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What form should your business take?
Check the advantages and disadvantages of each business entity before deciding which is right for your business.
When you start a new business, there seems to be a multitude of choices. The services you will provide, the products you will produce, where you will set up shop, even the hours you will keep. When it comes to the legal form your business will assume in California, you are limited to just four:
(1) Sole Proprietorship
(3) General or Limited Partnership
(4) Limited Liability Company (LLC)
(5) Limited Liability Partnership (LLP)
(for professionals such as doctors & Lawyers)
The choice of what business form to choose is dependent upon a variety of factors, because as notes Vernon Castle, executive director of the Dallas-based American Small Business Association, "The only thing all small businesses have in common is that they are small."
Understanding the advantages and disadvantages of each form will help you to decide which is most appropriate for your business. Obviously, if you have assets you should protect them. Consequently, one of the main reasons for incorporating a business is to protect your personal assets.
We live in a litigious society. Some sole proprietors and partnerships, especially when starting out, have very little liability and financial risk, and any risk they have can be protected by insurance. As the business grows, employees are hired and assets increase, the liability factor may necessitate forming another type of business entity that affords more protection from personal liability to its owners.
In a sole proprietorship you are the business. Many people chose to start as a sole proprietorship because it is less expensive than starting up a corporation, and requires less complicated bookkeeping and tax reporting. Advantages of a Sole Proprietorship Significant tax savings. Since your are taxed at the personal level by Uncle Sam, there is only one tax return to file. Starting a sole proprietorship is usually a simple matter.
First, check that your place of business complies with local zoning laws. Then determine whether a business license or fictitious business name statement is required. Less regulation and red tape. Since there is no board of directors, you do not have to keep minutes, report to stockholders, or conduct annual meetings. There is also only one profit and loss statement. When the time comes to close the doors on a sole proprietorship it is as easy as saying "I quit". Just file a final schedule "C" and possibly a final state tax return.
Your business licenses and fictitious names registrations simply expire if not renewed. (However, we recommend not just walking away, but canceling the fictitious business name statement to avoid possible liability with future name confusion, etc.)
Disadvantages of a Sole Proprietorship
- Unlimited personal liability.
- If you are sued for damages.
- Loss or infringement: it is possible for you to lose all your
personal assets except for a few exempt belongings. If your
business fails, you are personally responsible for all debts
and losses. There is no legal distinction between you and
your business. Consequently, both your business and personal
assets are subject to attachment by creditors.
- Ineligibility for tax-free benefits.
- You cannot deduct the premiums for either your own or your
employee's health, life or disability insurance.
PARTNERSHIP ( General Partnership andLimited Partnership )
A general partnership exists when two or more people or corporations get together to form a business. Whether or not there is a formal partnerhip agreement, or registration of the partnership, the partners may incur personal liability for the debts of the partnership. It is important to have a well drafted partnership agreement, that clealy and aconcisely sets forth all of the agreements between the partners
before a dispute or misunderstanding arises. A partnership is similar to a marriage in that it is a legally binding agreement between two or more people, whether that agreement is written or oral. There are two types of partnerships: general and limited.
A limited partnership occurs when investors, the limited partners, fund a business that is managed by general partners. The limited partners have little say in the day-to-day operations of the business and their financial responsibility is limited to their investment, while the general partners are personally liable for all business debts and liabilities.
Just as it makes good sense to have a written partnership agreement, it is advisable to know your partners as well as you know your spouse, since breaking up a partnership can be as complicated as a messy divorce. In order to minimize potential problems, experts advise addressing certain issues before entering into a partnership:
- How will the business be capitalized?
- How will the profits and losses be divided?
- Who makes the decisions and what happens if there
is a stand-off in case of a disagreement?
- What happens if one partner becomes disabled or dies?
Advantages of a Partnership
- Simple taxation - As a general rule, the pros and cons of a general partnership and for the general partners of a Limited Partnership are the same as for a sole proprietorship. There are a few minor differences that should be discussed with your tax accountant.
Disadvantages of a Partnership
- The General Partners are personally liable for all of the debts of either a General Partnership, or a Limited Partnership. Limited Partners liability is limited to the amount of their investment, but are not allowed to maintain any amount of control of the Limited Partnership.
