Business Structures Which to Choose (Is Easiest and Simplest Always The BEST?

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Patrick N. T. So youve started up a business and youve done so in the easiest and simplest way. You started a Sole Proprietorship. Although its been working for you so far, your current form of business organization may not be best suited to future expansion plans. Although you may be running your business in what is the most common form of business structure, it will not allow for the flexibility that you will need to acquire the capital needed to expand should you wish to do so in the future. In addition to the lack of flexibility regarding raising capital, you could also be facing increased personal liabilities some bordering on the catastrophic if an employee were hurt on the job or a customer was ever injured while doing business with you (or as a result of doing business with you). In order for you to successfully (and safely) accomplish future and expanded business goals, you should examine carefully the following seven factors and take note of how the various business restructuring options relate to them:

LIABILITIES TAXATION LONGEVITY / CONTINUITY CONTROL PROFIT RETENTION LOCATION CONVENIENCE or BURDEN

Before we move on to listing the advantages and disadvantages of the various forms of business structures that are available, I would like to first take a close look at why you might wish to move on (and away) from the sole proprietorship form. The sole proprietorship (or SP) offers you total autonomy in running your business an undoubtedly attractive feature. In addition to the ease of creation and set-up that this structure brings, it is also the form that enables you as the owner (the sole proprietor) to make any business decision or follow any business path without any need to consult with others. The profits from your business also belong to you completely with no requirement to share them or to be accountable to any other parties except state and federal tax agencies. Your profits, however (because there is no legal distinction between you and your business) are considered as ordinary personal income the downside of which is that this is a form of income that incurs the highest rate of taxation. With or without your business expansion, the sole proprietorship structure also carries with it the greatest chance of personal liability. Since there is no legal distinction between you and your business, any debts incurred by the business are legally your own personal debts. Any civil legal action taken against your business such as a damages or injury claim - is also a legal action that will be taken against you personally. This is known as unlimited liability and places any and all of your personal property (house, savings, possessions, vehicles, etc.) at risk should your business be sued for damages, breach of contract, or debt collection. Aside from the liabilities, you are also disadvantaged in terms of expansion and raising capital. As a sole proprietorship, your only means of raising capital is through personal finances or through personal loans. A bank will not grant you a business loan as it will not make a distinction between you (the owner) and the business. You are also unable to take on investors. Should someone (a friend or relative, for instance) wish to invest in your business to help you in a future business expansion, there would be no means by which that benefactor will be able to legally share in the profits gained through their funding or to own a portion of the business in exchange for their investment. With those thoughts in mind, lets look at the seven business factors that I noted earlier and see how they apply to the sole proprietorship structure.

1. SOLE PROPRIETORSHIP (SP) Pros and Cons:

LIABILITIES High (unlimited, actually) Because there is no distinction between you and your business, any action taken against your business is an action taken directly against you. This places all of your personal property and personal finances at risk. TAXATION High (typically incurs highest rate of taxation on profits) All profits from the business are considered as personal income, a fact which typically places this income within the highest taxation categories. LONGEVITY / CONTINUITY None (business dies with owner) There is no way to pass on ownership of the business without selling it off in its entirety. Leaving your business assets to your heirs also incurs potential inheritance taxes unless careful estate planning is exercised. CONTROL Complete (owner answers to no one) One of the advantages of a sole proprietorship is the total autonomy you are provided in making business decisions without any need to consult with or report to others. PROFIT RETENTION Complete (owner shares profits with no one) Another of the advantages of a sole proprietorship is that you retain 100% of the profits and also have complete control over how they are used. The profits are legally yours in their entirety - and are considered personal income. LOCATION Easy (most states require little or no filing requirements) You can easily move into another state to do business without any need to be overly concerned with the filing procedures of an additional jurisdiction (corporations, on the other hand, need to submit a foreign corporation application to operate in another state). CONVENIENCE or BURDEN Burden outweighs convenience The filing and reporting requirements of an SP are a very small burden, but the conveniences are outweighed by the burden of unlimited liabilities (and their potential impact on personal property and finances). There is also the inability to obtain expansion capital through investors (thus placing the financial burden for expansion solely on the owner). This is especially relevant with regard to your own expansion plans. Now lets review the other five business structures that are available and see how they stack up against these same 7 business factors:

