Sole Proprietorship

In a sole proprietorship, the assets and liabilities of the business are owned directly and entirely by one individual. This is the simplest form of business. A sole proprietor considering incorporation should know that incorporating would mean he could no longer treat the business as his own, though he owns 100 percent of the stock. Many of the tax difficulties of a one person corporation are due to the owner's inability or refusal to recognize that he cannot toy with the assets of the business. The net income of a proprietorship is taxed directly to the owner of the business. The sole proprietor is also at risk for the business's liabilities. Along with the business, he or she could lose personal assets such as a home, car or savings.

Partnerships

Partnerships include any unincorporated trade or business carried on by two or more persons who contribute capital or services to the venture and share in its profits and losses. In addition to the ordinary partnership, the term includes syndicates, groups, pools, and joint ventures. The net income of a partnership is taxed to the individual partners in accordance with their percentage share of the business. This income is taxed whether or not it is distributed to the partners.

Partnerships can be General, in which all partners are at risk, or Limited, in which some of the partners’ risks can be limited to their investment.

Limited Liability Company

The limited liability company (LLC) is the newest form of business entity. The owners of an LLC are referred to as “Members.” Its liability protection is similar to corporations and its flow-through losses are similar to partnerships and S corporations. The LLC offers an unlimited number of owners, but cannot offer fringe benefit and retirement packages available to corporate employees. A limited liability company is ideally suited for real estate transactions. They may not be as advantageous for some types of business activities. One of their deficiencies is that they are not as portable across state lines as a corporation and may not have the same degree of shareholder protection as a corporation in certain interstate transactions.

Because they are relatively new and the terminology is different than corporations, many people do not understand a limited liability company and view them with suspicion. Case law on these business entities is not as fully developed as corporations.

Corporation

A Corporation is an entity created under business corporation state law which is taxed as a corporation under federal income tax law. The net income of a corporation is taxed directly to the corporation at corporate rates. A corporation can have one shareholder or many shareholders. A properly structured corporation can protect you from creditors of the business yet enable you to control both day to day operations and organic corporate acts such as redemptions, acquisitions and even liquidations. Personal assets are protected from corporate liabilities and vice versa. A corporation requires articles of incorporation, bylaws, a Board of Directors, a resident agent, organizational meetings and minutes.

A corporation is referred to as a C corporation, and is subject to income taxation, unless all of the shareholders agree to elect Subchapter S status (discussed below).

The greatest disadvantage of a C corporation is that the earnings are subject to double taxation. They are taxed at the corporate level at rates up to 40% and then again taxed when they are distributed to the owner as dividends. In many closely held corporations, the double taxation can be managed through bonusing of compensation to the business owners. However, if the business must accumulate earnings for capital investments, it often is not possible to bonus all of the earnings out of the business.

The C corporation is the easiest entity to be able to provide fringe benefits and qualified pension plans in a tax favored manner to the owners.

A C corporation is the most flexible entity in terms of raising equity capital from outside investors. C corporations are allowed to have multiple classes of stock that can have different rights and preferences; they are most easily understood by most people; all states recognize C corporations and their limited liability characteristics. A corporation doing an initial public offering will always be a C corporation. Venture capital firms generally will only invest in C corporations because of the tax implications to the venture capital firms.

Even though the corporate form provides some personal liability protection, state laws may limit that protection for professional practices and it will not shield the officers of the company from personal liability for payroll taxes.

A “Sub S” corporation is a small business corporation, limited to 100 shareholders, in which the net income or loss is reported directly by the shareholders and no corporate-level income tax is paid. Electing Sub S status effectively avoids the double taxation that occurs in a C corporation.

The S corporation offers many of the advantages of a C corporation in avoiding personal liability. But an S corporation is taxed in many ways like a partnership in that the earnings or losses are allocated to the owners so that they may include them in their personal income tax returns. This has the advantage of avoiding the double taxation of a C corporation.

The S corporation has an advantage over some other types of entities in that it is easily understood by most persons, has limited liability inherent in a corporation, is generally recognized by all of the states and provides the flexibility of avoiding double taxation. A risk with an S corporation is the need to monitor the stockholders to be sure an inadvertent S election termination does not occur. If this occurred, then all of the stockholders would lose the advantage of the pass-through entity.

Many start-up businesses benefit from the S corporation status because the losses incurred in the initial years of operations can be deducted. However, there are significant limitations on the ability to deduct the losses for certain shareholders. The losses that can be deducted are limited to a shareholder's basis, which for most shareholders is defined as their cash investment in the business.

The S corporation suffers from some of the same fringe benefit problems that a partnership faces. Health insurance, life insurance and some other forms of benefits may be deducted by the corporation but are treated as taxable income for the recipient.

