The Wrong Choice Could Be a Costly Mistake
Nearly three-fourths of the millions of small businesses in the United States are sole proprietorships according to the U.S. Department of Commerce. But is that the best choice for you and your business?
That’s a question you should consider carefully whether you’re just getting started or if you’ve been giving some thought to changing your present form of business.
There are four basic classifications of business entities from which to choose: Sole proprietorship, partnership, corporation and Limited Liability Company (LLC). While there are a number of variations among these choices, these four are the most relevant to your business. Each of these choices has its own distinct set of advantages and disadvantages that need to be carefully considered. Even if you feel comfortable with your current business entity, you should be familiar with the legal, financial and practical consequences of each choice.
The simplest and least expensive way to launch a new business is, of course, as a sole proprietor. This choice requires little or no legal expense, no complex tax structure and no one else to interfere with management decisions.
As a sole proprietor, you may operate under your own name or you may choose a business name that will be your d.b.a. name (doing business as). Either way, you will need a business license issued by the municipality or state in which the business will operate. In most states, that’s your only legal requirement to begin business as a sole proprietor.
As a sole proprietor, profits flow directly through your personal tax return (using a separate tax form called Schedule C, Profit or Loss from a Business). You get to keep or reinvest all of the after-tax income produced by your business. If it ever becomes necessary to do so, a sole proprietorship is the easiest of all business structures to dissolve.
Still, sole proprietorship has its own set of disadvantages. As a sole proprietor, you bear unlimited personal liability for all debts against the business. Both your business and personal assets are at risk in the event of legal trouble.
Other disadvantages include possible difficulty in raising funds from outside sources. Also, operating as a sole proprietor may make it more difficult for you to attract high-caliber employees.
As far as most legal and tax considerations are concerned, a partnership is treated essentially the same as a sole proprietorship. While the partnership must file an annual income and expense report on Tax form 1065, each partner is jointly and separately liable for the financial and tax obligations incurred in the name of the business. Each partner is taxed on his or her share of the profits generated by the business.
Keep in mind, however, that business partnerships, like domestic partnerships, do inject some challenging personal issues.
The choice of a business partner is fraught with potential danger. Some experts suggest good friends or relatives rarely work out as business partners because of the inevitable disagreements over business decisions that can easily turn into emotional issues. That’s why it’s so important in partnerships to have a clear understanding at the outset of such issues as:
- Who does what? The specific role of each partner should be clearly defined and scrupulously honored.
- On what basis will the partners share in the profits of the business? Will it be 50-50 or will there be some other arrangement? How will the major financial decisions be handled? Such issues are extremely important and should never be left to be decided later.
Also to be considered in the very beginning is what happens if one partner dies? In such a case, you may find yourself in business with your partner’s widow or widower.
“To help avoid this, there are two things you should do,” said Geneva Fulbright, CPA in Durham, North Carolina. “First, consider purchasing key-person life insurance. Then, with the help of your attorney, draw up a written agreement clearly establishing procedures for buying out a partner’s interest in the event of death or any other unforeseen circumstance.”
These and other considerations make it unwise to establish a business partnership without a written agreement drawn up with the help of an experienced attorney.
A corporation is a separate legal entity that carries with it the same rights and responsibilities as those conferred upon us humans. The corporate form of business will limit your personal financial liability, be more stable in the event of your death and will probably make it easier for you to raise money for expansion and growth. In the light of harsh reality, however, you should investigate carefully before you leap.
One problem is the sometimes unrecognized differences between large, public corporations and the closely-held corporations typical in a small business such as yours. If you try to swing a loan in the name of your small corporation, you may find that the lender will require you to sign personally, making you just as responsible for the loan as you would be in a sole proprietorship. Further, in the event of a lawsuit, you may find yourself as well as the corporation named as a defendant. So much for the protection of personal assets.
Will a corporation stand a better chance of survival than a sole proprietorship or partnership in the case of the death of a principal? Usually; but not always. Many small businesses survive as a direct result of the talents of the founder and prime mover and shaker. Nowhere would this be truer than in a complex fast lube operation. In such a case, if the founder dies, the business may well follow along shortly, regardless of the legal form bestowed upon it.
Finally, any business owner considering incorporation should be aware that doing business in that form will introduce complications that can be a nuisance to someone used to the simple life. Corporations must follow rigid rules, file separate tax returns and maintain specified records. Shareholders must elect a board of directors and appoint a president. Even if you form a corporation as the only shareholder, you must name yourself to the board of directors and appoint yourself as president — not a major roadblock to an entrepreneur seeking the advantages of incorporation, but a good indication of the unending stream of annoying details involved.
If you are a sole proprietor considering incorporation, you may have considered using one of those companies that allow you to incorporate over the Internet, taking advantage of some state’s liberal laws regarding incorporating. That’s an easy and inexpensive way to incorporate your business; however, there are some disadvantages to keep in mind.
“If a business owner wants to incorporate in a state other than the one in which the business operates, an ‘authority to do business’ form must be filed in the resident state,” Fulbright said. “That means two state returns would be required instead of one.”
Also, you should be aware that some states have passed laws intended to make it more difficult to file incorporation papers in a state other than the one in which the business resides. For example, California charges several hundred dollars per year for a license for a foreign corporation or LLC to operate in the state.
“That’s why I recommend clients who use the Internet to research information on incorporation consult with legal counsel familiar with the State laws in which the business will operate,” Fulbright said.
To make life a little easier for the small entrepreneur, a special form of corporation known as Subchapter S was created. Among other things, an S Corporation allows small business owners to enjoy the advantages of incorporation without such penalties as separate taxation on the corporation and on the dividends awarded to shareholders. A lawyer familiar with business structures should be consulted for more details on the S Corporation.
Limited Liability Company (LLC)
“Another form of business entity, The Limited Liability Company can be advantageous to small business owners under some circumstances,” Fulbright said. “In an LLC, compared to a corporation, there are fewer restrictions placed on the owners in how they take money out of the business and how much they take out as compensation. “An LLC does not pay entity level taxes on profits (the owners pay taxes on their allocated share of profits, and losses can offset owners’ other income to the extent of active participation).
“An LLC provides greater protection from creditors and general lawsuits if run properly, compared to a general partnership and other entities.
“An LLC is a good way to hold real estate because it allows for easier distribution of assets without having to consider dividends or other forms of compensation to the business owners (i.e. C-Corp and S-Corp have to consider salary levels, distribution methods, etc.)”
Sound complicated? Well, it is. That’s why no single form of business structure can be said to be the best choice for every entrepreneur.
As with most other business decisions,a sound knowledge of the alternatives provides the best foundation for making the right choice. Before you make any decision involving your business structure, you should consult with your accountant and an attorney who specializes in business issues.