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New to Business Guide |
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Types of Businesses |
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In this Section
Different Business Organizations
A sole proprietorship is the most common form of business organization. A sole proprietor is fully and personally liable for all the obligations (including debts) of the business. Of course, the sole proprietor is also entitled to all of the business's profits and exercises complete managerial control. Generally, the earnings of the sole proprietorship itself are not subject to income tax, although some state and local governments do impose an unincorporated business tax on profits. Income and losses, however, must be included in the owner's personal tax returns. The sole proprietorship terminates on its owner's death or retirement. A sole proprietor is not ordinarily required to file any documents with the state unless it is doing business under an "assumed" or "fictitious" name -- that is, a name other than the real name of its owner. In that case, the owner must usually file a "doing business as" or "d/b/a" certificate. This typically gets filed in the county or with the secretary of state of the state in which the business is located, and a filing fee is often required. Return to Table of Contents for this guide | Return to index of all guides | Return to the top of this page In its most basic form, a partnership is an association of two or more people who agree to share in the profits and losses of a business venture. A partnership can usually be formed without paying any fees or filing any papers, except for the "d/b/a" certificate. In fact, you're not legally required to put a partnership agreement in writing, although it is highly recommended, especially if you're starting a venture with several partners who are investing different amounts of money. Typically, when you form a partnership, it is done in the spirit of optimism and success. Unfortunately, conflicts often arise. By putting your agreement in writing, you can help avoid potential conflicts at the outset. Some of the topics a partnership agreement might include are:
What are the Advantages of a Partnership? A key advantage of a partnership is that no taxes are paid by the partnership itself. Although a federal income tax return must be filed by the partnership with the IRS, it is for informational purposes only. Profits or losses are "passed through" directly to the partners, who report them on their individual returns. Also, because filing requirements are minimal, partnerships can be created relatively inexpensively. One of the main disadvantages of a partnership involves liability -- each partner is personally liable for the obligations of the business. This means that someone who sues the partnership can also sue and recover from each individual partner. If the partnership owes money, each partner can be held liable for the amount of the entire debt. So, when you enter into a partnership agreement, not only is your investment in the business at stake, but all of your other personal assets may be at risk as well. In addition, any one partner can enter into a contract for which that partner and all of the other partners will be responsible. So, if your partner in That's The Way The Cookie Crumbles makes a deal to buy $100,000 worth of chocolate chips, you, your partner and your partnership business will be liable for meeting the $100,000 obligation incurred, even if the partnership had already decided to discontinue the chocolate chip cookie line. Another disadvantage of a partnership is that partners aren't always free to come and go. If you want to sell your interest in a partnership, you usually need the consent of all the other partners. If you leave without their approval, you may forfeit your partnership investment. You should remember, though, that many of these disadvantages can be anticipated and addressed in a partnership agreement. That's a good reason for having one. What is a Limited Partnership? A limited partnership has two kinds of partners: general and limited. The rights and obligations of a general partner are very similar to those of a partner in a regular partnership. A general partner has the right to participate in the management of the partnership and has unlimited personal liability for its debts. A limited partner, on the other hand, is personally liable for the debts of the partnership only to the extent of his or her investment in it and has little, if any, voice in its management. You might want to form a limited partnership if you have financial backers for your partnership venture who do not want to be involved in running it. As a matter of fact, limited partners who become actively involved in the management of the partnership run the risk of losing their limited personal liability. While a regular partnership can be entered into rather informally, a limited partnership is created only when it is formally registered with the state in which the partnership proposes to do business. To register, you must file a "certificate of limited partnership," which provides certain information required by law regarding the partners and the partnership. If you are thinking about forming a limited partnership you should consult an attorney. Not only should you have help preparing your written agreement, but you also may have to comply with certain federal and state securities laws intended to protect investors from fraud. When you sell interests in a limited partnership, or even offer to sell them, you may be required to file certain documents, such as a financial statement or a prospectus. These documents generally should be prepared with the assistance of an attorney. A failure to make the required disclosures could result in steep fines and even criminal penalties. Return to Table of Contents for this guide | Return to index of all guides | Return to the top of this page A corporation is an independent entity that is usually created to conduct a business. A corporation is like an individual. It can:
