BUSINESS STRUCTURING

Selecting the structure under which you will operate your business, is the most important business decisions you will make. The basic organizational structures available to entrepreneurs today are sole proprietorships, partnerships, corporations, and limited liability companies.

The type of business organization you choose will depend on many factors, including: the nature of the business operation legal restrictions, capital needs, tax advantages, intended division of earnings number of owners, planned life of the business, and whether you need to protect personal assets from business debts or law suits.

The following comparisons of the advantages and disadvantages of business structures, provided below, will help you clarify which organizational structure may best suit your situation. For more assistance, please contact us. Again, thank you for visiting ProBusinessCoach.com. We look forward to serving you.

Genuinely,


Johnny Rhondo, Founder
ProBusinessCoach.com

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Sole Proprietorship

A sole proprietorship is the simplest form of business organization and the most common type of business in America today. Simply put, a sole proprietorship is a business which is owned by one person. This can be the least costly and quickest way of starting a business because registering the business name and obtaining the necessary operating licenses may be all that is required.

Advantages of Sole Proprietorships:

* Easy to start.

* Provide greatest freedom of action to follow your business vision.

* You, the owner, make the business decisions.

* Your business taxes are passed through to your personal IRS return.

Disadvantages of Sole Proprietorships:

* You, the owner, have unlimited personal liability for business debts. Personal and business obligations are one and the same.

* Illness or death may threaten your business.

* You are eligible for fewer business deductions compared to other types of business organizations. When you own a sole proprietorship, you are the business. As a result, any debts or judgments against the business become your personal debts. This means that your personal assets such as your home, car, and personal savings are exposed to business creditors. This usually gives business creditors recourse against your business assets only.

The pass-through tax advantage of passing business income through to your personal IRS return is the same for sole proprietorships and LLCs.

The sole proprietorship costs slightly less to form and to properly maintain than other business structures such as corporations, LLCs, or partnerships. However, fewer types of business deductions are allowed for sole proprietorships than for these other types of entities.

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Partnerships

The Elements of a Partnership

There are two basic elements common to all partnerships: (1) community of interests and (2) the sharing of profits. According to the law, a partnership is an association of two or more persons for the purpose of carrying on a business as co-owners for profit.

This association can be for an indefinite period of time or for a fixed period of time. However, the basic intent of the business association must be the continuous operation of the business, rather than the operation of the business for a single or separate series of transactions, like for example, a Joint Venture. In other words, the association must be founded on the intent of the partners to share a community interest in the successful and continuous operation of the business.

There are many unincorporated associations that are formed for both profit and non-profit purposes, which in a sense, operate like partnerships. However, a true partnership cannot be formed for non-profit purposes, since its existence depends on its profit-making intent. Without a doubt, there are many partnerships that fail to make a profit, but this is not the issue, since the initial intent of the partnership was for profit.

It thus can be seen that the two basic principles underlying a legal partnership are: (1) the intent of the parties to associate themselves for the purpose of carrying on a continuous business venture and (2) that such business venture is profit motivated.

Types of Partnerships

The Uniform Partnership Act recognizes several types of partnerships, for example: (1) General Partnership, (2) Limited Partnership, (3) Joint Venture, (4) Joint Stock Companies, (5) Business (Massachusetts) Trust, and (6) Unincorporated Associations. These types of partnerships are described as follows:

GENERAL PARTNERSHIP. A General Partnership is the simplest and most prevalent form of partnership. It can be formed by a handshake, a verbal agreement, or by a formal Partnership Agreement. In any case, it constitutes a formal business association between the partners which necessarily entitles them to all of the rights and obligations recognized by law. Similar to sole proprietorships, your personal assets are not protected from creditors of your business.

LIMITED PARTNERSHIP. Limited partnerships also involve two or more individuals. However, one of the partners - the limited partner - limits his or her activity in the business to capital investment. This partner does not actively participate in the management of the business. The other(s) - called general partners or operating partners - run the day-to-day operation of the business. Under this arrangement, the limited partner's personal liability for business debt is only as much as his or her capital investment. Unlike the operating partners, the limited partner's personal assets are not exposed.

