What's In A Name?
8/31/2000 by Elena Fawkner

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 nterested 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.

Elena Fawkner is editor of the award-winning A Home-Based Business Online ... practical home business ideas and resources for the work-from-home entrepreneur. Subscribe at http://www.fawkner.com/subscribe.html"