A corporation can do all of these things under its own name, without making the individual owners and investors, known as shareholders, liable. The shareholders must always keep in mind, however, that they and the corporation are separate entities, and that they must treat the corporation as such in order to take advantages of its benefits. This rule applies even when the corporation has only one shareholder. What are the Advantages and Disadvantages of a Corporation? One significant advantage of the corporate structure is that the shareholders are usually protected from personal liability. Of course, any shares you own are vulnerable if the corporation has excessive debt or goes bankrupt. Still, you will be liable only to the extent of your investment in the corporation; your assets beyond that ordinarily will be shielded. Another advantage is that, unlike a partnership, you are free to sell your interest (shares) in a corporation. Unlike a sole proprietorship or a partnership, a corporation's life span is usually perpetual, even when there is only one shareholder. If you intend for your corporation to grow beyond your lifetime, the fact that it can "outlive" you and that your shares are transferable can be very helpful in getting long-term financing as your business grows. The major disadvantages of a corporation are the expenses of startup and the meticulous record keeping required to comply with the many formalities of state laws. A failure to make filings and payments on time carries penalties. In addition, all-important corporate decisions must be approved by the board of directors, and sometimes may require the involvement of an attorney. Are There Different Kinds of Corporations? Yes, there are several types. These include charitable (not-for-profit) corporations and professional (P.C.) corporations. Professional corporations are formed by certain professionals who are required to be licensed in order to render their services. Attorneys and physicians typically use this structure. For most small businesses, though, there are basically two types of corporations: the "C corporation and the "S" corporation. A "C" corporation may have an unlimited number of shareholders. An "S" corporation, on the other hand, can have no more than 35 shareholders, all of whom must be U.S. citizens or residents. The key difference lies in the way the two types of corporations are taxed: "C" corporation shareholders are taxed twice at the federal level. First, the corporation pays tax on its earnings, and then the shareholders pay tax on any dividends they received. "S" corporation shareholders, on the other hand, are taxed only once, because the corporation pays no tax on earnings. As with a partnership, profits or losses of an "S" corporation are passed through to the shareholders to be reported on their personal tax returns in proportion to their ownership interests in the corporation. You should note, however, that the "S" corporation shareholders are taxed on the corporation's earnings whether or not a dividend is actually paid. To qualify as an "S" corporation, a corporation with 35 shareholders or less must file a special form with the IRS requesting to be treated as an "S" corporation. In addition, about two-thirds of all states recognize "S" corporations for state tax purposes. You must file a form with your state's tax authority to qualify. You should consult with your tax advisor to determine your corporation's eligibility for treatment as an "S" corporation and to ensure that you comply with IRS and state law requirements once your corporation qualifies. What is the Difference Between a "Publicly Held" and a "Closely Held" Corporation? It's a key distinction between types of corporations. A "publicly held" company is one that typically either has shares that trade on a recognized exchange (for example, the New York Stock Exchange), or has assets of more than $5 million and has a class of stock held by 500 or more people. Publicly held corporations are regulated by both state agencies and the federal Securities and Exchange Commission (SEC) which require that they make regular "disclosures" to shareholders regarding the corporation's assets and liabilities. The purpose of these disclosures is to enable the investing public to make informed decisions when considering the purchase of the corporation's securities. A "closely held" or "privately held" corporation usually has a relatively small number of shareholders, no shares of stock available for public purchase, and active participation by many of the shareholders in the management of the corporation. Small businesses are closely held companies and are not required to make the same types of disclosures. As a small business owner, however, you must keep in mind that you and your corporation must still comply with the relevant anti-fraud provisions of both the laws of your state and the SEC. You should consult with an attorney about your responsibilities and potential liability under these laws, particularly if you intend to offer or sell interests in your business to the investing public. How is a Corporation Run? Major business decisions for a corporation are made by its board of directors, which is elected by the shareholders. The day-to-day responsibility for running the corporation is typically handled by its officers. The corporation's by-laws (its rules and regulations), which are written at the time of incorporation (when the company is formed), specify the number and respective duties of directors and officers. Traditionally, state statutes have required all corporations to have certain officers, including:
