Types of Legal Structures and Aspects to Evaluate

The most common legal structures for small businesses in the United States are sole proprietorships, partnerships, and corporations. In a sole proprietorship the business is owned and managed by one individual, although there can be employees. This is the most common way to start a small business. Partnerships are associations of two or more persons that decide to go into business together. They can be either general partnerships or limited partnerships. Corporations are separate legal entities, that can be closely-held, with the original owners holding all the stock, or they can be open, allowing others to purchase stock in the corporation. And certain small corporations can elect to be treated as subchapter S corporations for tax purposes.

Some of the aspects to be considered when deciding upon the legal structure for a small business are:

• Requirements, complexity, and costs involved in setting up the legal structure
• Ownership and control of the business
• Liability for business obligations or losses
• Continuity of the business and transferability of ownership
• Taxes on earnings

Sole Proprietorship

This is the most common way of operating a small business and is the simplest to start up. There is no need to set up a separate legal entity, since the owner and operator of the business are the same person. In this sense, there are no specific legal requirements or costs involved in setting up the business.

Setting Up

A sole proprietorship is started simply by beginning to do business, either under the owner’s name or another name. If a different business name is used, it may be necessary to file a fictitious name certificate, and a business permit may be required in the state or locality in which the business is located.

Ownership and Control

The owner has complete control of the business. A sole proprietorship can have employees and the owner can delegate authority and decision-making, but the owner has final legal responsibility for the decisions made and the actions taken by the business.

Liability

In a sole proprietorship the owner is personally liable for business obligations and losses. Since there is no separate legal entity, there is no distinction between the owner and the business, and creditors could potentially have recourse against the owner’s personal assets to cover business debts.

Continuity and Transferability

A sole proprietorship continues in existence as long as the owner is alive and wants to keep operating the business. The sole proprietorship ceases to exist when the owner dies, and business assets pass to the owner’s personal estate. The owner can freely transfer the business to another person, by selling the business assets. A sole proprietorship could also be sold to another legal entity, such as a partnership or corporation. The sole proprietorship would then end, and the business assets would become part of the purchasing entity’s assets.

A sole proprietorship can take on new owners by becoming a partnership or corporation. In this case, the business could continue, but it would no longer be as a sole proprietorship.

Taxes on Earnings

The owner is entitled to all profits from the business, and also assumes all losses. There could be a profit-sharing plan with the employees of the sole proprietorship, but there is generally no legal obligation to do so, and this would be at the discretion of the owner.

Business profits and losses are reported on the owner’s individual income tax return each year and are taxed at individual income tax rates. The owner must pay self-employment tax on income from the sole proprietorship, and must withhold payroll taxes and pay the employer’s portion of payroll taxes for any employees of the business.

Partnership

There are two types of partnerships: general partnerships and limited partnerships. A general partnership is started when two or more persons agree to form a business and jointly own the assets and share in the profits and losses. There is no limit to the number of partners, and the partners can be individuals or legal entities, including other partnerships or corporations.

Setting Up

A general partnership can be formed by a verbal agreement, but normally there is a written agreement, signed by all the partners, that may be formalized in the partnership by-laws. The agreement should address the following major issues:

• Each partner’s contribution to the partnership, in terms of money, property, and time
• How decisions will be made
• How profits and losses will be distributed among the partners
• What will happen to a partner’s share if the partner dies, becomes disabled, or wishes to withdraw from the partnership
• The duration of the partnership

A limited partnership has one or more general partners, who are generally liable for the business, and one or more limited partners, who have limited liability. Certain statutory requirements must be met in order to form a limited partnership. If these requirements are not met and the partnership is not legally set up as a limited partnership, it will be treated as a general partnership.

It may be necessary to consult with an attorney to properly set up a limited partnership that meets the statutory requirements of the state in which the partnership is established. It may also be advisable to have an attorney help draft the partnership agreement and by-laws in the case of a general partnership.