2. GENERAL PARTNERSHIP Pros and Cons:

LIABILITIES High (same as an SP, but affecting ALL partners) As in the case of an SP, there is no distinction between you, your partners and your business. Therefore, any action taken against your business is an action taken directly against you and your partners. This places all of your personal property and personal finances and that of your partners - at risk. This is potentially an even greater risk than an SP because any misdeeds connected to any single partner places all of the other partners at risk - regardless of their innocence. TAXATION High (same as an SP, but affecting ALL partners) Once again, as in the case of an SP, all profits from the business are considered as personal income for all partners. Once again, the income is usually categorized within the highest taxation categories for all partners. LONGEVITY / CONTINUITY Better than SP Your business can continue if you or any of your partners leave or die. Remaining partner(s) can continue doing business if a partner leaves, but will need to abide by a buy-out clause if one was written into a partnership contract. If a partner dies, the remaining partner(s) may need to buy the deceased partners business assets from his or her surviving heirs. CONTROL Less than SP Single owner autonomy is relinquished. No one partner can make a business decision without consulting the other partner(s) PROFIT RETENTION Same as an SP, but shared among partners All profits legally belong to all the partners in their entirety - and are considered personal income for all. LOCATION Easy (same as an SP) You can easily move into another state to do business without any need to be overly concerned with the filing procedures of an additional jurisdiction. CONVENIENCE or BURDEN Burden outweighs convenience As in the case of an SP, the filing and reporting requirements of an general partnership are a very small burden, but the conveniences are outweighed by the disadvantages of unlimited liabilities (and their potential impact on personal property and finances for all of the partners) and the inability to obtain expansion capital through outside investors (thus placing the financial burden for expansion solely on the partners).

3. LIMITED PARTNERSHIP Pros and Cons:

LIABILITIES High (same as an SP, but not for ALL partners) Anyone entering the business on a limited partnership basis will be protected from the unlimited liability risks faced by an SP or by general partners. In a worst-case scenario, the most a limited partner can lose is their investment into the business. As a former SP, however, the only way you can personally enjoy this protection is by entering into a partnership in which you are in the position of limited partner. The drawback is that you will no longer be fully involved in the decision-making process - this is reserved for the general partner(s) while limited partners are not involved in the day-to-day management. TAXATION - High (same as an SP, but affecting ALL partners) No difference from an SP or a general partnership. All profits from the business are considered as personal income for all partners (limited and general). This places business profits into the highest taxation categories. LONGEVITY / CONTINUITY Same as a general partnership Business can continue if any partners leave or die. Remaining partner(s) can continue doing business but will need to abide by a buy-out clause if one was written into a partnership contract. If partner dies, remaining partner(s) may need to buy a deceased partners business assets from his or surviving heirs. CONTROL Limited partners relinquish their decision-making right No one partner can make a business decision without consulting the other GENERAL partner(s), but LIMITED partners do not need to be consulted. PROFIT RETENTION Same as an SP or general partnership All profits legally belong to the partners (general and limited) in their entirety - and are considered personal income. LOCATION Easy (same as an SP and general partnership) You can easily move into another state to do business without any need to be overly concerned with the filing procedures of an additional jurisdiction. CONVENIENCE or BURDEN ONLY limited partners escape burden of liability As in the case of an SP or general partnership, the filing and reporting requirements are a very small burden. However except for the limited partners - the disadvantages of unlimited liability remains. There still remains the lack of flexibility to obtain expansion capital through outside investors (once again placing the financial burden for expansion solely on the partners).

4. C-CORPORATION Pros and Cons:

LIABILITIES None for owners (business functions as a separate legal entity) The business is viewed legally as though it were a separate person. Any liability incurred by the business stays within the business while the shareholders personal assets are safe. TAXATION Lower tax rates for corporate-held profits, but there is double taxation Since a C-corporation is a separate legal entity, it must pay taxes federal and state on its net profits. Corporate tax rates are, however, less than the tax rates for personal income. If the corporation pays out dividends to its shareholders, those net profits are taxed again as personal income (double taxation). LONGEVITY / CONTINUITY Business continues regardless of ownership The continuation of the corporation is not affected by either a change of ownership or the death of an owner. Corporations can exist beyond the lifetime of the original founder(s). CONTROL Board of Directors and C-Level officers run day-to-day operations Shareholders (owners) elect a board of directors. The directors are responsible for approving the C-level employees who will run the day-to-day operations of the corporation. C-level employees remain responsible to the board and are charged with the responsibility of making sure that the boards business strategies are carried out. It is also possible for C-Level officers to serve on the board of directors and to be owners of a controlling share of stock. A privatelyowned company can be fully owned and controlled, for instance, by three shareholders - all of whom are C-level officers and who also reside on the board of directors (this is an example of a closely-held private corporation). PROFIT RETENTION Profits maintained by corporation unless paid by dividends Unless the corporations board of directors decides to pay out a dividend to the shareholders, all profits are retained by the corporation (and taxed on the lesser corporate rate). Shareholders, however, can reside on the board (enabling them to decide whether dividends will be paid) and can also act as salaried C-level employees. LOCATION Can be somewhat burdensome for additional state(s) In order to conduct business in a state other than that in which a corporation was originally filed, a C-corporation must file in the additional state(s) as a foreign corporation. Depending upon the requirements of the additional state(s) in which the corporation wishes to conduct business, foreign corporation set-up procedures and compliance may entail time and expenses significantly greater than the non-corporate forms of business structure. CONVENIENCE or BURDEN Personal liability protection outweighs additional burdens Filing requirements, fees and procedures differ between states and doing business in more than one state requires additional set-up and filing work. Corporate law also requires much more accountability for the business day-to-day financial dealings. The additional expense and burden, however, is greatly outweighed by the protection from liability afforded owners by the corporate structure. The corporate structure also makes it easier to obtain outside capital as investors are protected from liability.

