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BUSINESS STRUCTURE BASICS
HOW TO CHOOSE A BUSINESS
STRUCTURE FOR YOUR SMALL BUSINESS
Choosing a structure for your business can be a confusing jumble of legalese and acronyms. However, with this basic guide, you will be able to select the structure that will serve your business best at tax time.
You, like every new business owner, must have asked yourself at one time or another, "What kind of business entity is best suited for my particular operation?" For most entrepreneurs, the answer lies within two specific questions.
1. Legal Liability: How can I get the best protection from general business liabilities that can threaten not only my business assets but my family's assets as well?
2. Tax Considerations: How can I get the best tax breaks out of the business entity that I select?
Liability is an argument best left to you, your business partners, and your business attorney. It is the second question involving the search for shelter from high taxes that sets the overall theme for Top Tax Savings Ideas.
How to Save Taxes with Your Business Entity
New business owners are quick to learn that confiscatory tax laws have a profound influence on the success or failure of all small business operations. As a small business owner, you want to get every break available under the law, and you don't want to see the results of all your hard work get eaten up by the IRS and the tough tax laws.
The problem, however, is that those tax laws have become so painfully complex that new business owners automatically assume they could never make the best of their available options without conceding the strategy planning to the tax professionals. Interestingly, the tax professionals themselves are often at odds with each other as to the best tax saving options in this ever-changing environment.
Understand the Differences between the Entities
We will discuss the specific tax advantages and disadvantages of the various business entities in another series of study. In this series however, we will just consider the basic nature and differences between each of the entities namely:
i. Sole Proprietorship,
ii. General Partnership,
iii. Limited Partnership,
iv. Companies, And
v. Limited Liability Company.
1. The Sole Proprietorship
The simplest form of business entity is the sole proprietorship. It is a business owned and run by one person. If you choose this legal structure, then, legally speaking, you and the business are the same. You can continue operating as a sole proprietor as long as you are the only owner of the business.
The sole proprietorship is thought of as the quickest and easiest way to set up a business operation. There are no blanket prerequisites, nor are there any specific costs in starting a sole proprietorship. There may be some minor formalities, however, that will need attention. These formalities, which of course apply to all business entities, mean that you will probably have to:
- Obtain an occupancy permit for your place of business,
- Secure a business license, and
- Apply for a franchise or registration number for your operation. This registration number will be used by the state agency to monitor the collection of sales tax and other regulatory matters.
All of these procedures are simple and can be done without the assistance of an attorney or accountant. Once you start a sole proprietorship, you are the sole owner. Unless you are in a community property state in which your spouse is vested with a one-half interest, you alone have full control and responsibility for the operation.
2. The General Partnership
General partnership is a business structure where two or more people own and run a business with equal unlimited liability. Like the sole proprietorship, starting up the general partnership could be a relatively easy process. No costs or formalities are required. Wise counsel, however, will give you about a dozen reasons why you should have a detailed partnership agreement drafted whenever you put yourself on the line with any other individual. A few items that you would be best advised to spell out in writing are:
- The amount of capital each partner is expected to contribute up front;
- The rights and duties of the partners;
- The method for sharing profits and losses;
- The authorization for cash withdrawals and salaries,
- The methods for resolving disputes or taking in new partners; and
- The method for dissolving the partnership should dissolution become necessary. Remember, this is often the case.
3. The Limited Partnership
A limited partnership is much like a general partnership except for one important fundamental difference. The law protects the limited partner because the limited partner's legal liability in the business is generally limited to the amount of his or her investment. It enables this special type of investor to share in the partnership profits without being exposed to its debts in the event of the company going out of business.
A limited partnership works like this. There must be one or more general partners with the same basic rights and responsibilities (including unlimited liability) as in any general partnership, and one or more limited partners who are usually passive investors. The big difference between a general partner and a limited partner is that the limited partner is not personally liable for debts of the partnership. The most a limited partner can lose is the amount that he or she:
- paid or agreed to pay into the partnership as a capital contribution; or
- Received from the partnership after it became insolvent.
To keep this limited liability, a limited partner may not participate in the management of the business, with very few exceptions. A limited partner who does get actively involved in the management of the business risks losing immunity from personal liability and having the same legal exposure as a general partner
Unlike the partnerships described above, the company is considered an artificially created legal entity that exists separate and apart from those individuals who created it and carry on its operations. With as little as one incorporator, a company can be formed by simply filing an application for incorporation with your country’s business registration authority. By filing this application, the incorporator will put on record facts, such as:
- The name of the intended company ,
- The purpose of the intended company,
- The names and addresses of the incorporators,
- The amount and types of capital stock the company will be authorized to issue, and
- The rights and privileges of the holders of each class of stock.
It is true that operating as a company has its share of drawbacks in certain situations. For example, as a business owner, you would be responsible for additional record keeping requirements and administrative details. More important, in some cases, operating as a company can create an additional tax burden. This is the last thing a business owner needs, especially in the early stages of operation.
Remember, aside from tax reasons, the most common motivation for incurring the cost of setting up a company is the recognition that the shareholder is not legally liable for the actions of the company. This is because the company has its own separate existence wholly apart from those who run it. However, let us examine three other reasons why the company proves to be an attractive vehicle for carrying on a business.
Unlimited life: Unlike proprietorships and partnerships, the life of the company is not dependent on the life of a particular individual or individuals. It can continue indefinitely until it accomplishes its objective, merges with another business, or goes bankrupt. Unless stated otherwise, it could go on indefinitely.
Transferability of shares: It is always nice to know that the ownership interest you have in a business can be readily sold, transferred, or given away to another family member. The process of divesting yourself of ownership in proprietorships and partnerships can be cumbersome and costly. Property has to be re-titled, new deeds drawn, and other administrative steps taken any time the slightest change of ownership occurs. With company, the shares of stock they hold represent all of the individual owners’ rights and privileges. The key to a quick and efficient transfer of ownership of the business is found on the back of each stock certificate, where there is usually a place indicated for the shareholder to endorse and sign over any shares that are to be sold or otherwise disposed of.
Ability to raise investment capital: It is usually much easier to attract new investors into a corporate entity because of limited liability and the easy transferability of shares. Shares of stock can be transferred directly to new investors, or when larger offerings to the public are involved, the services of brokerage firms and stock exchanges are called upon.
5. The Limited Liability Company (LLC):
A Limited Liability Company (LCC) is a hybrid entity that has the legal protections of a company and the ability to be taxed (one time) as a partnership. In many regards, LLCs are treated much like S corporations for tax purposes. However, there are some additional advantages over S corporations, including the following examples:
- The LLC usually offers better leeway for owners who wish to write off business losses in a business that relies on entity-related debt that is incurred
- The LLC allows greater flexibility for the owner to take assets out of the company without incurring unplanned tax liability
Remember to check with your lawyer or accountant about the advantages of the LLC in your particular country. Ask up front what it would cost to form a corporation versus the cost of forming an LLC. You may be surprised to learn that in some countries an LLC could be established by filing a simple, one-page document, which lays out the Regulations of Incorporation of your LLC, with the registrar of business.
You can form an LLC for any lawful business as long as the nature of the business is not banking, insurance, and certain professional service operations. An LLC takes on a separate identity similar to a corporation, but without the tax problems of the corporation, it will be taxed like a partnership.