Legal Forms of Organization...

Starting & Operating a New Small Business		  
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Legal Forms of Organization

 

There are three basic legal forms to choose from when starting a business. Each has advantages and disadvantages. Many businesses start in one form then change to others at different stages of their life.

Sole Proprietorships are the most common form by far. However, Corporations account for the largest percent of sales receipts

 
 
Issues in Legal Ownership


When choosing your form of business you must weigh several factors for their importance to you and your goals. Consider risks, your long term plans and your resources.

Your legal form will make a big difference for sources of financing, personal and financial risk, taxes, workload, signing contracts, buying a business or selling one, debt and liability issues and more.

Consider each factor below then consider which form of organization best meets your needs.

  • Liability
  • Taxes and tax status
  • Sharing Profits and Losses
  • Control and Decision Making
  • Co-mingling and Division of Assets
  • Workloads
  • Litigation
  • Agency
  • Expenses
  • Starting and Stopping
  • Continuity and Growing
  • Paperwork
Sole Proprietorships

Sole proprietorships and partnerships are forms of business ownership that mingle the owner's rights, liabilities and responsibilities with the business' rights, liabilities and responsibilities.

Sole Proprietorships - One owner and the owner and the business are the same legally. It is the most common form of business. An individual owns, manages the business and is responsible for all transactions and activities. Key characteristics of a sole proprietorship include:

  • Own and operate for any duration of time
  • sell it, close it whenever the owner wants to
  • pass the business to heirs
  • no specific business taxes; all profit is personal income
  • comply with all license and permits necessary fir a business to operate legally; no special "sole proprietor" paperwork or requirements - need dba, business license if required, etc. as any business would
  • personally responsible for all debts and liabilities of the business, even after it closes until its affairs are completed
  • unlimited personal liability; liability for acts committed by employees
  • pay self-employment taxes (Medicare. social security); business expense
  • the IRS and most states expect self-employed individuals to pay income tax throughout the year, usually quarterly estimates; failure to so so results in fines and interest payments
  • no salary expense
  • eligible for Keogh plan and other tax deferred retirement plans

Start by engaging in business: buy, sell, open business bank account, and so on. They are usually started with loans in combination with personal assets and cash form savings contributed to the business operations by the sole owner.

Advantages of a Proprietorship

  • Easy and inexpensive to start and stop legally
  • Generally less expensive to start
  • No profit sharing
  • No business tax
  • Owner is in charge and makes decisions
  • sell or transfer business at your discretion
  • Speed in decision making

Disadvantages of a Proprietorship

  • Unlimited personal liability
  • Owner's limitations (skills, time, etc) limit business
  • Harder to access capital
  • Continuity of business - re-establish all contracts and relationships is sold or transferred; terminates with death of owner
  • Personal assets subject to lien
Partnerships


Partnerships - established with written or oral Agreement. Assumed to exist if:

  • clearly perceived intention to be one
  • co-ownership or co-interest in the business
  • profit/loss is shared
  • May be implied by actions

Operates under Uniform Partnership Act, as modified by any partner agreements. Partnerships follow default legal guidelines but these guidelines may be modified by a partnership agreement.

Partnership Legal Defaults


1. Mutual Agency - any partner can act on behalf of the other partners; all partners fully represent the business for any action or transaction.

2. Unlimited Liability - each partner is fully responsible and liable for the business and the acts of the partners.

3. Three types of partnerships:

  • General
  • Limited
    • at least one general partner
    • plus one or more limited partners
    • liability limited to investment for limited partners; unlimited liability for general partners
    • no management participation for limited partners
    • requires a certificate of limited partnership and a written partnership agreement
    • can allocate profits and losses
    • interests are freely transferable
  • Joint Venture


4. Limited Life of the Legal Partnership: The partnership ends and its affairs must be concluded:

  • accomplish the partnership objective
  • admit a new partner
  • withdrawal of partner
  • death of partner
  • personal bankruptcy
  • time or date set for dissolution
  • partner incapacity (need court decree)
  • misconduct…

5. Continuity of the Business: The partnership as a legal entity is a form of ownership for a business but is not the business. A legal partnership may end but the business may continue with supplier/customer agreement and business contracts and relationships reestablished or modified to continue an existing partnership.

6. Co-Ownership of Property - all property, whether donated, purchased with capital or gained through profit and growth is co-mingled. It is considered fully owned by each partner and subject to each partners discretion for use as an asset of the business.

7. Non Taxable Entity - the partnership itself is not subject to taxes. The owners each pay personal income tax based upon their respective shares of profits and at their individual tax rates. Each partnerships profit or loss is personal taxable income or loss.

8. Profits/Losses equally divided - unless modified in a partnership agreement, all profit or loss is equally divided proportionally amongst the number of partners ( 3 partners, three equal shares)

9. Entered into by any combination of individuals or legal business entities - A partnership can be any combination of individuals, other partnerships, or corporations.
Partnerships agreements and terms for modifying partnerships

A partnership agreement should be put into writing as a contract between the partners. Partnerships operate under the Federal Uniform Partnership Act as adopted and modified by each state. Partnership agreements should be filed at the Secretary of State's office in the State Capital.