In this traditional corporate form, one person can hold any two offices -- except for the offices of secretary and president -- unless the corporation has only one shareholder. A corporation's officers are usually elected by the board of directors. The directors have the power to elect anyone they wish, including themselves or family members. The board also has the power to fire corporate officers. Members of the board of directors as well as corporate officers have what is known as a "fiduciary duty" to the corporation. This means that they have an obligation to protect the shareholders' interests rather than their own personal interests. This is true even when the board member or officer is a shareholder. This fiduciary duty requires all board members and officers to:
These are essentially the same guidelines that a reasonable person uses when running a business. Corporate officers and directors are generally not held personally liable for the success or failure of a corporation's actions unless they have violated these guidelines. For example, an officer who commits fraud using the corporation's assets could be held liable for any losses incurred by the shareholders. What Are the Rights of the Shareholders? Although the shareholders are the owners of a corporation, their role in management is usually limited, unless the business venture is relatively small. Shareholders of large or small companies can, however, influence the conduct of business in a number of ways. For example, shareholders have the power to:
The more shares a person holds, of course, the more influential his or her vote will be, since each share ordinarily gets one vote. How Do You Incorporate? The rules for incorporating vary from state to state. Generally, however, you must file articles of incorporation with the secretary of state of the state in which you are incorporating, and pay a filing fee. The information in the articles of incorporation usually includes:
Your filing date will be the date of receipt in the secretary's office; and, if it is approved, your corporation will be considered to have been formed on that date. Is a Lawyer Necessary? No, but it is advisable to consult one. While there are a number of companies that can help you form your corporation, such as The Company Corporation, if there is any problem with your filing, the corporate structure could be jeopardized, and you could end up with a liability that you did not expect. Are There Other Steps Necessary to Complete the Incorporation Process? Yes. Although your business is officially incorporated on the date of acceptance of your filing in the secretary of state's office, several additional steps must be taken to get your corporation up and running. First, the initial board of directors or the incorporators (depending on the laws of your state) must adopt by-laws: the procedural rules and regulations that govern how the corporation is run. The by-laws generally cover the following considerations:
Unlike the articles of incorporation, the corporation's by-laws do not have to be filed with the secretary of state. After the by-laws have been adopted, the following actions are taken by the board:
Upon the adoption of these resolutions, the corporation is usually in business. Some states may require you to file additional documents, such as your employee identification numbers, before the corporation is considered up and running. Where Should You Incorporate? The general rule of thumb for the small business owner is to incorporate in the state in which he or she intends to operate the business. Many business owners seem to have a preconceived notion that Delaware is the most desirable incorporation choice. For some companies, such as those contemplating a "public offering" of their shares, Delaware may still be a good choice because its law is particularly well developed. Because individual business circumstances vary, you should carefully consider which state in which to incorporate. In making your decision, you should bear in mind that states generally impose a tax (commonly known as a "franchise" tax) on corporations that are either incorporated under their laws or do business within their borders. So, if your business is incorporated in one state but headquartered in another, it may be subject to tax in both states. Return to Table of Contents for this guide | Return to index of all guides | Return to the top of this page A limited liability company is a business structure which is best described as a "hybrid" between a partnership and a corporation in that it gives its owners the best of both worlds: (1) a "pass through" of all profits and losses to the owners without taxation of the entity itself, as in a partnership, and (2) a shield from personal liability, as in a corporation. An "S" corporation and a limited partnership also offer these advantages. But, unlike an "S" corporation, a limited liability "company" is actually a non-corporate entity. State laws, which would require a board of directors and officers and would dictate adoption of by-laws, do not apply. Also, unlike the limited partner in a limited partnership, a member of a limited liability company may participate actively in its management without risking loss of the limitation on personal liability. The limited liability company, then, offers a great deal of flexibility. It is preferred primarily by owners of small, but relatively riskier, ventures who seek an active management role and limited liability. How is a Limited Liability Company Formed? Although a limited liability company is free from the restrictions of the