LIMITED LIABILITY COMPANY (LLC) and
LIMITED LIABILITY PARTNERSHIP (LLP) FOR PROFESSIONALS
These are relatively new forms of companies in California, designed to have the liability protection of a corporation, with the informal tax reporting requirements of a partnership.
The characteristics of an LLC or LLP are:
- Avoids liability.
- Can be taxed like a partnership, incurring
potential tax savings over the corporate form.
- Can have foreign shareholders or members.
Before LLC's and LLP's most small business elected to incorporate. There are still situations where the corporate form is the most advantageous. Like an LLC and an LLP, a corporation's liability is limited to the assets of the corporation. If thebusiness is sued, the only assets that can be attached are those of the corporation. That means your houses, cars, children's college education funds, stock portfolios and savings accounts are safe from creditors.
The taxation of Corporations are governed by a distinct set of state or federal laws and come in two taxation forms: companies that pay their taxes in the manner prescribed by Internal Revenue Code Subchapter"C", and those that file their taxes in the manner subscribed in Internal Revenue Code "S". Although often referred to as a "C" corporation, or an "S" corporation, this is not a "type" of corporation, but merely an election as to how to be taxed under the Internal Revenue Code. Not all states recognize Subchapter "S" corporations for state taxation purposes, but California does.
The primary disadvantage of Subchaper "C" status for a small companies is that earnings are first taxed on the corporate level, and then again on the personal leve, after dividends are distributed. To avoid this double taxation trap, it may be wise for some corporations to elect the Subchapter "S" status. You are advised to consult a tax specialist for assistance with all tax matters
With a Subchapter "S" election, the Internal Revenue Service taxes its earnings only at the personal level. This way you are taxed like a sole proprietor but without the liability. In addition Subchapter "S" corporate losses can be used to offset other earned income on your tax return. Subchapter "S" companies have an ownership limitation of 35 shareholders, all of whom must be either U.S. citizens or legal permanent residents, with no shares owned by another corporation.
Advantages of Incorporation
- Freedom from personal financial liability, as long as you have not given your personal guarantee on a business-related obligation such as a bank loan or a lease, which modernly is required of small corporations by most lenders and landlords.
- Corporations are treated as legal entities under the law. They can own property in their own name, sue and be sued apart from their officers, directors or shareholders. Corporations can go into debt, and can raise capital by issuing and selling stock to investors. Since the shareholders own the corporation, the transfer of a majority of shares can also transfer the control and management of the corporation.
- Incorporation can enhance the credibility of a business.
Disadvantages of Incorporation
- Because corporations are regulated by state and federal laws, various documents must be filed or registered with the state. Officers and directors must be elected at meetings held at regular intervals, with minutes kept and copies retained in the Corporate Minute Book. Unless these documents are kept properly current, the corporate "veil of personal protection from liability" may be "pierced" by creditors, and the stockholders may be held personally liable for the debts of the corporation. Therefore, you must follow corporate guidelines to the letter, or rusk loosing the corporate "veil". Keeping proper corporate records and insuring sufficient capitalization will prevent this from happening.
- Tax reporting for corporations is complicated.
- Since the stockholders own the corporation, the transfer of a majority of shares can also transfer control and management of the corporation to strangers.
- Although a corporation may apply for a bank loan, banks often require a personal guarantee from a majority shareholder, thereby defeating the limited liability advantage vis-à-vis that particular transaction. The same holds true for premises leases and leases of capital equipment. Some states, including California, have a minimum tax for corporations, regardless of profit. Bankruptcy, even at the corporate level, does not discharge tax obligations.
The jurisdiction where you incorporate, form an LLC, or an LLP, is a question of practicality. Depending upon the goals you wish to achieve and the type of business you do, it may be more advantageous to incorporate in a state other than California, or even in another country. If you form an out of state, or foreign corporation, LLC or LLP, and are doing business in California, you must register that entity to do business California and pay the appropriate California Franchise Tax.
No one knows better than you the circumstances of your individual business. By looking at your options carefully and discussing them with your attorney and your accountant, you will be able to make an informed decision. You can then put your energy where it belongs . . . into running a successful business.
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