The following are common terms that should be clearly spelled out unless you want to operate under the default laws of partnership as stated above.

  • Name & Term
  • Purpose
  • Contributions - cash, services, property
  • Profits, Losses, Draws
  • Payback of Loans by partners
  • Authority & Decisions Making
  • Management Responsibilities
  • Partners' Outside Business Activities
  • Departure of Partner - Buyouts
  • Continuity of Partnership
  • Non-Competition of Departing Partner
  • Control of Partnership Name
  • Resolving Partnership Disputes
  • Changes in Your Partnership
  • Distribution of Assets upon dissolution
 

Advantages of a Partnership

  • Easy and inexpensive to start legally
  • Greater access to capital
  • no business tax
  • informal management and structure
  • Greater access to skills, time, money, an so on.
  • no written agreement required (but advisable)

Disadvantages of a Partnership

  • Unlimited liability of general partners
  • Joint and several liability
  • Harder to keep profit in the business for growth (Capital Accumulation)
  • More difficult to raise capital
  • Changing the partnership agreement may dissolve the partnership or be difficult
  • Interest is not freely transferable
  • Personal and authority conflicts
  • Decision making is slow, shared, and partners are bound by the law of agency
  • difficult or expensive to dissolve

Corporations

A corporation is a legal entity, separate from its owners, with many of the rights of an individual: a name, enter contracts, own property, sue & be sued and so on. (It can't get a Driver's License or Register to vote). General characteristics of corporations include:

  • Dividends
  • Double taxation
  • Shielded from personal liability as "owner" (stockholders)
  • Salary is expense
  • Can offer fringe benefits
  • Stock:
    • common
    • preferred: 1st dividends & claim to assets, no vote
    • many other types of stock are possible
  • Ownerships (shares of stock) freely transferable
  • Domestic, Foreign, Alien (Domestic = in state; foreign = other state; alien = other country)
  • Articles of Incorporation and Bylaws
  • More difficult to start and operate in terms of effort, paperwork, organizational structure and meetings
  • Perpetual life
  • Legal requirements include Board of Director meetings, shareholder participation and annual reports, etc.

Types of Corporations

"C" or Close Corporations

  • Less than 35 stockholders
  • One kind of stock
  • No qualifications of securities
  • Private offering - no public advertising

"S" Corporation - a close corporation of individuals, trusts, estates. Created by legislation to ease corporate tax burdens; treated as a partnership for taxation.

  • Deduct tax losses personally
  • No double taxation on dividends
  • Spread income within family
  • Limited to 100 shareholders
  • Can Have 1 shareholder
  • All shareholders must consent to S format
  • No corporate or foreign investors (individuals only)
  • Must be domestic
  • can't own> 79% of another corporation

"LLC" - Limited Liability Corporation - 1 or more "members" in California (most states allow a single member) and has the tax advantage of being treated like partnership by the IRS; all advantages of an S Corp including personal liability and debt protection. Unlike a corporation it is free of legal requirements such as annual reports, director meetings, shareholder requirements and so on.

  • No limit on number of members
  • Allows foreign and corporate members
  • Pass-through tax entity - can allocate profit and loss any way they wish to members on individual tax returns regardless of share of ownership
  • No business tax
  • Limited liability for all
  • Owners can participate in management
  • LLCs can hire a management group that includes members, nonmembers or a combination
  • Fixed 30 year term
  • Requires an operating agreement
  • Some states require at least two members
  • Interests may not be freely transferable
  • difficult to raise capital
  • No automatic termination for death or withdrawal
  • S corporation may be more tax friendly
  • Can pay salary and fringe benefits
  • Members don't pay Self-employment Tax

How do LLCs work? The LLC allows for multiple owners, or members. Additionally, there is a managing member, who also enjoys the rewards
of limited liability and is typically the person responsible for managing the business. (However, if the LLC has just one owner, it will be taxed as a sole proprietorship.)

The profits or losses of the business pass directly through to the owners' personal income tax returns, on their Form 1040. The LLC files a Form 1065, and then lists each member's taxable profit on Form K-1. In other words, the LLC itself does not file taxes.

This is what we mean when we say you avoid double taxation with an LLC. In a corporation, it works differently. The corporation is taxed and, accordingly, must file taxes. Then, distributions to the owners are taxed. In essence, the government takes two bites out of your revenues instead of the one bite they'll take if you've form an LLC instead of a corporation.

With an LLC, the bottom-line profit of the business is not considered to be earned income to the members, and therefore is not subject to self-employment tax. But keep in mind that the managing member's share of the bottom-line profit of the LLC is considered earned income, and therefore is subject to self-employment tax.

Members are compensated using either distributions of profit or guaranteed payments. A distribution of profit allows each member to pay themselves by merely writing checks--whenever they need the money (provided the business has the available cash). However, as a member of an LLC, you are not allowed to pay yourself wages.