A Limited Partnership differs substantially from a General Partnership in that there are two classes of partners, i.e., General Partners and Limited Partners. Each such class of partners has a separate and distinct status, in fact and by Law, for example:

a. General Partners. Every Limited Partnership must have one or more General Partner(s) who is(are) active in the operation and management of the partnership affairs. The General Partners assume all of the rights and obligations inherent in a General Partnership. This necessarily means that they are personally liable for all of the partnership's obligations.

b. Limited Partners. Limited Partners have four characteristics which set them apart from General Partners. They are: (1) limited investment, (2) limited liability, (3) non-participation in management, and (4) transferability or withdrawal of interest. Each is described as follows:

c. Limited Investment. A Limited Partner enters a Limited Partnership with a designated amount of Capital. The financial benefits derived from the partnership are tied directly to the amount of capital committed to the partnership, at a fixed percentage of the net income.

d. Limited Liability. A Limited Partner's liability is limited strictly to the amount he(she) has invested in the Limited Partnership.

e. Non-Participation In Management. A Limited Partner is prohibited by law from participating in the management functions of a Limited Partnership. If a Limited Partner does, in fact, participate in the management functions of a partnership, his(her) status becomes that of a General Partner, subject, of course, to those obligations imposed by Law on General Partners.

To further clarify this point, it does not mean that a Limited Partner is prohibited by law from exercising any management functions of a partnership. It does, however, mean that, if the Limited Partner exercises province and control to a measurable degree over the decision-making functions of the partnership, he (she) is then, by law, considered a General Partner. The effect of this recognition is simply that it prevents a Limited Partner from acting in the eyes of the public as a General Partner without being ultimately responsible for his(her) decisions.

f. Transferability or Withdrawal of Interest. A Limited Partner is in the unique position of being able to legally transfer or withdraw his(her) interest in the partnership without otherwise affecting the legal status of the partnership.

JOINT VENTURES. A Joint Venture is, in all respects, a partnership organized for some limited purpose, rather than as a continuing business enterprise. Usually, a Joint Venture arrangement is used when several investors associate together to invest in a certain project, such as a building or land development, etc. There is, of course, no limitation as to the liabilities of the Joint Venture Partners. If the project fails, then each of the Joint Venture Partners is liable.

JOINT STOCK COMPANY. A Joint Stock Company is a special type of partnership that resembles both a Corporation and a Limited Partnership. It is usually an organization with many members who hold transferable shares of stock, although they are co-partners in other respects. This form of business organization is not commonly used today since a Corporation is much more adaptable to this type of operation, plus it eliminates the liability factor of a partnership.

BUSINESS (MASSACHUSETTS) TRUST. The Business Trust described here is commonly called a Massachusetts Trust. Its features are notable since it amounts to a freewheeling trust arrangement whereby the beneficiaries of the Trust can call the shots, yet they are not liable for any of the business obligations.

The Business Trust arrangement is actually an irrevocable trust which is initiated by the execution of a trust instrument that typically provides for: (1) the naming of one or more trustees who will not hold legal title to the trust property, but will manage the business affairs of the trust, while assuming all of the liabilities of the trust assets, and (2) regulate the freely transferable Certificates of Beneficial Interest, among other provisions.

The beneficiaries under the trust receive their share of the trust profits in direct relationship to the number and/or kind of certificates held. However, the beneficiaries do not normally assume any liabilities for the trust debts, although there have been recent court decisions that have held that the beneficiaries are, in fact, liable for the trust debts, notwithstanding such prohibitions contained in the trust instrument. The court reasoned that, since the beneficiaries exercised substantial control over the acts and activities of the trustees, the organization is nothing more than a partnership, thus subjecting all of the holders of the Certificates of Beneficial Interest to personal responsibility for the trust debts.

UNINCORPORATED ASSOCIATIONS. This group of organizations includes: Credit Unions, Fraternal Groups, Labor Unions, Non-Profit Associations, and Professional Societies. All of these organizations are internally governed by their Constitutions and Bylaws, which, in effect, constitute a contract among its members, the trustees and the managers. While the members are usually not liable for the association's debts, the trustee and/or managers may be held personally liable for such debts. However, in most states, provided that the officers or trustees of the unincorporated association are not paid for their services to the association, they are personally exempt from all liability.

The Constitutions and/or Bylaws of these organizations generally contain provisions for reimbursing the trustees or managers for any such debts that they have been forced to settle from their personal assets. This is valid so long as fraud or gross negligence did not occasion these acts. The modern trend is to incorporate these types of organizations, which effectively eliminates the liability factor, plus it also provides the organization with entity status, which means, among other things, it can sue and be sued.

