Mind Your Own Business

by Elaine Orgain and Alan T. Foster

Business Structure: form and features

Every act of commerce represents a form of business. Whether it is a formally recognized business entity or simply an individual selling items through an on-line auction site, each business has a structure. It is wise to recognize the differences in the various forms and choose the one most closely aligned with your reasons for being in business in the first place.

Factors that determine the appropriate business structure

In order to identify and evaluate possible structures for your company, you must set and prioritize your personal objectives as well as the goals of the business. As an owner, consider the level of control you wish to hold over the operation, the amount of personal liability you are willing to accept, and the amount and complexity of administration you can manage. For the business itself, determine the profitability and tax goals, the exit strategy, cash requirements, and return on investment needed to succeed. Once you have the answers, put them in order of importance and select the form of business that satisfies the most critical elements.

Sole Proprietor

The simplest form of business is the sole proprietorship, where the business and the owner are considered one and the same legally. As the name implies, it is an individual (or may include your spouse) that has full control and ownership of the enterprise. With full ownership, however, comes personal responsibility for all debts and liabilities too. So, although you receive all of the income, you also pay all of the bills, debts, claims and taxes, including lawsuit judgments. A sole proprietorship is fast, easy and inexpensive to set up (and to close) and an owner may withdraw funds from the company at will. The results of operation are reported on Schedule C of the owner’s personal tax return. This type of company may not, however, be easy to finance unless the owner can provide all of the cash required to launch it.

Partnership

A partnership is shared ownership of a business. By agreement, the partners divide the business responsibilities and income. Tax reporting is passed through to their individual returns in predetermined proportion. It is important to note, however, that although they share the income, partners each carry full liability for any and all activities of the operation and the other partners.

A partnership is easy to organize but may have a limited life (could dissolve upon the death of a partner). It is always advisable to document the relationship of the partners in a written legal agreement. Only if allowed in the agreement, may owners periodically withdraw funds. With clear form and purpose, it is possible for a partnership to secure additional funding by the inclusion of ‘limited’ partners but this adds to both the complexity and up-front costs.

Corporation

A corporation is a unique legal entity qualified to do business by the state. It can raise funds through the sale of stock, enter into contractual agreements, hire employees, take on debt, and it pays income tax on its profits. It is separate from its shareholders and, therefore, survives independently of the purchase or sale of shares. This independence also protects the shareholders from personal liability in most instances.

A corporation may grant stock and stock options to reward its employees and service providers under laws that are well-established from a legal and tax standpoint. This makes this entity attractive to businesses who desire to use non-cash incentives to “grow” the company.

Businesses seeking to attract outside funding from venture capitalists, corporations or private “angel” investors typically incorporate, since outside investors prefer to take equity in the form of stock.

A corporation is more costly to establish and has somewhat complex operating requirements. A Board of Directors must be installed who, in turn, appoint officers to manage the operation. Regular meetings of the Board and an annual meeting of shareholders must be held and appropriately documented. Most of this effort is to establish the independence of the corporation (to shield the shareholders from liability) and many find the trade-off worth the effort.

Benefits are fully tax-deductible for the corporation where they are only partially deductible for Sole Proprietors and Partnerships. But, because the corporation pays tax on its income and shareholders must report dividends issued by the company as personal income, there can be “double taxation” in some cases. This should be taken into account when determining the overall best form of business for you.

Sub-chapter S Corporation

Within 72 days of incorporation, shareholders may submit a Sub-chapter S election to the IRS which asks for the corporation’s income to be passed through to the shareholder’s personal tax returns. This eliminates the ‘double taxation’ issue but does impose some restrictions on the corporation. Shareholders working for the corporation must pay themselves a ‘reasonable’ salary (subject to payroll taxes), Sub-chapter S corporations can only issue one class of stock, they are limited to 75 shareholders, and all shareholders must either be individuals who are US citizens or resident aliens, or specific kinds of trusts or tax-exempt organizations. In all other aspects, the Sub-chapter S organization is the same as a regular C corporation as to set-up and operating requirements.

Limited Liability Company

A Limited Liability Company combines the operational flexibility of a partnership with the liability protection of a corporation. Profits are passed through to the individual’s tax returns (as in a partnership) and the members are afforded liability protection (as with a corporation.) An LLC requires a written Operating Agreement, limits ownership to the LLC members (it cannot sell stock), and has a limited life. The initial set-up is somewhat complicated and expensive but an LLC is not subject to as many operational constraints placed on a corporation so may be easier to maintain once under way. Since the LLC is a relatively new type of entity, it is advisable to locate an attorney experienced in forming these entities in your state (some states allow single member LLC’s.)

Document the relationship of the owners:

Even the simplest of relationships between the owners of a business should be formalized in writing. It is impossible to imagine all of the circumstances a business will encounter and equally unpleasant to consider the many ways owners may disagree on how to manage in the best interest of the company. Include a hierarchy of decision-making, a definition of authority to act on behalf of the company, a process for resolution of disputes between owners, and address the disposition of ownership upon the death or withdrawal of an owner. It is vital to agree on each owner’s role in the beginning so everyone has a clear vision of how each contributes to the success of the firm.

Get professional advice:

Every business and its owners have a unique set of goals and strategies they are pursuing, and these may evolve over time. It is imperative that they operate with a full awareness of the ever-changing legal and tax implications of every decision they make. A trusted attorney and tax accountant are critical to developing a business structure that can maximize achievement of goals with minimum exposure to risk. If you are looking for qualified professionals to serve your business, get referrals from organizations and associates you trust, research the background of each candidate, and interview them thoroughly before putting the future of your company in their hands.

Elaine Orgain is co-founder and CFO of New Business Consultants, Inc. and can be reached at 408-733-2663 or via email at elaine@newbizconsultants.com.

Alan T. Foster is founder of the Foster Law Group and can be reached at 650-330-4195 or via e-mail at afoster@fosterlawgroup.us.

Resources for further study:

http://www.score.org/readingroom.html
http://www.score.org/leg_6.html
http://www.score.org/leg_8.html
http://www.score.org/leg_3.html
http://www.smallbusinessnotes.com/operating/legal/legalform.html
http://www.bizfilings.com/learning/corptypes.htm