Guaranteed payments represent earned income to the members, thereby qualifying them to enjoy the benefits of tax-favored fringe benefits. The members' share of bottom-line profit is not considered earned income because the members are considered to be inactive owners; therefore, the members do not qualify for special tax-favored "fringe benefit" treatment.

A corporation can be a member of an LLC. This allows you to create an additional level of ownership, which is designed to create an entity that can offer such traditional fringe benefits as retirement plans and an additional level of protection from liability.

The managing member of an LLC can deduct 100 percent of the health insurance premiums he or she pays--up to the extent of their pro-rata share of the LLC's net profit , because the profit is considered earned income. Note: If a member has earned income, he or she will also qualify.

More information:
legalzoom.com | LLC advantages  | California LLC  |C-Corp, S-Corp or LLC? | Where to Incorporate | Resoures


If you plan to take the business public you may want to form it as an "S" corp or convert it. LLCs have only existed as a form of business since 1996, so there is little legal precedent to help owners predict how court decisions or legal disputes may affect the business.

Where Should You Incorporate? - Your State

Incorporating in your home state is usually the preferred choice because it is the least costly and least complicated. For example, if you incorporate in a state other than your state of operation you may have to qualify to do business in your home state as a “foreign corporation.” Also, if you incorporate and operate in different states you may have to file annual reports in both states and may have to pay income and franchise tax in both states. Incorporating in your state of operation will simplify procedures and cut back on these redundant costs.

Finally, incorporating in your state of operation will allow you, or someone closely associated with your company, to serve as your company’s resident agent. Naming yourself or someone associated with your company as resident agent ensures that you will personally receive important documents without wasted time and money.

The Delaware Option

Delaware has the longstanding reputation as the best state in which to incorporate. Thousands of start-up companies make this choice every year, despite the fact that they operate completely or partially in states other than Delaware. The upfront benefits of incorporating in Delaware are applicable to both large and small businesses. For example, Delaware offers low incorporation and franchise fees. Additionally, companies which conduct all business outside of Delaware are not subject to Delaware state income tax. Management Flexibility is also an advantage, as Delaware allows a corporation with fewer than 30 shareholders to be managed directly by the shareholders.

Although Delaware incorporation may be beneficial to any size company, it is the larger companies that have the most to gain. For instance, Delaware incorporation is advantageous to companies who intend to offer their shares to the public. For this reason the majority of companies on the New York Stock Exchange, as well as 58% of Fortune 500 companies, are incorporated in Delaware.

Also, if you choose to incorporate in Delaware, you may have to “qualify” to do business in other states that you operate in. This means that you will probably have to qualify to do business in your business’s home state. Further, you may have to file annual reports in both Delaware and your home state of operation, and will likely be subject to franchise taxes in both states. The cost and complexity of the dual reporting requirements are more easily absorbed by larger companies.

If you choose to incorporate in Delaware but do not have a physical street address within the state, Direct Incorporation can provide you with dependable Delaware resident agent services.

The Nevada Option

In recent years, Nevada has gained recognition for its favorable corporate laws. As such, a growing number of out of state businesses choose to incorporate in Nevada. The tax savings of incorporating in Nevada is one advantage. Nevada does not tax corporate profits, there is no state personal income tax, and there is also no franchise tax.

Shareholders of a Nevada corporation also enjoy the benefit of complete privacy. In contrast to most states, Nevada has minimal reporting and disclosure requirements. For example, Nevada does not require shareholders to be listed on public record, as most states do.

However, like Delaware incorporation, larger corporations have the most to gain from incorporating in Nevada. In fact, for smaller corporations, the disadvantages of Nevada incorporation may outweigh the benefits. For example, if you choose to incorporate in Nevada and mainly operate in another state, you may have to “qualify” to do business in that other state. Furthermore, all states have annual reporting requirements, and although Nevada’s requirements are minimal, it is generally less complicated to deal with the reporting requirements of just one state- your state of operation- rather than two.

If you choose to incorporate in Nevada but do not have a physical street address within the state, Direct Incorporation can provide you with dependable Nevada resident agent services.

Corporate Organizational Structure

A corporation must have a Board of Directors to represent stockholder interests, hire the President and oversee the direction and guide major business decisions. The President manages and operates the day-to-day business decisions. The Articles of Incorporation and the Bylaws establish the lines of authority between these three authorities: Owners, Board and Management. (see Startup Forms, Paperwork and Regulations)

Stockholders

Board of Directors
(Chair, CFO, Secretary)

CEO/President
Top Management
Middle Management
Supervisory Management
Staff



Advantages of a Corporation

  • No personal liability for stockholders (owners)
  • Can attract capital easier and in large amounts
  • Has a "perpetual" life
  • Easy to transfer ownership/transfer may not affect operations
  • Attract skilled people
  • Easier to raise capital

Disadvantages of a Corporation

  • Cost and time to incorporate/paperwork, legalities to operate
  • Double taxation (corporate profits, dividends/salaries)
  • Potential loss of control by founder

 
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