In both general and limited partnerships, your taxes continue to pass through to your personal income statement. Unlike a sole proprietorship, you can obtain additional tax advantages by arranging income or loss to suit the needs of the individual parties. This can be done by modifying the percentage of the tax liability each partner is responsible for.

Advantages of Partnerships:

* Partners can combine their experience to easily make sound business decisions and simple agreements.

* Ease of raising capital.

* There are more tax advantages through arrangement of profit or loss to suit the individual needs of the partners.

* More pass-through tax possibilities exist.

* Ease of organization.

* The ability to cross state lines without having to register to do business in other states.

* Well established laws regarding partnerships.

Disadvantages of Partnerships:

* Unlimited personal liability allowing the personal assets of any operating partner are exposed to business creditors.

* Business is financially dependent on the limited partner in the case of limited partnerships.

* Illness or death may dissolve the business or restrict its productivity.

* Limitation on pension plan deductions.

* Lack of ownership transferability.

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General Corporation

The general corporation is the most formal business structure available to business owners. It is a legal entity in its own right, separate from its owners, that is owned by an unlimited number of stockholders.

The owners' personal assets are protected from business creditors due to the legal separation of the corporation from the owners. Stock-holders do not have liability for acts of the corporation and have financial exposure only to the limit of their investment.

Advantages of General Corporations:

* Owners' personal assets are protected from business debt.

* The corporation has unlimited life that extends beyond the illness or death of the owners.

* A corporation receives tax-free benefits such as life and health insurance, travel and entertainment deductions, and retirement plans.

* Transfer of ownership is easily facilitated through the sale of stock.

* Change of ownership can occur without affecting management.

* It is easier to raise capital through the sale of stocks and bonds.

Disadvantages of General Corporations:

* Corporations are more expensive to form than most other types of business.

* More legal formality and record keeping are required.

* More federal, state, and local rules and regulations affect the corporation.

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Close Corporation

There are two significant differences between general corporations and close corporations. First, most states that recognize close corporations limit partnership to 30 to 50 stockholders

Second, and more importantly, ownership of a close corporation's stock is restricted. Sellers must offer corporate stock to existing owners before it is sold to new stockholders. The close corporation is particularly advantageous for the entrepreneur who wants to run a one-person corporation, or for the small group of individuals who all want to participate in running the business.

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S Corporation

S corporations have the same basic advantages and disadvantages as general and close corporations except that this corporate form allows stockholders to pass the profits or losses from the business directly to their personal income tax return. This eliminates the double taxation issue discussed above. However, in order to receive S corporation tax treatment by the IRS, the business owner(s) must first form a general or close corporation. Within 75 days of forming the corporation all stockholders must elect the S corporation status by filing federal Form 2553.

S Corporation Requirements

Certain requirements must be met before qualifying for S corporation status. They are:

* The corporation must be a U.S. corporation.

* Only one class of stock is permitted.

* There can be only 75 stockholders.

* Only individuals may be stockholders. Other business entities cannot be stockholders.

* All stockholders must be U.S. citizens.

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The Limited Liability Company (LLC)

A new business entity - the limited liability company, or LLC - has been created legislatively in all 50 states and in the District of Columbia. Hailed as the latest advance in the evolution of business formation in America, the LLC is actually not a new concept at all.

The first recognized limited company was formed in Germany in 1892. Limited liability companies quickly became the predominant form of business organization in many countries. In many instances, they have become more popular than corporations.

Wyoming wanted to capitalize on the benefits this new business structure offered, particularly to small businesses. The state enacted the first U. S. LLC legislation, modeled after the German example, in 1977. Five years later Florida followed Wyoming's lead. When the Internal passed Ruling 88-76 on September 2, 1988, other states also began to pass LLC legislation. The Wyoming law and the IRS ruling are the basis upon which most other state LLC regulations drafted.

IRS regulations effective January 1,1997, added flexibility to the LLC. This may have a significant role in your selection of the legal form of business you will choose when starting your new business. Limited liability companies that are properly formed in compliance with IRS regulations can offer individuals and small businesses a clear and, frequently, a superior alternative to general corporations, partnerships, and joint ventures. This is because the LLC combines the corporate advantage of limited personal liability with the pass-through tax advantage of partnerships. Many business advisers believe LLCs could ultimately replace general and limited partnerships, joint ventures, and general and S corporations. LLCs also offer definite advantages over sole proprietorships, and close or regular corporations with closely-held stock.

