Let’s say 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 Christina Aguilera—who reportedly owns over 400 pairs of various footwear—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? What will it take me to maintain them? Will I have to contend with painful blisters 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 am have a bias on the topic. 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.
Can a home-based sole proprietorship business be taken seriously?
A 2018 Small Business Administration Office of Advocacy report (www.sba.gov) states home-based businesses make up roughly half of all U.S. businesses—including 60.1% without paid employees—and most of them (about 73%) are sole proprietorships.
If you are just starting out with a modest, in-your-garage vehicle wrap shop, you may decide to maintain sole proprietorship status, but consider this critical question: Am I willing to put at risk all of my personal assets—my home, my savings, etc.—in the event a customer sues me for damages to their vehicle, or makes an error and omissions claim against me for inadequate work, an oversight in charges, or didn’t fulfill their expectations?
To add to it, of the home-based business owners I’ve met, many are frustrated at how the business must constantly re-validate itself whenever applying for a business loan, seeking credit terms from suppliers and/or being taken seriously when courting a bricks-and-mortar prospective client.
Can such an enterprise be taken seriously? The short answer is yes, if the owner employs some of these tips and techniques:
- Officially change the address of the business to include the house number and street followed by “Suite G” (for garage) or “Unit 200” (or any other number) to give the impression the company is in a commercial location. Another option is to get a P.O. Box number.
- Get a separate business phone line and have a responsible-sounding adult answer it in a professional manner. Also, have a voice mail greeting that lets callers know they’ve reached a viable business and not someone’s home.
- Issue professional-looking invoices and keep accurate accounting books and records. Also, arrange to accept payment by various means—including credit cards. 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 becomes the focal point of any IRS audit or action. Open a separate business checking account and utilize debit and credit cards with the company name on them.
- Develop a company logo, have a professional web presence—with its own URL and email address (not a generic server, like gmail.com or yahoo.com)—create a catchy tagline, and host select social media pages. Also, get a supply of good-looking business cards with your contact info on them.
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—mostly to extract monies from it. 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 is never-ending.
Choosing the right operating entity can be compared to taking a cross-country trip: you need to know in what direction you are going, what route you will take, and where you hope to end up. Smart entrepreneurs—the quest for start-up capital notwithstanding—begin with a thoroughly written plan spelling out issues that the company will face in the next five to ten years. This business plan should strongly influence the proper legal structure as it will address ownership, risks, goals and tax implications.
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 stunt the growth and success of the business.
The jolly ol’ sole proprietor
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.
The downside to a sole proprietorship is that you and the business are legally the same thing. If something goes awry, guess what—or, rather, who—becomes fair game? Not only will the business be put at risk, but your 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 spouse/life partner may have in the business, their 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.
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. Partnerships have been around ever since the first lawyers and accountants popped up. A partnership involves two or more people who agree to share in the profits or losses of a business.
There are two types of partnerships: general and limited. 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. General partners basically run the business day-to-day.
A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses—profits or losses are “passed through” to partners to report on their individual income tax returns. A primary disadvantage is liability—each partner is personally liable for the financial obligations of the business. 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. You may want to craft your well-written partnership agreement by answering the following questions:
- How much will each partner contribute?
- Who is going to perform the work?
- How much will each partner be paid for his/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 become at-odds with a partner. If partners are having difficulty finding the right words to describe something in such an agreement, use examples to illustrate what you mean.
There is one last type of partnership 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 so few of these companies—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.
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.
Take it to the limit
A hybrid form of partnership—the limited liability company (LLC)—has steadily been gaining in popularity since the early 1980s because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this business format are that profits and losses can be passed through to owners without taxation of the business itself while owners are shielded from personal liability.
The LLC is a creature of state law and you should be careful to read the statutes of the state in which it operates. 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.
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. However, 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
- most shareholders will have little say in the company’s day-to-day operations.
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 two types of entities from which to select—a sub-chapter S corporation (S-Corp) or a C corporation.
Still, an S-corporation may be the way to go for many vehicle wrap businesses, provided they can meet the qualifying criteria. S-corporations are limited to 75 shareholders—all of whom must be individuals or certain trusts—and there has to be unanimous consent among of 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 the case with 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.
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. Check out the websites www.mycorporation.com or www.LegalZoom.com for online help as well. Often, the cost of setting up an LLC or Corporation is a few hundred dollars or less, plus your state’s filing fees. 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!