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Friday, November 12, 2010

Choosing a Legal Entity

Before we set up our business, we must think about whether we are acting alone or with partners. We must also examine our purpose in establishing a business. Are we establishing it because we
  • were downsized
  • feel we can run a business better than our boss because we are smarter than he is and have more energy
  • can't take direction from someone else
  • feel we want to grow something, perhaps a hobby, and make it a megacompany in the future and get rich
  • want to leave something to our children for them to run and develop further
Whatever our reason we must decide how to establish our business and understand the tax implications of our decision.

A sole proprietorship is merely a company with one owner doing business under his chosen name for the business. It is the simpliest and cheapest business structure to form. Merely decide upon a name for the business, and file it with the Secretary of State in the state in which you will be doing business, and obtain a license for the business.

The beauty of a sole proprietorship is that you are in full control of your business, and you are the sole decision maker and creative presence.  All the responsibility is on the owner's shoulders, and once the owner passes away, the entity as registered passes away with him.
What are the tax implications of the sole proprietorship?   All the liabilities of the business are the responsibilty of the owner. The owner is exposed to all taxes. How does a sole proprietorship pay its taxes?The profits and losses of the business are entered onto Schedule C (for a sole proprietorship) and "Passed-through" to the owner's 1040 Form.
The ability to raise capital for the business in a sole proprietorship is limited by the amount of money the individual owner can raise based on his own collateral, creditworthiness and capacity.

Another form we can opt for is that of a partnership. Two or more co-owners can come together under a partnership. Usually the partners split the responsibilities and run the business. A Partnership Agreement must be drawn up which indicates the rules and regulations of running the partnership, adding investments, transferring partnership interests, and dissolving the partnership. A partnership has a predetermined life, usually of 40 years. Again, you file your business name and your partnership agreement with the Secretary of State.
The liability for the business is not as great as in the sole proprietorship, however, each partner is responsible for the liabilities of the partnership as a "joint and several" obligation. The profits and losses of the partnership are indicated on Form 1065, and the individual percentage of the partnership profits and losses are reported on Schedule K and K-1. The profits and losses are again passed through to the individual partner's 1040 Form.
The ability to raise capital for the business is not as restricted as in a sole proprietorship. There are more individuals who collectively have more borrowing power and collateral than the sole proprietor.

A corporation is considered an entity or an individual by the state and by the Internal Revenue Service, and thus it files its own tax form, unlike the previous two structures. A corporation can be a corporation of one or of many owner-investors. The evidence of owning a piece of the corporation is in the form of a stock certificate given in exchange for cash. Liabilities for the business are kept in the corporation. The individual owners are not responsible for the liabilities of the corporation. Therefore, there is limited liability and the individual is protected by the corporation.
In setting up a corporation you need to have prepared the Articles of Incorporation and the By-Laws, obtain a Corporate Seal and file with the Secretary of State.
Since the corporation is considered an entity, it must file its own income tax reports, file annual reports and hold shareholders' meetings. It is a more expensive form of business, however, the protection it affords owners in the way of tax liabilities can far outweigh the costs.
Also, a corporation exists forever. There is no limitation on its life. Raising capital is easier than the sole proprietorship and partnership because you merely sell shares of stock to raise additional funds.  It is the profits and history of the corporation and its performance in its industry that will govern its creditworthiness and soundness as an investment.

The decision as to which form of organization to choose should not be taken lightly.  You should discuss the advantages and disadvantages with an attorney and an accountant.
For additional information on choosing a structure for your business, you can refer to the Small Business Administration site on structuring your business.

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