Advantages of sole proprietorships

Besides being the easiest to start and least expensive form of organization, sole proprietorship also gives the owner complete control of the company. You make all the decisions and suffer all the consequences, but the income from the business is yours and you’re taxed only once at your personal income tax rate.

Many professionals, such as consultants, authors, and many home-based business owners, operate as sole proprietors.

Disadvantages of sole proprietorships

For many entrepreneurs, the sole proprietorship form of organization isn’t satisfactory, for several reasons:

• As a sole proprietor, you have unlimited liability for any claims against the business. In other words, you are putting your personal assets at risk — your home, car, bank accounts, and any other assets you may have. So, having business liability and errors and omissions insurance is extremely important. If you’re producing a product, you’ll need product liability insurance to protect you against lawsuits over defective products. If your company does work for other people (such as a construction company), you may be required to have bonding insurance to ensure that you complete the work specified in your contract. Because there are so many areas of liability and so many different types of insurance, you should talk to a good insurance broker.
• Raising capital is difficult, because you’re relying only on your financial statement. You are, for all intents and purposes, the business, and most investors don’t like that situation.
• You probably won’t have a management team with diverse skills helping you grow your business. You may have employees, but that isn’t really the same thing. Putting together an advisory board of people with skills you need may help compensate for the skills you lack.
• Because the survival of your company depends on you being there, if something happens to you or a catastrophe strikes, the company doesn’t survive. Legally, if the sole proprietor dies, so does the business, unless its assets are willed to someone.

If you intend to really grow your business, organizing as a sole proprietorship may not be a good idea, unless you’re taking advantage of income and control benefits during the early stages of your business — for example, through product development.

Forming a partnership

You don’t have to have a written agreement when forming a partnership; a simple oral agreement works. In fact, in some cases, the conduct of the parties involved implies a partnership.

Accepting a share of the profits of a business is prima facie (legally sufficient) evidence that you are a partner in the business, meaning that you may also be liable for its losses.

Partnerships come in several flavors. In most partnerships, entrepreneurs are general partners, meaning they share in the profits, losses, and responsibilities, and are personally liable for actions of the partnership. But other types of partners have more limited liability, including the following:

• Limited partners: These partners’ liability generally is limited to the amount of their investment.
• Secret partners: These partners are active in the ventures but are unknown to the public.
• Silent partners: These partners are usually inactive with only a financial interest in the partnership.

The partnership agreement

It’s hard to overstate the importance of a partnership agreement. Many a prospective partner says things like “We’ve been the best of friends for years; we know what we’re doing,” or “How can I ask my father to sign a partnership agreement?” Well, how can you not? You must separate business from friendship and family, at least when it comes to structuring your company. This is a serious deal. No matter how well you know your partner, you probably haven’t worked with him or her in this particular kind of situation. You have no way of predicting all the things that can cause a disagreement with your partner. The partnership agreement gives you an unbiased mechanism for resolving disagreements or dissolving the partnership, if it comes to that.

Consulting an attorney is necessary when drawing up an agreement, so that you’re not inadvertently causing yourself further problems by the way a phrase is worded in the agreement or leaving something important out. The partnership agreement addresses the following:

• The legal name of the partnership.
• The nature of your business.
• How long the partnership is to last. As with any contract, it needs a stop date.
• What each of the partners is contributing to the partnership — capital, in-kind goods, services, and so forth. This is the initial capitalization.
• Any sales, loans, or leases to the partnership.
• Who is responsible for what — the management of the partnership.
• The sale of a partnership interest. This clause restricts a partner’s right to sell his or her interest to third parties. It provides, however, a method by which a partner can divest his or her interest in the partnership.
• How the partnership can be dissolved.
• What happens if a partner leaves or dies.
• How disputes will be resolved.

If you don’t execute a partnership agreement, all partners are equal under the law.

Enjoying the benefits of a corporation

The advantages of a corporate form definitely outweigh the disadvantages. For one, the owners enjoy limited liability to the extent of their investment (the one important exception is payroll taxes that haven’t been paid to the IRS). By selecting the corporate form, you also can do the following:

• Raise capital through the sale of stock in the company.
• Own a corporation without the public being aware of your involvement. So, if you want anonymity, it’s the way to go.
• Create different classes of stock to help you meet the various needs of investors. For example, you may want to issue nonvoting, preferred stock to conservative investors wanting to be first to recoup their investment in the event the business fails. Most stock issued is common stock, the owners of which enjoy voting rights and share in the profits after the preferred stock has been paid.
• Easily transfer ownership. In a private corporation, you want assurances that your shareholders can’t sell their stock to just anyone. In other words, you want to know who owns your stock. You can protect yourself by including a buy-sell clause in the stockholder’s agreement. Usually, this clause specifies that the stock must first be offered to the corporation at an agreed-upon price.
• Enter into corporate contracts and sue or be sued without the signatures of the owners.
• Enjoy more status in the business world than other legal forms because corporations survive apart from their owners.
• Enjoy the benefits of setting up retirement funds, Keogh and defined-contribution plans, profit sharing, and stock option plans. The corporation deducts these fringe benefits as expenses that aren’t taxable to the employee.

Weighing the risks

Every legal form has disadvantages and risks, and the corporation is no exception. Here are risks worth considering when contemplating using the corporate form:

• Corporations are much more complex, cumbersome, and expensive to set up.
• Corporations are subject to more government regulation.
• A corporation pays taxes on profits regardless of whether they are distributed as dividends to stockholders.
• Shareholders of C Corporations don’t receive the tax benefits of company losses.
• By selling shares of stock in your corporation, you’re effectively giving up a measure of control to a board of directors. The reality, however, is that the entrepreneur determines who sits on that board of directors in privately held corporations.
• You must keep your personal finances and the corporation’s finances completely separate. You must conduct directors’ meetings, and maintain minutes from those meetings. If you don’t, you may leave your company open to what is known as piercing the corporate veil, which makes you and your officers liable personally for the company.