5. S-CORPORATION Pros and Cons:

LIABILITIES Same as a C-Corp (None for owners / business is a separate legal entity) The owners (shareholders) are separate from the business. The business is viewed legally as though it were a separate person. Any liability incurred by the business stays within the business while the shareholders personal assets are safe. The most a shareholder can lose is the original amount of his or her investment. TAXATION Better than a C-Corp / No double taxation Only shareholders are taxed on their respective ownership percentages (proportional share) of the corporations profits. The corporation itself is not taxed as its profits are passed through to the shareholders effectively eliminating the double taxation incurred by a C-corporation. The taxation only takes place at the shareholder end. LONGEVITY / CONTINUITY Same as a C-Corp / Continues regardless of ownership The continuation of the corporation is not affected by either change of ownership or death of owners. Corporations can exist way beyond the lifetime of the original founder(s) or owner(s). CONTROL Same as a C-Corp / CEO and C-Level officers run day-to-day operations Shareholders (owners) elect a board of directors. The directors are responsible for approving the C-level employees who will run the day-to-day operations of the corporation (and who remain responsible to the board and who are charged with the responsibility of making sure that the boards business strategies are carried out). It is also possible for C-level officers to serve on the board of directors and for both to be owners of a controlling share of stock. A privatelyowned company can be fully owned and controlled, for instance, by three shareholders - all of whom are C-level officers and who also reside on the board of directors (this is an example of a closely-held private corporation). PROFIT RETENTION All profits passed through to shareholders Unlike a C-Corp, all profits are passed through to the shareholders based upon their individual proportionate share of ownership (stock holdings). LOCATION Same as a C-Corp / Can be somewhat burdensome In order to conduct business in a state other than that in which a corporation was originally filed, an S-corporation must file in the additional state(s) as a foreign corporation. Depending upon the requirements of the additional state(s) in which the corporation wishes to conduct business, foreign corporation set-up procedures and compliance may entail time and expenses significantly greater than the non-corporate forms of business structure. CONVENIENCE or BURDEN Personal liability protection outweighs additional burdens As in the case of a C-Corp, the S-Corp offers the owners (shareholders) protection from personal liabilities. Unlike the C-Corp, however, the S-Corp is a convenient structure for small closelyheld private companies that wish to avoid the double taxation liability. Basically, the S-Corp was designed for small businesses. In order to qualify, the business must be limited to 100 shareholders (all of whom must be US citizens) and the company profits must be shared among the shareholders based upon their proportionate ownership (stock holdings). In addition, there can only be one class of stock.

6. LIMITED LIABILITY COMPANY Pros and Cons

LIABILITIES Limited / Personal assets are protected An LLC is just like a corporation a separate legal entity from its owners. This protects the personal assets of the owners (referred to as members in an LLC) from lawsuits directed against the business. TAXATION Most flexible structure / can change year-to-year Sophisticated and extremely flexible tax planning is possible within the LLC structure. The business can choose how it wants to be taxed. It can, for instance, choose to be taxed as a C-corporation based on its net profit or as a pass through (S-corporation) in which only its members are taxed in the form of personal income. The business can also choose its method of taxation on a year-to-year basis. LONGEVITY / CONTINUITY Same as a corporation The LLC structure allows for perpetual duration as long as the business remains in good standing and stays up to date with the requirements of the state it was formed in. Unlike a sole proprietorship, the surviving members of an LLC are not affected by the death of the original founder. CONTROL LLC members manage day-to-day business affairs Unlike a limited partnership in which protection from liability prohibits a limited partner from involvement in day-to-day business affairs, members of an LLC can be involved in company management while still enjoying a personal liability shield. PROFIT RETENTION Flexible / Members can divide profits in a variety of ways The LLC structure enables the company owners (members) to divide the profits based on investment amount, the degree of managing responsibility, the amount of time devoted, or any combination of these factors that represents an agreed upon equitable arrangement. LOCATION Easier than for corporations In order to transact business in a state other than the one in which it was originally formed, an LLC must register within that state. As in the case of corporations, the registration requirements vary from state to state, but the overall filing procedures and costs are significantly less for LLCs than they are for corporations. In most states, no legal or third-party assistance is required. CONVENIENCE or BURDEN Convenience outweighed by the difficulty in obtaining investors if a company has expansion plans beyond the current means of its owners Fundraising through outside (new) investors can be difficult and banks require a PG (personal guarantor) for any loans made to an LLC.

I hope this brief overview was helpful in understanding each business structures pros and cons as weighed against the seven basic organizational considerations. As ever and always in business - look before you leap. Think carefully and seek the advice and counsel of an accountant or business finance professional before settling in on any one course of action. Ask every question you can possibly think of when consulting with business and finance professionals. Prepare a list in advance, and if you ever detect annoyance with your questions, find somebody else - it never hurts to get a second opinion anyway.