
of new partners and the withdrawal of existing partners.  In the
absence of a partnership agreement, the profits and losses of
the partnership are distributed equally amongst the partners.
If this is not the intention (for example, because of a disparity
between partners' respective contributions), the partnership
agreement should provide for this.

=> Advantages

As with a sole proprietorship, a partnership is relatively simple
and inexpensive to set up; each partner reports his or her
share of the partnership profits or losses on their personal
income tax return (again, the partnership doesn't have to file
its own tax return); a partnership offers a deeper talent pool
than does a sole proprietorship; the burden of running the
business is shared and, generally speaking, a partnership is
stronger financially than a sole proprietorship.

=> Disadvantages

As with a sole proprietorship, however, the partners are each
jointly and severally (i.e. together and separately) liable for the
debts and other obligations of the business.  In addition, each
partner is liable for the acts of the other partners (within limits).
Another potential disadvantage is that because decision-making
authority is divided, disagreements may arise which may cause
friction between the partners.  It would be a good idea to provide
for a dispute resolution mechanism in the partnership
agreement to overcome deadlocks.
 

LIMITED PARTNERSHIP

A limited partnership offers a useful compromise for the business
that wants to attract capital but doesn't want to relinquish control
of the business.  A limited partnership is one in which there are
two types of partners: "general" and "limited".  A general partner
has exactly the same rights and obligations as a partner in a
traditional partnership arrangement (discussed above).  A limited
partner, however, contributes financially to the business but has
minimal control over its management.  So long as the limited
partner stays out of the control of the business and doesn't get
involved in any misdeeds that adversely affect the partnership
and the other partners, he or she enjoys a cap on personal
liability set at the amount of the investment or the amount
received from the partnership after it became insolvent.

=> Advantages

In addition to the advantages discussed above of a normal
partnership, a limited partnership offers the additional advantage
of being a way for the general partners to raise cash without
involving outside investors in the management of the business
and without having to deal with the intricacies of creating a
corporation and issuing stock.

=> Disadvantages

For the general partners, the disadvantages are the same as
for a normal partnership.  In addition, it should be noted
that a limited partnership is more expensive to create than
a general partnership.
 

CORPORATION

A corporation (or company) is an entity created and regulated
by state law (at least in the US).  A corporation is a separate
entity from those who create it; it is, in fact, known as a legal
"person".

=> Advantages

Because the corporation is a separate legal entity, the
shareholders (owners) are protected against personal liability
by a corporate "veil" or "shield".  The corporate veil limits the
owners' personal liability because, as the corporation is a legal
entity unto itself, it has capacity to enter into contracts, incur
debts etc. in its own name and therefore only the assets of the
corporation are at risk.

In practice, however, lenders and other contracting parties will
typically require personal guarantees from the directors and/or
shareholders so such protection is probably pretty illusory in a
practical sense.

Unlike a partnership, however, individual owners are protected
from the misdeeds of fellow owners so long as the corporate
entity is not merely an "alter ego" for the shareholders.  (Alter
ego liability will arise if, in litigation, a court finds that the
corporate arrangement is nothing but a sham; a way of protecting
individual shareholders/owners from liability for premeditated
misdeeds.  In such circumstances the court will "lift" or
"pierce" the corporate veil and attach personal liability to the
individuals behind the company.)

One particular advantage of a corporate structure for a
business is that it may afford the owners a more favorable tax
treatment because of what is known as "income splitting".
Essentially, because the first $75,000 (or whatever amount
applies in your jurisdiction) of retained profits are taxed at
separate corporate income tax rates that may be lower than
the individual income tax rates of the business owners, owners
who work for their own corporation can split income between
themselves and the corporation which may mean a lower
overall tax bill.  Check with your lawyer or accountant about
whether this is something you can take advantage of.

Finally, because a corporation issues stock, it is an ideal
vehicle for bringing in outside investors or rewarding employees
with stock options.

=> Disadvantages

The main disadvantage of a corporation is that it is more
expensive to create than a partnership (general or limited) or a
sole proprietorship.  For this reason, you should probably
(subject to legal and accounting advice) only consider it if your
business faces or is likely to face substantial risk (and even if it
does, consider whether insurance may not be a more cost-
effective protection); you want to raise substantial amounts of
capital or there are significant tax benefits available to you
under such a structure.

Also, you may find the paperwork onerous.  Many companies
will use their lawyers to attend to the various filing and annual
formalities rather than attempting to do it all themselves.

Because a corporation is a separate legal entity apart from the
owners, it is also a separate taxable entity.  This means the
corporation must file its own tax return and this can lead to
double taxation.  Income is taxed twice: once in the hands of
the corporation because dividends are not tax-deductible and
again in the hands of shareholders who must pay tax on
dividends received.  On the other hand, however, where
shareholders are also employees, they can receive salaries
and bonuses as compensation rather than dividends and the
corporation can then claim such amounts as are "reasonable"
as an expense.

One way of avoiding the double taxation problem is to elect to be
taxed as an "S corporation" if eligible to do so.  If a company is
eligible, the shareholders can file an election with the IRS to
have corporate profits/losses flow through the corporation
directly to the shareholders who then declare the profit/loss on
their personal income tax return.  The S corporation does not
have to file an income tax return itself.  There are limitations on
the types of corporation that can elect an "S corporation" status
including the number and residency of shareholders.  Talk to your
lawyer or accountant for more information if this sounds like
something you may be interested in.

LIMITED LIABILITY CORPORATION

A limited liability corporation (or "LLC"), fits somewhere between
sole proprietorship/partnership and a corporation.  Similarly to an
S corporation, the members (owners) of an LLC are taxed on
business profits which flow through the corporation to be
declared on their personal income tax returns.  In other words,
like an S corporation, an LLC is not a separate taxable entity.
Like a corporation, however, an LLC IS a separate legal entity
so all owners are protected from personal liability for business
debts and other obligations.  Note that as with a normal
corporation, the protection is not absolute.  Owners will still be
liable if they sign personal guarantees and they must beware of
alter ego liability (discussed above).

=> Advantages

LLCs offer a more favorable tax treatment than a normal
corporation because the IRS rules allow LLCs to choose
between being taxed as a partnership or a corporation.  An
LLC is also more flexible than a corporation when it comes
to allocating profits/losses and management duties.  Unlike
a corporation, profits and losses can be allocated
independently of ownership interests.  An LLC is also less
expensive to set up and maintain than a corporation.

=> Disadvantages

There would seem to be few disadvantages associated with
an LLC other than that it is more expensive to set up and
maintain than a sole proprietorship or partnership.  Perhaps the
greatest potential disadvantage is one of uncertainty.  The LLC
is a relatively recent creation of the legislature and, as a result,
many issues that may be expected to arise have not yet been
tested by the courts.
 

As you can see, there are several business entities to
choose from for your business; each of which has its own
advantages and disadvantages.  What is right for you depends
on your particular circumstances: your personal financial
situation; the financial risk inherent in your business; your
business's financial position and whether capital needs to
be raised; the level of control you want to exert over
management decisions and many other considerations.
It is therefore imperative to seek professional legal advice
before making a final decision but do seek it.  Your business
is a serious undertaking.  Protect it and protect yourself.

_________________________

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Elena Fawkner is editor of Home-Based Business Online. Best business ideas and opportunities for your home-based or online business.

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