Where and how to incorporate

You create a corporation by filing a certificate of incorporation with the state in which you do business and issue stock, making your company a domestic corporation. If you incorporate in a state other than the one in which you do business, your company is a foreign corporation.

In general, you want to incorporate in the state where you’re planning to locate the business so that you don’t find yourself working under the regulations of two states. When deciding where to incorporate, consider the following:

• The cost difference of incorporating in your home state versus doing business as a foreign corporation in another state: In general, if you’re doing business mostly in your home state, incorporating there won’t subject you to taxes and annual report fees from both states.
• The advantages and disadvantages of the other state’s corporate laws and tax structure: For example, in some states, a corporation pays a minimum state tax regardless of whether it makes a profit, whereas other states have no minimum state tax. Likewise, if you’re incorporating anywhere other than your home state and find yourself defending a lawsuit in the state of incorporation, you may incur the expense of travel back and forth during that time.

Sizing up the S Corporation

An S Corporation is a corporation that elects and is eligible to choose S Corporation status, and shareholders at the time consent to the corporation’s choice. In general, an S Corporation doesn’t pay any income tax. Instead, the corporation’s income and deductions are passed through to its shareholders. The shareholders must then report the income and deductions on their own income tax returns.

An S Corporation can provide employee benefits and deferred compensation plans. To qualify for S Corporation status, you must

1. Form your corporation with no more than 100 shareholders, none of whom may be nonresident aliens.
2. Issue only one class of stock.
3. Ensure no more than 25 percent of the corporate income is derived from passive investments like dividends, rent, and capital gains.

In addition, your S Corporation can’t be a financial institution, a foreign corporation, or a subsidiary of a parent corporation. If you elect to change from an S Corporation to a C Corporate form, you can’t go back to being an S Corporation form for five years.

In general, S Corporations work best

• When you expect to experience a loss in the first year or two, and owners have other income they can shelter with that loss.
• Where shareholders have low tax brackets (lower than the corporate rate), so the profits can be distributed as dividends without double taxation.
• Where your business may incur an accumulated earnings penalty tax for failure to pay out its profits as dividends.

Comparing the S Corporation to the LLC

The Limited Liability Company (LLC) is the newest legal form of business organization, and although it’s gaining in popularity for many entrepreneurs, it confuses the many choices they already face in structuring their companies. The LLC combines the best of partnerships (pass-through earnings) with the best of the corporate form (limited liability). LLCs have grown in popularity because they

• Limit liability for business debts up to the amount invested.
• Offer flexible management structure that allows the members (the equivalent of shareholders in a corporation) or nonmembers they hire to manage the organization.
• Allow the choice of being treated as a partnership with the benefits of pass-through earnings or as a corporation, whichever provides the lowest tax liability.
• Enable flexible distribution of profits and losses, meaning that you can divide them up any way you want among the members.

So what are the differences between an LLC and an S Corporation? Why would you choose one over the other?

• An LLC provides for an unlimited number of owners, whereas the S Corporation limits you to 100.
• An LLC permits you to include nonresident aliens, pension plans, partnerships, and corporations as members, whereas the S Corporation doesn’t.
• LLCs can have different classes of stock, whereas an S Corporation is generally limited to one class.

The members of an LLC are analogous to partners in a partnership or shareholders in a corporation. If the members self-manage, then the members act more like partners than shareholders, because they have a direct say in what happens within the organization. Stock in an LLC is known as interest.

If you’re looking for more flexibility in what you’re able to do in the long term, you would probably choose an LLC over an S Corporation.

Making profits in a nonprofit organization

Let’s dispel the biggest myth about nonprofit organizations first. You can make a profit in a nonprofit company; in fact, doing so is a good idea. What you can’t do is distribute those profits in the form of dividends the way other legal forms do. A nonprofit (or not-for-profit corporation) is formed for charitable, public (in other words, scientific, literary, or educational), religious, or mutual benefit (as in trade associations).

Like the C Corporation, the nonprofit is a legal entity with a life of its own and offers its members limited liability. Profits that it generates from its nonprofit activities aren’t taxed as long as the company meets the state and federal requirements for exemption from taxes under IRS 501(c)(3). When you form a nonprofit, you actually give up proprietary interest in the corporation and dedicate all the assets and resources to tax-exempt activities. If you choose to dissolve the corporation, you must distribute those assets to another tax-exempt organization — you can’t take them with you. Any profits you make from for-profit activities are taxed the same as any other corporation.

Nonprofit organizations derive their revenues from a variety of sources. They receive donations from corporations (which are tax deductible to the corporation) and others, conduct activities to raise money, or sell services (a for-profit activity). As entrepreneurs, founders of nonprofit, tax-exempt corporations can pay themselves a good salary, provide themselves with cars, and generally do the kinds of things you would do within a normal corporation — except distribute profits.

Most entrepreneurs who start nonprofits do so for reasons other than money — for example, a driving need to give back to the community. James Blackman founded the Civic Light Opera of South Bay Cities, Redondo Beach, California, providing a cultural arts center for the community. The opera became the third-largest musical theater in California and has won many awards. Blackman’s company also provides opportunities for physically and mentally challenged children to experience music and the theater.