Appendix B

Legal Business Structures

This appendix is intended as a brief description of the three major forms of legal business structures available to business (sole proprietorship, partnership, and corporation), along with a description of the most recent legal structure (the limited liability company or LLC). You are encouraged to consult the U.S. Small Business Administration (SBA) website for more detailed descriptions of the various structures and legal requirements (including taxation).1 Although descriptions are provided and comparisons of structures are made, the materials presented here are for your preliminary consideration only, as the author is not a legal professional. You are encouraged to consult your legal advisor for a more thorough discussion before your adoption of a particular legal structure for your business.

The Sole Proprietorship

A single person starting a business by simply opening the doors of a business is the example of a sole proprietorship. This is the most common form of legal structure found in the United States today. The reasons for this are very simple: the sole proprietorship makes it easy and inexpensive to start a business and there are no extra tax filing requirements (aside from adding a Schedule C form to your personal tax returns).

Although easy to enter, this type of business structure is fraught with problems for the business owner. For one thing, it leaves the owner very vulnerable to liability lawsuits. In the instance that someone falls in your store or accuses you of having sold tainted food, or any other cause for action, a judgment against you puts your personal assets at risk. Therefore, no matter how successful you might have been up to the point of that judgment, anything and everything of value that you had been able to amass would be subject to seizure to satisfy the judgment against you.

In addition, when you open a business and operate it alone, you have only your own business and managerial knowledge and skills to draw upon. Unless you succeed in getting capable people to invest time advising or mentoring you, the business is left to what you can do on your own.

Furthermore, and perhaps of more concern to some, as a sole proprietor, you are less attractive as an investment risk. You will find it more difficult to attract funding (whether equity or debt). Again, unless your own network has a very broad reach and you are extremely highly regarded, you are unlikely to have access to the financial resources that you will need to start your business or fund its growth.

Due to the disadvantages associated with operating a sole proprietorship, it is recommended here that you not opt for this structure. Even if you do not expect your business to grow substantially, you need not subject yourself and your future (and that of your family) to the possibility of one day having to vacate your home or relinquish other valuable assets in order to pay off a debt incurred while operating this type of business.

The Partnership

A partnership is a noncorporate legal structure entered into by two or more persons who share ownership and control of a business with the intent of making a profit.2 The partnership can take on a number of forms (e.g., limited partnership, limited liability partnership, R&D limited partnership, etc.); however, the discussion here will be kept at a general level (except for a brief reference to the limited liability partnership).

There are several things that you should know and consider before entering into a partnership. Perhaps, the most important thing to know is that, in every partnership except limited liability partnerships,3 all partners are jointly and severally liable for the debts and obligations of the partnership. Therefore, friendship and familial emotions and loyalties aside, questions that you should ask yourself before going into partnership with someone else minimally include the following:

• Length and nature of relationship: How well do I really know this person?

• Trustworthiness: What evidence do I have that I can trust this person? Have I conducted a background check?

• Character: Does this person’s character reflect an innate sense of honesty, fairness, and the desire to do what is right and legal?

• Financial status and responsibility: Is the person financially stable? What is the person’s track record with respect to managing money (e.g., have I seen a credit report)?

• Competence: What are the person’s strengths, particularly in professional areas that are important to the business?

• Reliability: Can I count on the person to be a steady high-performer, particularly when it comes to conducting business?

• Flaws and idiosyncrasies: Are there major weaknesses or quirks that I recognize in this person that could make it difficult for us to work together over the long term?

• Significant others: How do I get along with this person’s wife or family? How do our families interact? Could these relationships threaten the partnership down the road?

In many ways, going into business with another person is like getting married. You are actually likely to spend more waking hours with that person than with your spouse. Therefore, you need to know as much as you possibly can about the individual before entering into a business arrangement. Key issues of concern to you should be discussed, and how these should be handled should be formally documented. In business, “formal” means in writing; therefore, you need to establish a partnership agreement that is signed by the partners before operations begin. This is important because it is often much harder to come to agreement over a matter after it has raised its head during day-to-day operations. Some of the issues that you should try to work through and document include the following:

• Ownership shares: What percentage of the partnership and its profits will be owned by each partner?

• Financial commitments: Who can financially obligate the partnership? Will one signature suffice or will more than one signature be required at all times or for certain dollar thresholds?

• Bank accounts: Who can sign checks and handle financial statements of the partnership? Will one signature suffice or will more than one signature be required at all times or for certain dollar thresholds?

