Suppose you’re in the market for a new pair of shoes. Not just any pair of shoes, but the perfect pair of shoes in terms of comfort, style, function and durability. Unless you are shoe-hoarding celebrity, you’ll likely avoid impulse and, instead, raise a few questions before making your decision.
“What kind of image will I project with my selection? How much am I willing to spend initially? Will they be costly to maintain? Will I have to contend with painful blisters at first during their break-in period? Will they allow me to do what I have to do and do it well? How long will they last before I outgrow them or they wear out?”
Likewise, choosing the right “legal entity” for your company involves the same kind of forethought. So, what might your questions be in this case? Sole proprietorship? (Pun most definitely intended!) Partnership? Corporation? Your choice will depend on the liability risks you are willing to accept, the control (and the accompanying responsibility) you want over day-to-day operations, and the time and money you have available to protect and grow the business.
I will tell you up front that I have a bias in this matter. Owning and running a business in today’s litigious society makes it nearly imperative that a company incorporate. But let us explore each of the options anyway, along with their advantages and shortcomings.
Are you ready for this?
If you don’t know it by now, operating a legitimate business is a highly regulated proposition. Several departments of the government agencies around you have a keen and dedicated interest in your enterprise. From simply applying for a business license, to triple-checking that the company pays the right amount of taxes on time, it seems your administrative to-do list continues to grow.
Choosing the right operating entity can be compared to taking a cross-country trip: you need to know in what direction you are going, where you hope to end up, and how you expect to get there. Smart entrepreneurs—the quest for start-up capital notwithstanding—begin with a written plan spelling out issues that the company will face in the next five to 10 years. This business plan should strongly influence the proper legal structure as it will address ownership, risks, goals and tax implications.
The Good Ol' Sole Proprietor
The best way to look at the available choices is to describe them from the simplest to the more sophisticated entities. Interestingly, a given business could pass through each of them over the course of its corporate lifetime. In fact, if management fails to adapt and migrate to a more appropriate legal structure when such an evolution is called for, it could actually limit the growth and success of the business.
Sole proprietorships are formed every day throughout the United States. A person gets an idea for a venture, decides on a name, gets an occupational license or permit and—voila!—she’s in business. In fact, 73 percent of over 24 million U.S. businesses are organized as sole proprietorships—which would suggest that such a percentage applies with reasonable accuracy within the sign and graphics industry as well.
The downside to a sole proprietorship is that you and the business are legally the same thing. If something goes awry—resulting an unexpected lawsuit or sizable damage claim—guess what, or, rather, who becomes fair game? Not only will the business be put at risk, but personal assets such as your home, cars and bank accounts can also be tapped. Depending on the nature of the claim and/or the casual involvement that your wife or husband may have in the business, a spouse’s assets may also be targeted.
Fortunately, most states have adopted legislation that guards some of your possessions in an action against creditors, but to exercise that protection, you may have to declare bankruptcy. Sole proprietorships normally end upon death, disability, bankruptcy or retirement of the owner.
The beauty of operating as a sole proprietor is the simplicity of administration, and the wide latitude you are given in making business decisions. You’re not bogged down with the detailed recordkeeping requirements, filing fees and other administrative costs that are required of corporations. And all revenue that flows into the business is treated as though it is individual earnings and is taxed at your individual rate.
You are able to take business deductions against not only your business income, but from any income, regardless of the source, because all your income and losses are lumped together. Expenses such as travel, meals, entertainment and automobile mileage all become deductible if they were incurred while conducting business. A word of caution: Keep your personal and business expenses separate. Failing to do so is one of the most common mistakes made by small business owners.
And even though your business may be small, you still should find yourself a good accountant and/or tax preparer in order that you may take full advantage of the tax credits from individual retirement accounts (IRAs), self-employed pension plans (SEPs), Keogh plans, or putting other members of your family, such as children, on your payroll.
When a business has more than one owner but still is unincorporated, its corporate structure is considered a partnership. There are two types of partnerships: general and limited. Partnerships have been around ever since the first lawyers and accountants popped up. Actually, about eight percent of all U.S. companies are organized as partnerships. This type of entity works best for service-oriented businesses.
Management of and profits from the business are shared between the partners in accordance with the terms of a partnership agreement, which can be written or oral. And here’s where things can get tricky.
Unless you want to invite trouble later, you should describe the partnership in terms of control, liability, tax burden and administration. Many partnership agreements are not written because people mistakenly think it has to be written in some specific format and has to be composed by a lawyer. Not so. You can write it yourself, but here are some questions that should be asked, considered and answered as you craft your well-written partnership agreement:
- How much will each partner contribute?