A partnership can take the name of one or more of the partners, or can take another name. As with a sole proprietorship, it may be necessary to file a fictitious name certificate if another name is used. Any state requirements regarding the name for a limited partnership should also be taken into consideration. It may be necessary to include an indication, such as LLP (Limited Liability Partnership), as part of the name.

Ownership and Control

The partners share the ownership and control of the business. The partnership agreement should specify what percentage of the business and profits each partner owns, and a separate account should be set up for each partner, showing capital contributions, accumulated profits and losses, and withdrawals from the partnership.

In the absence of an agreement, each partner will generally be deemed to have an equal ownership interest in the partnership’s assets and liabilities, and an equal share of profits and losses.

The partnership agreement should also specify who will manage the business and how decisions will be made. Unless otherwise specified, all partners generally have equal control over the management of the partnership business. In this case, all the partners would have to consent and agree to all partnership decisions. But for legal purposes, any partner can make commitments and bind the partnership to contracts and obligations with third parties, even without the consent of the other partners.

In a limited partnership, the general partners are responsible for managing the business. The limited partners have an interest in the business, but are generally silent with regard to day-to-day management decisions.

Liability

In a general partnership, the partners are jointly and severally liable for the partnership. That is, all of the partners are liable together, and each partner is individually liable for all partnership obligations. A creditor of the partnership could make a claim against the personal assets of each and all of the partners.

In a limited partnership, the general partners are generally liable. But the limited partners are at risk for partnership obligations and losses only to the extent of their capital contributions to the partnership.

Continuity and Transferability

A partnership continues as long as the partners agree it will, and as long as all the general partners remain. In the absence of an agreement otherwise, the partnership will dissolve if a general partner dies or leaves the partnership. In this case, the partnership assets would have to be liquidated to pay creditors and distribute the balance among the partners.

The partnership agreement can include a provision for continuation of the partnership, even if one of the general partners dies or leaves the partnership, and can state whether partners are allowed to sell or transfer their interests in the partnership. When a partner leaves, there should be an accounting of that partner’s share of the assets and profits to date, and how they will be paid. If a partner is allowed to transfer a share of the partnership, he or she will be personally liable for any partnership losses up until the date of transfer.

The partnership agreement should also include a provision for bringing in new partners, if the exisitng partners wish to do so. If there is not an agreement, bringing in a new partner would probably result in the termination of the original partnership and the formation of a new one.

Taxes on Earnings

Profits and losses are allocated among the partners according to the partnership agreement, and in the absence of an agreement, they are allocated in equal portions. The partnership itself is not responsible for paying taxes. It files an informational return (Schedule K-1, Form 1065), and the partnership profits and losses flow down to the individual partners who each report their respective share of the earnings on their individual income tax returns. There are certain restrictions on using partnership losses to offset other personal income for federal income tax purposes. Partners must also pay self-employment tax on their share of the partnership income.

Corporation

A corporation is a separate legal entity and there are formal state requirements for setting it up. The individuals who will own the business will be shareholders, or stockholders, and will need to agree on the following before proceeding to form the corporation:

• The name of the corporation
• The total number of authorized shares of stock that the corporation can issue
• The stated value, or par value of each share of stock, although in some cases shares do not need to have a par value assigned
• The number of shares each owner will buy, and the money or property they will contribute to buy those shares
• The line of business in which the corporation will engage
• The directors and officers who will manage the corporation

Setting Up

Once these matters are agreed upon, they must be formalized in the articles of incorporation, which must be filed with the state in which the business is to be incorporated. Corporate by-laws, which are the rules and procedures for running the corporation, including board of directors’ meetings, shareholders’ meetings, the presentation of financial statements, and independent audits, will also need to be drafted and filed.

The state charges an initial fee when the corporation is set up, and an annual fee for allowing the corporation to continue operating. These fees may be based on the stated value of the authorized stock.

