CHOOSING THE BUSINESS LEGAL STRUCTURE
by Robert Sullivan, author of "The Small Business Start-Up Guide"

Okay, you've chosen your business. What next? No doubt, one of the most asked questions by the prospective business owner is "Should I incorporate?" To answer this question, we need to examine what the options are and their respective advantages and disadvantages. So as not to keep you in suspense, it should be noted that most new small businesses will not incorporate - but will operate as a sole proprietorship.

Actually, you have three basic business structures from which to choose:

1. Sole proprietorship
2. Partnership (limited or general)
3. Corporation (S, C or LLC)

The legal structure you choose depends on a number of things, including your type of business, individual situation, goals for the business, and a number of other personal and financial factors. Before deciding what's best for you, discuss your plans with your accountant and attorney. Make sure you are prepared to describe your business plans in some detail. It will be money and time well spent. Making the right choice can help you avoid a mistake that can cost you big in terms of possible future liability.

Before you have any discussions with your professional advisors, it is useful to understand the basics of the various legal structures available to you ... sole proprietorship, partnership, and various forms of corporations.

SOLE PROPRIETORSHIP

This is the most popular form of small business and, as the name implies, ownership is totally vested with one person. It is the easiest to establish since no legal formalities are necessary. The only business requirement may be a license from your local jurisdiction to allow you to conduct the type of business you are planning. For example, you may need a license to sell food to the public.

Sole Proprietorship Advantages:

• Easy and quick and usually the least ex-pensive to establish.
• You have total ownership and control of the business.
• All the profits of the business belong to you, the owner.
• No additional Federal taxation on business profits (No double taxation).
• No periodic business reporting to the IRS or other government agency is required.
• Income tax filing is simply part of your annual personal tax return (Schedule C).

Sole Proprietorship Disadvantages:

• The owner is personally liable for all business debts and the liability is not limited to the value of the business. You are personally liable for any and all business debt you incur.
• It is generally more difficult to borrow money or obtain outside investment than with other types of legal structures.
• If the owner is incapacitated for any reason, the business is likely to fail.
• All management responsibility is with the owner which can be a heavy burden.

IMPORTANT NOTE

A "home business" is frequently a sole proprietorship and offers a number of unique ad-vantages. However, just because you are con-ducting business from your home does not exempt you from possible legal or other liabilities.

PARTNERSHIP

This type of business is just what the name implies: Business ownership is divided between two (or more) partners. The general partnership is the most common and is formed to conduct a business with two or more partners being fully involved in the operation of the business. All the partners share both profits and liabilities. A limited partner-ship, as the name implies, provides for limited liability of the partners. (This liability can be no greater than the partner's investment in the partnership). In a limited partnership there must be a least one general partner who remains liable for all the debts of the partnership. Forming a partnership is complex and legal advice is very important. The kind of partnership and the type of partner you will be determines your potential personal liability.

Partnership Advantages:

• Synergy as a result of pooling partners' different areas of expertise.
• The partnership does not pay Federal in-come taxes. An informational tax return (IRS Form 1065) must be filed which shows the pass-through of income/loss to each partner.
• Liability may be spread among the partners.
• Investment can come from the partners in the form of a loan which creates interest income for the partners and a business deduction for the partnership.

Partnership Disadvantages:

• Formation and subsequent changes in structure are complex.
• Problems with partner(s) as the result of misunderstandings, different goals, etc., can weaken or destroy the partnership.
• Limited partners are liable for debt if they are active managers in the business. General partners have unlimited liability. You may also be liable for the commitments of your partners.

CORPORATION

There are three major types of corporations, the C-corporation ("regular corporation"), the S-corporation (or "S-Corp"), and the Limited Liability Corporation (or "LLC"). All of these forms of the corporation are complex legal entities. Their detailed structure may vary from state to state (incorporating a business in a given state allows you to conduct business only in that state). It is essential for you to obtain legal advice if you are thinking about forming a corporation. Since each state has its own set of corporation laws, you should contact the appropriate state office in your state (usually the office of the Secretary of State) for additional material and procedures. Most offices can provide a guide for new businesses to follow for incorporation and doing business in their state. Call or write for a copy.

Most people immediately think of incorporating in order to minimize their personal liability. Indeed, the liability of stockholders (owners) in a corporation is limited under certain and complex conditions. Today, with the Tax Reform Act of 1986 and other legislation, there are really few good tax reasons to incorporate (with the exception of dividing corporate profits as noted below). The best reason for incorporating is, in fact, the limited liability. However, there is no such thing as total insulation from liability resulting from doing business as a corporation.