- Who is going to perform the work?
- How much will each partner be paid for his or her contribution?
- How will profits be divided?
- If a partner makes a loan to the business, will interest be paid?
- Who owns the customer list and how will the assets be divided if the partnership dissolves?
Sounds like a pre-nuptial agreement, doesn’t it? And not by accident, either. If these questions can’t be answered while everyone is getting along, you can bet things will get uglier than a forgotten box of leftovers in the fridge if you come to be at odds with a partner. If partners are having difficulty finding the right words to describe something in such a document, use examples to illustrate what you mean.
As with a sole proprietorship, a business structured as a partnership does not continue after the partners die, leave or go broke. Likewise, partners are legally liable for each others’ actions, and personal assets aren’t protected from creditors.
The difference between a general partnership and a limited one is the degree of control and liability. In a limited partnership, at least one partner is named a general partner and the others are named limited partners. Limited partners have limited liability—up to the amount of his or her contribution plus potential income—while general partners have general liability including all of the debts of the partnership. General partners basically run the business day-to-day.
The major disadvantage of a limited partnership is the complexity of setting one up. You should consult a lawyer when writing the partnership agreement. For example, limited partnership interests are considered securities and must comply with state and federal securities laws.
Finally, both types of partnerships are considered “pass-through” entities and each partner is taxed directly upon his/her share of the profits.
Living La Vida, Inc.
When a business incorporates, it creates an entity that has a life of its own: It has its own federal tax ID number. It can buy and sell property in the corporate name. And it has several tax advantages that are exclusive to corporations, such as pension and profit-sharing programs.
If you are looking to raise capital for your company, investors tend to take companies that incorporate more seriously than they do sole proprietorships and partnerships. Almost 20 percent of companies in the U.S. have taken formal steps to incorporate. If you decide to do so, there are three types of entities from which to select—a limited-liability company (LLC), a sub-chapter S corporation (S-Corp) or a C corporation. The latter two are code names given by the Internal Revenue Service.
LLCs first gained popularity in the early 1980s when businesses wanted the advantages of a corporation and a partnership, but did not want the disadvantages. The LLC is a creature of state law and you should be careful to read the statutes of the state in which you incorporate. LLCs work best for small to mid-sized companies that want to shield the owners’ personal assets from business-related debts and lawsuits.
LLCs do not issue shares of stock. Their owners are called “members” instead of shareholders. For that reason, LLCs may find it difficult to attract outside investors or motivate employees because of the absences of stock options.
The drawbacks of incorporating include:
- The cost to create the corporation—you will need to file Articles of Incorporation in your Secretary of State’s office;
- The administrative effort to maintain it—such as filing the minutes of the Board of Directors meeting;
- The fact that majority shareholders can overpower minority shareholders; and
- That most shareholders will have little say in the company’s day-to-day operations.
Still, an S-corporation may be the way to go for many sign and graphics businesses, provided they can meet the qualifying criteria. S-corporations can have no more than 75 shareholders—all of whom must be individuals or certain trusts—and there has to be unanimous consent among the shareholders before the 15th day of the third month of its taxable year to qualify for that year.
In an S-corporation, all of the profits and losses flow through directly to the shareholders and are not subject to “double taxation” as is a C-corporation. Double taxation occurs when a C-corporation has profits at the end of the year, pays taxes on those profits, then makes dividend distributions to the shareholders, on which the shareholders must pay taxes.
C-corporations can offer significant benefits to their owners (over S-corps), including publicly traded stock, unrestricted retirement plans and medical reimbursement plans.
Something new on the horizon
There is one final type of entity to consider. The limited liability partnership (LLP) is a fairly new concept, but creates a legal structure that offers the advantage of a general partnership and the liability protection of a limited partnership. Because there are relatively so few of these companiesâ€”and there hasn’t been sufficient litigation brought before the courts for any substantive evaluation—the jury is still out on the viability of this selection.
So which entity is best for your company? The decision is an important one and should not be made just because one happens to be easier than another. Your decision should be based on facts, and on understanding the type of ownership and control you desire, along with the potential liabilities for which you are setting yourself up . . . rather than just by chance.
Take the time to consult professional advice in this matter, and avoid being influenced by a friend’s or relative’s experiences. Think of it this way. If you had a choice between borrowing someone else’s used shoes or buying a new pair custom-fitted to your own two feet, what would you do? Smart decision. Good luck!