corporate form, its formation and general manner of operation are governed by state law. The entity may be formed by two or more persons who must file with the secretary of state of the state in which the enterprise is to be established its articles of organization, and pay a filing fee. Because the powers of the limited liability company are very similar to those of a corporation, the provisions of its articles of organization, which are also prescribed by law, are quite similar to those of the articles of incorporation of a corporation. The limited liability company comes into existence when the secretary of state issues a "certificate of organization." The duration of a limited liability company is limited to 30 years. Unlike a corporation, the limited liability company has no by-laws. The consensus of its members regarding managerial and related issues are set forth in an operating agreement, which is analogous to the "shareholders agreement" among the owners of a corporation. In fact, state laws typically require that the limited liability company have an operating agreement. It is advisable to consult a lawyer when organizing a limited liability company. Return to Table of Contents for this guide | Return to index of all guides | Return to the top of this page A franchise is a business relationship in which an owner (the franchisor) licenses others (the franchisees) to operate outlets using business concepts, property, trademarks and trade names owned by the franchisor. Your local McDonald's is probably operated as a franchise. Franchise relationships are regulated by each state and by the Federal Trade Commission and are often quite complex. A contract known as a franchise agreement should spell out the details of each particular venture. The franchisor often provides the initial capital for the franchise and, in turn, typically takes in a larger share of future profits. In addition, a franchisor usually provides:
The franchisee provides:
The franchisor and the franchisee both share in the risks and returns of the business, although each agreement is structured differently. Typically, the franchisee is his or her own boss on a daily basis. The franchisor also has a say in the business. For instance, the franchisor is usually responsible for quality control and for maintaining a uniform image among all franchisees. If the quality is not up to par, the franchisor may direct the franchisee to make changes. Is a Lawyer Necessary? It is highly advisable to consult a lawyer. A franchise agreement is a highly technical business document that can have serious financial consequences. The laws regarding franchising vary from state to state, and you do not want to end up with an invalid agreement or unintended liabilities. Franchising Checklist Before entering into a franchise agreement, you should consult a lawyer to be sure that you understand what your responsibilities are. As a potential franchisee, you, along with your lawyer, you should:
Before signing the franchise agreement, you should know what it says regarding certain key issues, including:
Return to Table of Contents for this guide | Return to index of all guides | Return to the top of this page Which Business Structure Is Best For You? While the advantages and disadvantages of each type of business structure are readily identified, choosing the most appropriate for your business may be a somewhat thorny issue. Many small business owners reflexively--and often wrongfully--assume that the corporate form is best for them simply because of the liability protection it offers. Before incurring incorporation and other expenses, though, you should consider several factors. First, forming a corporation does not necessarily guarantee protection from personal liability. For example, you may be asked to give a personal guarantee on a commercial lease entered into by your corporation. Also, there is a legal concept known as piercing the corporate veil. If your corporation is substantially undercapitalized, or if you consistently fail to observe corporate formalities (such as keeping your personal assets separate from those of the corporation), a creditor may ask a court to rule that you and the corporation are essentially one and the same. The court could pierce the corporate veil, and your personal assets could be used to satisfy the creditor's claim. Certain state law provisions may also result in personal liability even if your business is incorporated. In New York, for example, the top ten shareholders of a closely held corporation are automatically personally responsible for the wages and certain other benefits owed to employees. Finally, you should investigate whether insurance can adequately cover your risk of personal liability. Depending on the nature of your business, reasonably priced insurance -- rather than incorporation -- may offer enough protection and save you from additional expense and administrative burdens. In choosing a corporate structure you should also take tax considerations into account. If you are like most small business owners, chances are that you will lose money during your first few years of operations. From the tax standpoint alone, then, there may be no advantage to incorporating -- at least during the years in which you are posting losses. For the "start-up" small business in particular, the driving consideration for determining the appropriate business structure probably remains the question of liability. If your business puts human life at risk (for example, you run a bike touring company), or you have substantial contracts with outside vendors, you would probably should incorporate and to make sure that you run a "tight corporate ship" even if you are adequately insured. |
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