Deciding Whether to Incorporate

From a tax viewpoint, the corporation and the unincorporated entity have advantages and disadvantages. Determining whether tax factors dictate a corporate or non-corporate form is easier for a sole proprietorship than for a multimember partnership with differing personal interests. Rarely will all partners agree that incorporation is either inadvisable or advisable when evaluating their individual interests. Situations do exist where the federal tax structure clearly favors one form of business. Some instances are listed below.

• A corporation is better for an infant or expanding profitable business which needs capital.
• When most of a successful business' employees are owners, the corporation - with its liberal deferred compensation and fringe benefit plans - is better.
• When the owners of a multi-employee business personally need or want their earnings now, a noncorporate form is better - especially if the business provides employees with minimal deferred compensation and fringe benefit plans.
• When the business is going through a loss era (perhaps because it is a new business), a non-corporate form or Sub S type corporation is better.

Small tax benefits alone do not justify the incorporation of a business, even though tax law facilitates incorporation. For example, if a business loaded with goodwill is incorporated tax free and liquidated two years later, the transaction could produce a substantial long term capital gain on the original amount of goodwill, although it is simply restored to the original owner. It makes sense, therefore, to incorporate under these conditions:

• The objectives of the business and its owners will clearly be better achieved under corporate tax rules.
• There is a nontax reason (such as limited liability) which compels incorporation regardless of tax consequences.

Legal Forms of Organization

The following short list compares the forms of business organization as they relate to human resources, funding, government regulations, and revenue. Keep in mind that your initial organization decision can be changed. As your business grows and prospers, your financial and tax situations may warrant a change in your form of organization.

Human Resources

Management Control

Proprietorship - One owner in total control

Partnership - Divided among two or more partners; decisions made by majority or prearranged agreement (limited partner cannot manage the business)

Corporation - Corporation acts as one person, but Board of Directors (influenced by votes of shareholders) hold legal, formal control; working control held by those who manage the business day-to-day

Limited Liability Company - Divided among partners unless limited by articles of organization

Personnel and Expertise

Proprietorship - Depends primarily on owner's skills; often hard to obtain qualified employees

Partnership - Depends primarily on partners' skills; often hard to find suitable partners or employees

Corporation - Allows for flexible management; easier to secure quality employees with the necessary expertise

Limited Liability Company - Depends primarily on partners' skills; often hard to find suitable partners or employees

Continuity/Transferability

Proprietorship - Ends on death of owner; free to sell or transfer

Partnership - Ends on death of partner (unless otherwise agreed in writing); transfer conditions vary with agreement

Corporation - Continues indefinitely; most flexible in terms of transfer of interest (i.e. ownership) from one shareholder to another

Limited Liability Company - Restricted transferability unless authorized by articles of organization or operation agreement. Death or bankruptcy of member causes dissolution (important for favorable tax treatment of LLC)

Initial Funding

Requirements and Costs

Proprietorship - costs are lowest (filing fee required if business held under name other than owner's)

Partnership - costs low; general partnership agreement optional but recommended (limited partnership means that an agreement stating the liabilities and responsibilities of each partner is required)

Corporation - Costs are highest; legal forms, documents, professional fees required

Limited Liability Company - Costs are higher than a partnership, but less than a corporation; must file Articles of Organization with the state

Ability to Raise Capital

Proprietorship - Limited - all equity (funding) must come from proprietor; loans based on credit-worthiness of owner

Partnership - Limited to resources of each of the partners and the ability of each to acquire loans and/or investors

Corporation - Greatest equity potential - can sell new stock; loans based on corporate financial strength and expertise thus providing larger borrowing base

Limited Liability Company - Limited to resources of each of the partners and the ability of each to acquire loans and/or investors

Losses/Debts

Proprietorship - Owner liable for all debts

Partnership - Partners liable for all debts (limited partner has restricted liability and involvement per partnership agreement)

Corporation - Corporation liable for debts (i.e., shareholders are liable only for amount invested; are liable for more only if personal guarantees were given)

Limited Liability Company - LLC is liable for debts (Shareholders are liable only for amount invested; liable for more only if personal guarantees were given)

Government Regulation

Proprietorship - Little regulation; few records needed

Partnership - Subject to limited regulation; few records needed; articles of partnership should be drawn up

Corporation - Extensive recordkeeping required; must have Articles of Incorporation; by-laws and filing fees

Limited Liability Company - Must have Articles of Organization; filing fees

Revenue

Profits

Proprietorship - All profits to owner

Partnership - Divided among partners

Corporation - Retained in corporation; shareholders receive dividends

Limited Liability Company - Divided among partners

Growth Potential

Proprietorship - Limited options - reinvest profits, obtain loans on owner's line-of-credit

Partnership - Limited options - reinvest profits, obtain loans on partners lines-of-credit

Corporation - Flexible - can reinvest profits (at discretion of Board of Directors); sell additional shares; obtain loans on corporate credit

Limited Liability Company - Limited options - reinvest profits, obtain loans on partners' lines-of-credit