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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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        ** Reprinting of this article is welcome! **
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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.

        Copyright 1998-2017, AHBBO.com. All rights are reserved. Tuesday, 26-Jan-2021 03:09:30 CST

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