Beyond the Sole Proprietorship – Industry Trend or Event
Which business structure right for you?
IT’S SOMETHING ALL ENTREPRENEURS have to face–you need a business structure for legal reasons. But what form should your business take? Most homebased businesses opt to stay a sole proprietorship because it can be too confusing figuring out the other options. Should you incorporate? What’s the difference between a C-Corp and an LLC? And, do you need an attorney to figure all of this out?
According to Kerry Branch, a specialist in business and corporate law with the firm of Morrison & Foerster, LLP in Los Angeles (www.mofo.com), there’s no one right answer that suits every business, so it’s best to do your homework, then consult with an attorney before deciding. When you boil it all down, you have three choices: stay a sole proprietor, incorporate, or form a partnership.
“There is no fixed point at which a home-based business owner should incorporate or form some type of entity to hold the business,” advises Branch. “Choosing to incorporate depends mainly on one’s long-range business plans. Will you go public? Will you acquire other businesses or assets? Do you plan to sell the company at some point in the future?”
The good news is that whichever route you choose to take, your decision is not cast in stone–you can change to another structure if your liabilities increase.
Going Your Own Way: The Sore Proprietorship Whether you know it or not, when you work for yourself, you’re already a sole proprietor. All you have to do to be a sole proprietor is choose a name for your business and get a business license. According to the IRS’s most recent 1997 figures, you’ll be in good company if you are a sole proprietor: nearly 75 percent of the approximately 24 million businesses in the U.S. are organized as sole proprietorships. Why? It’s simple and less expensive to operate as one.
Another benefit of a sole proprietorship is that business expenses and losses are deductible on your personal income tax returns. However, earnings still need to be reported in the year they are earned even if you do not remove funds from the business.
In this simple structure, you can also share ownership of your business with a spouse and still maintain the status of a sole proprietorship. But, you can’t extend ownership to other family members because then the business becomes a partnership. Within the structure of a sole proprietorship, you can hire your spouse, claim that salary, and a portion of family health insurance premiums on your income tax. The only caveat: If the IRS ever audits you, you have to prove your spouse is actually an employee of your company.
Getting Finandal Protection Forming either a corporation or a limited liability company (LLC) is more involved and costly than a sole proprietorship. But it can be worth the expense in that these two plans offer personal financial protection by limiting the owner’s personal liability for business debts or court judgments.
The Corporation Forming a corporation is the most costly and the most complicated way to go, but it offers more benefits. It generally applies to large companies, but a small-business owner can do this in order to take advantage of the benefits–you’ll want to form a corporation if there’s a need to protect your personal assets. There are two kinds of corporations: “S” and “C,” each with its own tax implications. (See the chart, “What’s Best for You? Untangling the Pros and Cons of Business Structures” on this page).
The Limited Liability Company The LLC is a new, more simplified version of a corporation. LLCs don’t own stock, but the structure allows you more flexibility in the way you operate your business. The LLC structure is preferable to a corporation, especially if you own property that’s likely to increase in value. With a corporation, shareholders are subject to a double tax when the property is sold. An LLC does not pay tax on its income, while a corporation does.
Some states require LLCs to have two or more members. A married business owner can include a spouse as a member. If you live in one of those states requiring more than one owner, you’ll be best off taking the corporation route.
Partnerships Partnerships are unincorporated companies. If you choose to partner with a friend or family member, no matter how smoothly the business runs at first, problems may arise. That’s when you’ll be glad to have the guidance of a partnership contract.
Most important to know is that partners are equally responsible for the actions of each other, even if they don’t give consent to, say, take out a bank loan. When one partner signs a legal document such as a lease or loan, he or she legally binds the other parties.
Seeking Out an Attorney Must you hire an attorney? Not necessarily, if you don’t mind doing the research and the legwork. In fact, you can find templates at www.findlaw.com, or you can purchase a do-it-yourself kit from a paralegal service. But keep in mind: even if you take the do-it-yourself legal route, there will be filing fees and a charge for mandatory legal notices in the local newspapers that can run several hundred dollars.
Paul Swanson, also an associate with Morrison & Foerster, advises business owners not to try to go it alone. “Align yourself with professionals,” he says. “Proper relationships with such professionals can open very large doors for your business.”
When you weigh the amount of time you will need to spend on research, you may decide your time is better spent on other business matters. Attorney fees for handling the matter of incorporating will be between $1,000 and $2,000, depending on the state–a small price considering it could save you thousands of dollars–and give you peace of mind for the long run.
What’s Best for You?
Untangling the pros and cons of business structures.
TYPE OF BUSINESS PROS CONS
SOLE PROPRIETORSHIP Simple and Legal risk: Owner
inexpensive to form personally liable
and operate for business debts
Owner can report Must report earnings
losses on personal in year earned
to offer financing
REGULAR Limited liability to More expensive to
CORPORATION owners for debts/ form business
Fringe benefits can paperwork
be deducted on
income tax Must abide by laws
and rules governing
Numerous other tax corporations
Must decide between
Can offer stock as “S” and “C” form
LIMITED LIABILITY Financing easier to More expensive to
Personal liability Tax laws not as
for business limited flexible; state and
More flexible sometimes fuzzy
reporting of Profit about governing LLCs
and Loss on income
Choice on whether
taxed as corporation
GENERAL PARTNERSHIP Inexpensive to form Owners personally
liable for business
Owners report profit debts
and loss on personal
income tax Partners liable for
actions of other
What’s Your Goal?
Writing a business plan will help you determine what structure to take (see Q&A in the Up Front section, page 15), and how to answer these six important questions. If you answer yes to any question, you may need to look beyond a sole proprietorship.
* Will you ever go public?
* Do you plan to sell the company in the next 5 to 10 years?
* Does your service or product lend itself to a potential lawsuit?
* Will you ever need to borrow a lot of money to run your business?
* Is there a possibility you may not be able to deliver goods or services as promised?
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