The owners or shareholders of a LLC can be individuals, trusts, partnerships corporations, and non-resident aliens. They can be active in the management of the business regardless of their share in the company. The LLC is a new statutory answer to at least three of the most pursued objectives of today's emerging entrepreneurs:

LLCs, like all types of corporations, offer limited personal liability or simply limited liability - to its owners, called members. This means that their personal assets are protected from debts and law-suits incurred by the business. In this case, owner liability is limited to the amount of the investment.

LLCs are treated like partnerships or S corporations for tax purposes. Business income, or loss, is only reported on the members' individual income tax return rather than on both the company and individual returns.

LLCs provide the most flexibility in business organization and management. In fact, many LLCs operate informally with little paper-work beyond a simple Operating Agreement or contract that describes a company's policies and organizational structure.

LLCs allow members to sell their interest without limitation or be subject to a right of first refusal by the other owners.

LLC managers need not own any interest in the LLC.

LLCs are not required to file for dissolution upon the death, bankruptcy, or insolvency of a member.

Like general corporations, LLCs offer their owners protected personal liability from suits and judgments against the business. Unlike general corporations which have an unlimited life span, LLCs must set a predefined duration to keep the pass-through tax advantage. This is usually set at 30 years.

Under new tax laws effective January 1, 1997, a LLC is not required to file for dissolution in case of death, resignation, bankruptcy or insolvency of a member. In addition, any owner of interest in a LLC can sell their interest without limitation or be subject to a right of first refusal by the other members.

LLCs do not face double taxation like corporations. Instead, profit or losses are passed through directly to the owners of the limited liability company.

The limited liability company retains all the benefits of a partnership especially pass-through tax treatment - while adding the advantage of limited liability protection.

An LLC is like a limited partnership because all of the LLC members have the same limited personal liability as the limited partner. An LLC is also like a general partnership because all the owners are free to participate in the management of the business. However, creating an LLC is more formal than the simple oral agreement of some partnerships, and involves an additional expense.

The similarities and differences between a close corporation and a LLC are much like those discussed with general corporations. Close corporations offer the same advantages as LLCs. On the downside, close corporation stock ownership restrictions can be very cumbersome. LLCs are not subjected to these same restrictions. Close corporations are double-taxed like general corporations.

S corporations and LLCs are very similar Both entities offer personal limited liability to the owners and solve the problem of double taxation. However, of the two, the LLC is the more accommodating business structure.

Tax Advantages of LLCs vs. Other Business Entities

Limited liability companies have several tax advantages as compared other Business entities. These are outlined below.

LLC Advantages Compared to General and Close Corporations:

* No corporate-level tax, no double taxation is assessed.

* No double tax is levied upon liquidation of the company.

* LLCs have the ability to specially allocate profits and losses for pass-through taxation.

* Debt in excess of basis may be contributed to an LLC and avoid gain recognition.

* Liquidating distribution of appreciated property from LLC is not subject to gain.

* Contribution of appreciated assets is not subject to tax.

LLC Advantages Compared to S Corporations:

* LLCs can have more than 75 members.

* Tax allocation for LLCs need not be based upon percentage of ownership.

* Non-resident aliens, corporations, partnerships, and trusts can all be members of an LLC.

* LLCs permit more than one class of stock.

* There is a step-up in basis at the death of member under IRS Section '54.

LLC Advantages Compared to Limited Partnerships:

* All members are permitted to participate in the management and control of the LLC - unlike limited partners.

* All members have limited personal liability - unlike operating partners.

Members are not classified as limited partners under the passive loss rules.

LLC Tax Disadvantages:

* LLCs have various tax disadvantages as illustrated below. These should be taken into account when considering the LLC relative to ocher business structures.

* LLCs currently have an individual marginal tax rate of 36.9%, whereas general and close corporations only pay 34%.

* It is not advisable to accumulate large amounts of working capital in an LLC.

* Most states don't allow one-member LLCs, whereas S corporations may have only one shareholder.

* In regards to the passive loss restrictions, there is more certainty about what constitutes material participation by an S corporation shareholder than by an LLC member.