Record keeping and tax matters with a corporation are difficult and time-consuming tasks usually requiring the services of an accountant. You need to keep this in mind when considering operating costs for your business.

Avoid the "do it yourself" incorporation guides. Incorporating is a complex process and you should not take on the task yourself. You cannot afford any mistakes at this point in your new business, so if you decide incorporation is for you, do it right and spend the money required to have it done professionally. Legal fees for setting up a corporation can run between $350 and $1,500 (assuming it is relatively straightforward).

REGULAR CORPORATION

The corporation is a taxable entity and, as such, pays taxes. This results in the "double taxation" you may have heard about. The corporation pays corporate taxes on its profits, and then, you the owner (shareholder), pay personal taxes on the dividends your corporation pays you. (The dividends are not deductible by the corporation). This is one of the biggest disadvantages of a corporation.

On the other hand, incorporating your business usually makes it easier to establish credit with suppliers and borrow from banks. If you expect to use outside investors for business capital, a corporation is a must.

Regular Corporation Advantages:

• Shareholders (the owners) enjoy personal limited liability.
• It is generally easier to obtain business capital than with other legal structures.
• Profits may be divided among owners and the corporation in order to reduce taxes by taking advantage of lower tax rates.
• The corporation does not dissolve upon the death of a stockholder (owner) or if ownership changes.
• Favorable tax treatment for employee fringe benefits including medical, disability, and life insurance plans.
• 70% of any dividends received by the corporation from stock investments are deductible (unless you purchased the stock with borrowed money).

Regular Corporation Disadvantages:

• More expensive and complex to set up than other legal structures.
• Completing tax returns usually requires the help of an accountant.
• Double taxation on profits paid to owners (corporation pays corporate taxes on profits and owner pays personal taxes on dividends from the corporation).
• Recurring annual corporate fees.
• Tax rates are higher than individual rates for profits greater than approximately $75,000.
• 28% accumulated earnings tax on profits in excess of $250,000.
• Business losses are not deductible by the corporation.

S-CORPORATION

The S-corporation offers the limited liability advantages of a corporation but does NOT pay Federal taxes. All the earnings and losses of an S-corporation are passed through to the share-holders. It is a popular form of incorporation in the startup years of a business but there are some subtle disadvantages that need to be taken into account as you grow. Again, because of the complexities involved, talk with your attorney and accountant.

S-corporation Advantages:

• Owners enjoy personal limited liability as in a regular corporation.
• No Federal income tax liability, and in most cases, no state income tax.
• 3. Profit/losses are passed to owners ... no double taxation.
• The S-corporation does not dissolve if one of the owners dies or otherwise leaves (like a regular corporation).
• Wholly owned subsidiaries are permitted.

S-corporation Disadvantages:

• Legal assistance is required to set up.
• Maximum of 75 shareholders.
• Only one class of common stock is permitted (no preferred stock).

LIMITED LIABILITY CORPORATION (LLC)

This type of corporation blends the tax advantages of a partnership and the limited liability advantages of a corporation. Owners of an LLC are referred to as "members." As you might expect, it also has some limitations but is definitely worth considering. Ask about the LLC when you contact your appropriate state office for incorporation information as suggested earlier in the chapter.

LLC Advantages:

• Limited personal liability for the owners (like a corporation and unlike a partnership).
• No Federal taxes (like a partnership).
• No limit on the number of stockholders (unlike an S-corporation).
• More than one class of stock is permitted (unlike an S-corporation).
• Business losses may be deducted on your personal tax return (like a S-corporation).

LLC Disadvantages:

• Legal assistance is required to set up. The paperwork is complex.
• No "continuity of life" as in a regular corporation. The LLC dissolves if one of the owners dies or otherwise leaves. However, other formal agreements between the owners can overcome this.
• Some states require than an LLC have more than one member.

MAKING YOUR CHOICE

It is difficult to give specific advice as to the choice of legal business structure since every situation will be unique. The ad-vantages and disadvantages noted above should be assessed based on your particular situation. In any case, it is important to discuss your plans with advisors including both an attorney and an accountant prior to making your final decision. The various tax consequences for corporations and partnerships are complex and must be carefully considered for each specific situation.