Ownership and Control

A corporation has a separate legal identity, and the assets of the business belong to the corporation. The corporation can have bank accounts and can own any other type of assets under its own name. Each of the stockholders owns a share of the corporation, and in effect a portion of the corporation’s assets, based on the number of shares of stock he or she has purchased. But the shareholders do not have direct ownership of any of the corporation’s assets. The money and other property that they contribute to the corporation in exchange for shares of stock become the property of the corporation and no longer belong to the individual shareholders.

The shareholders have ultimate control over the corporation, and they exercise this control by electing a board of directors. The board is normally elected by a simple majority of the outstanding shares, so the shareholders who hold a majority of the stock can effectively elect the members of the board. The terms of the directors should be defined in the corporation’s by-laws, and shareholders can normally elect themselves to be on the board, if they wish to do so.

There are some major decisions that require the direct approval of the shareholders, such as amendments to the articles of incorporation, or the dissolution of the corporation. In some states, these decisions may require more than a simple majority vote to pass.

The board of directors is responsible for making most other major decisions. Normally there must be a meeting of the board at least once a year, and each director normally has one vote, with a simple majority needed to approve a decision. The board of directors elects the corporate officers, including the president, vice-president, secretary, and treasurer. Depending on the state, it may be possible for one person to hold more than one of these officer positions.

The corporate officers are responsible for the day-to-day operations of the business, and for making decisions on normal matters affecting the corporation. The officers can be employees of the corporation, and shareholders can be elected as officers.

Liability

Since a corporation is a separate legal entity, the shareholders are not personally liable for obligations or losses of the corporation. Each shareholder is at risk for the amount paid for his or her stock in the corporation. Creditors of the corporation do not have recourse against the personal assets of the shareholders. This is provided that the corporation is legally established and is operating in accordance with statutory requirements. But if shareholders personally guarantee a loan or other obligation of the corporation, they are legally responsible for the guaranteed obligations. And if shareholders make loans to the corporation, they will generally be repaid after other creditors if the business fails.

Continuity and Transferability

As a separate legal entity, a corporation has its own "life" and can continue to exist beyond the life of any of its shareholders. Normally a corporation’s life is perpetual, but if the shareholders decide to include a duration in the articles of incorporation, or to terminate the corporation at some point, they can do so.

Since the ownership of a corporation is represented by shares of its stock, ownership can be transferred by selling the stock. Also, additional shares can be issued to increase the owners’ equity. Selling newly issued shares will be subject to certain federal or state securities laws. In a closely-held corporation, where the original owners want to maintain control over the business, they may put certain restrictions on the sale of stock to outside parties.

Taxes on Earnings

A corporation’s earnings may be distributed in the form of dividends, or they may be retained and reinvested in the business. The board of directors normally makes the decision regarding dividend distributions. A corporation files its own income tax returns and pays taxes on its net income. The shareholders pay income tax on the dividends they receive. If the corporation’s profits are retained, the shareholders are in effect building up value in the corporation but generally are not subject to tax until profits are distributed.

Shareholders who also work as employees of the corporation receive a salary or wages. This compensation is an expense to the corporation, and taxable income to the shareholder employee.

Subchapter S Corporations

A small business set up as a corporation may be able to elect to be treated as a Subchapter S corporation for tax purposes. The advantage of this election is that generally the Subchapter S corporation does not pay corporate taxes. Instead, they are passed through to the individual shareholders and reported on their individual income tax returns. In this case, the individual shareholders may have to pay tax on their earnings from the corporation even if they have not been distributed in the form of dividends.

There are certain requirements that must be met in order to qualify as a Subchapter S corporation:

1. There must be no more than 100 shareholders (members of a family can elect to be treated as one shareholder).
2. The corporation must have only one class of stock.
3. All the shareholders must be U.S. citizens or residents.
4. All the shareholders must be individuals, and not partnerships or other corporations.
5. The corporation must operate on a calendar year basis.

IRS Form 2553 must be filed to elect Subchapter S status.