Legal Structures

One of the most important decisions entrepreneurs make is how to legally set up their businesses. The choice can be a wise move or a costly mistake with regard to taxes paid, protection from liability, and the amount of resultant flexibility in running the operation.

The initial choice of a business form, even if it achieves optimum results in the start-up phase, may require adjustment or alteration as the business matures. It is important to periodically re-examine the appropriateness of the type selected. Below is a description and a comparison of the advantages and disadvantages of each form of organization.

Sole Proprietorship

For an individual who wants to keep the operation small and simple, this is the easiest, least costly, and least regulated type of business to enter into. A sole proprietorship can be formed by just finding a location and opening the door for business. There are the usual fees for registering your business name and for legal work in changing zoning restrictions and obtaining necessary licenses. Attorneys' fees will be less than for other forms of incorporation because less document preparation is required.

The sole proprietor has total responsibility and control, and can hire any number of employees who may even be paid a percentage of the profits as wages. The owner is personally liable for all claims, taxes and debts against the business, as well as for any injuries caused by or to employees during their employment. The sole proprietor is entitled to all profits made in the business, which must be included in the individual income tax return. If a person has assets, or is developing an asset base, this form of business exposes the individual to litigation.

Advantages

-Easiest to get started

-Greatest freedom of action

-Maximum authority

-Income tax advantages

-Social Security advantages

Disadvantages

-Unlimited liability

-Death or illness endanger business

-Growth limited to personal energies

General Partnership

A partnership can be formed by simply making an oral agreement between two or more persons, but such informality is not recommended. It is wise to have an attorney draw up an agreement among all partners, clearly stating the specific duties and rights of each of them, to help resolve any future disputes. Almost any type of management and profit-sharing arrangement can be agreed upon.

Each partner is an "agent" for the partnership and can individually hire employees, borrow money and operate the business. A partnership is not a separate legal entity, even though required to report its income on a separate, informational tax return (Form 1065), but profits made must be included in each partner's individual tax return.

The important thing to keep in mind regarding a general partnership is that each partner is personally liable, just as in a proprietorship, for debts and taxes to the extent that personal assets can be subject to attachment and liquidation if the partnership itself cannot satisfy creditors' claims.

Advantages

-Two (or more) heads better than one

-Additional sources of venture capital

-Better credit rating than corporation

Disadvantages

-Hazy line of authority

-Difficult to get rid of bad partner(s)

-Death, withdrawal or bankruptcy of one partner endangers business

Corporation

Think of a corporation as legally separate from its shareholders. This is the most important feature distinguishing it from a partnership or proprietorship. It is definitely best to get an attorney to take care of the formalities of setting up a corporation, even in the case of a small family corporation where an attorney can help prevent hard feelings and squabbles. This type of business is usually the most costly to form, especially if organizational problems are complex.

People usually incorporate to limit personal liability for the debts and liabilities of the business. However, with many new businesses this limit of personal liability applies only to judgments brought against the company for negligence, defective products, or frivolous suits. In fact, the owner(s) of a new business will usually remain liable for the repayment of loans and other debts because most major creditors, especially lenders, will try to limit their risks by requiring owners to pledge their personal assets as security for a debt. In some cases, an officer or employee of a corporation may also be personally liable for failure to withhold taxes. A corporation is a separate legal entity and a more structured form of business. It can continue to function even without the existence of original ownership or other key individuals. It also has advantages in terms of enabling employees to participate in various types of insurance and profit sharing. A corporation has more flexibility in terms of different approaches to taxation.

Advantages

-Limited liability for stockholders

-Continuity

-Transfer of shares

-Easier to raise capital

-Possible to separate business functions into different corporations

Disadvantages

-More expensive to launch and maintain

-Gives owner a false sense of security

-Heavier taxes

-Power limited by Charter

-Less freedom of activity

-Legal formalities

Conclusion

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