• Areas of responsibility: For example, which one of you will be responsible for day-to-day management issues and who will be responsible for marketing?

• Sale of partnership interest: Can a partner desiring to sell all or a part of partnership interest do so? If so, will the other partner have first right of refusal to purchase the interest? Will the partner desiring to sell have to obtain the existing partner’s prior approval of the proposed new partner?

• Dissolution of partnership: If, at some time in the future, the partners mutually decide to dissolve the partnership, what terms will govern how the assets and liabilities of the partnership are handled? If one partner wants to buy out the interest of the other partner, what terms will govern this transaction?

• Death or incapacitation of a partner: If a partner dies or is incapacitated to the extent of being incapable of fulfilling the duties and responsibilities set forth in the partnership agreement, what will happen to that partner’s interest in the business? In the event of death, will heirs inherit partnership interest with all the rights and responsibilities of the deceased partner? Will the terms prescribed for sale of partnership interest or dissolution of the partnership govern, or will other specific terms apply?

• Dispute resolution: How will you settle major disputes (e.g., mediation, arbitration, etc.)?

The Uniform Partnership Act has been adopted by every state. You should review it to familiarize yourself with the requirements for your state.4

The Corporation

A corporation is an artificial entity which has an identity that is separate and distinct from its owners and exists only in contemplation of the state. The corporation has an indefinite life and, thus, can outlive its owners.

The regular corporation has a number of advantages. The most notable advantage of adopting a corporate structure is the limited liability that it provides. Unless you are found liable in the case of fraud or a breach of fiduciary duty, you are not personally responsible for legal judgments that result from actions of the corporation. Therefore, even though the corporation might have to pay out sizable amounts to claimants, those payments are drawn from the assets of the corporation and not your own personal resources. The corporation is also typically viewed as a more sophisticated structure, with more management depth than other structures, and the ability to attract investors and financing. Most of the largest businesses in the country are corporations.

However, there are also disadvantages associated with operating under the corporate structure. The most notable disadvantage is double taxation. This means that the corporation is taxed and any dividend distributions to shareholders are also taxed. Yet another disadvantage of operating a corporation is the paperwork that is required. Annual tax filings of corporations can be expensive, and preparation and forwarding of tax statements to sometimes hundreds or thousands of shareholders can be costly and time-consuming.

S Corporation

The S corporation (also referred to as the S Corp and formerly known as Subchapter S corporation) is a special type of corporation that must be applied for and approved by the Internal Revenue Service (IRS). The structure offers the limited protection of the corporation without double taxation. Instead, the S Corp is allowed to pass through gains and losses to shareholders.

Several provisions govern your ability to qualify for this status, including, minimally:

• All members have equal voting rights

• The entity must be a domestic corporation (i.e., it must maintain its headquarters or conduct operations within the state in which it is incorporated)

• No members of affiliated companies may be a shareholder of the S Corp

• Maximum of 100 shareholders5

In addition, once you obtain S Corp status, you are restricted for a five-year period from reelecting it if you decide to relinquish it and elect another legal structure.

The Limited Liability Company

The limited liability company (LLC) is the most recent form of legal structure and it is recognized in every state; although, provisions such as the permitted lifespan of the LLC may vary from state to state and you should learn what you can about the provisions that pertain to your state.6

What makes the LLC so attractive is that it allows the flexibility or relative freedom of a sole proprietorship (single-person LLC) or partnership (two or more-persons LLC), including the pass-through of profits and losses to members that is allowed with the S Corp. LLC’s also offer limited liability protection, just the same as a corporation. As such, owners of an LLC may function with the knowledge that, unless found liable for improper conduct such as fraud or breach of fiduciary duty, personal assets may not be seized to satisfy any judgments granted to creditors.

Unlike more longstanding structures, there is currently no uniform set of standards governing limited liability companies across the 50 states. In some states (e.g., Maryland), owners of LLC’s for some time did not have to pay fees on the enterprise, except for the initial fee to establish the business structure. However, over time, as the popularity of the structure increased, tax filing fees were imposed in Maryland (moving fees from $0 to $300 annually). On the other hand, the federal government does not tax LLC’s, but persons operating LLC’s are regarded as self-employed and must, therefore, pay self-employment taxes such as Medicare and Social Security (see SBA website).7

In sum, there are several options from which you can choose when legally structuring your business. Table B.1 briefly chronicles some of the major distinctions among the various legal business structures.