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Choosing sole proprietorship or corporation

September 1st, 2009 / By: / Management

The wrong choice can be a costly mistake .

Nearly three-fourths of the millions of small businesses in the United States are sole proprietorships, according to the U.S. Department of Commerce. But is that the best choice for you and your business?

That’s a question that you should consider carefully, whether you’re just getting started or if you’ve been thinking of changing your present form of business. There are three basic classifications of business entities: sole proprietorship, partnership and corporation. Each has its own advantages and disadvantages. You should be familiar with the legal, financial and practical consequences of each choice.

Sole proprietorship

The simplest and least expensive way to launch a new business is as a sole proprietor. There are little or no legal expenses, no complex tax structure and no one else to interfere with management decisions. As a sole proprietor, profits flow directly through your personal tax return (using a separate tax form called Schedule C). You keep or reinvest all of the after-tax income produced by the business. A sole proprietorship is the easiest of all business structures to dissolve.

Sole proprietorship has its disadvantages. As a sole proprietor, you have unlimited personal liability for all debts against the business. Both your business and personal assets are at risk in the event of legal trouble. Other disadvantages include possible difficulty in raising funds from outside sources, and it may be harder to attract high-caliber employees.

Partnership

As far as most legal considerations are concerned, a partnership is treated essentially the same as a sole proprietorship. Each partner is jointly and separately liable for the financial obligations incurred in the name of the business, and each is taxed on their share of the profits generated by the business. However, partnerships do inject some challenging personal issues.

The choice of a business partner is fraught with potential danger. Some experts suggest that good friends or relatives rarely work out as business partners because of the inevitable disagreements over business issues. Of great importance in partnerships is a clear understanding of such issues as:

  • Who does what? The job of each partner should be clearly defined and scrupulously honored.
  • On what basis will the partners share in the profits of the business? Will it be 50/50? How will the major financial decisions be handled?
  • What happens if one partner dies? You may find yourself in business with your partner’s widow or widower. “To help avoid this, there are two things you should do,” says Geneva Fulbright, CPA, Durham, N.C. “First, consider purchasing key-person life insurance. Then, with the help of your attorney, draw up a written agreement clearly establishing procedures for buying out a partner’s interest in the event of death or any other unforeseen circumstance.”

Corporation

A corporation is a separate legal entity with the same rights and responsibilities as those conferred upon us humans. The corporate form of business will limit your personal financial liability, be more stable in the event of your death, and will make it easier for you to raise money for expansion and growth. You should investigate carefully before you leap.

One problem is the sometimes unrecognized differences between large, public corporations and the closely-held corporations typical in small businesses. If you try to swing a loan in the name of your small corporation, you may find that the lender will require you to sign personally, making you just as responsible for the loan as you would be in a sole proprietorship. Further, in the event of a lawsuit, you may find yourself and the corporation named as a defendant. So much for the protection of personal assets.

A corporation usually, but not always, stands a better chance of survival than a sole proprietorship or partnership in the case of the death of a principal. Many small businesses survive as a direct result of the talents of the founder and prime mover and shaker. If he or she dies, the business may follow along shortly regardless of the legal form bestowed upon it.

Anyone considering incorporation should be aware that doing business in that form will introduce complications that can be a nuisance to someone used to the simple life. Corporations must follow rigid rules, file separate tax returns and maintain specified records.

To make life a little easier for the small entrepreneur, a special form of corporation known as Subchapter S was created. It allows small business owners to enjoy the advantages of incorporation without such penalties as double taxation.

“Another form of corporation, The Limited Liability Corporation can be advantageous to small business owners under some circumstances,” Fulbright says. “In an LLC:

  • There are fewer restrictions placed on the owners in how they take money out of the business and how much they take out as compensation
  • The LLC company does not pay entity level taxes on profits (the owners pay taxes on their allocated share of profits, and losses can offset owner’s other income to the extent of active participation)
  • The LLC provides greater protection from creditors and general lawsuits if run properly, compared to a general partnership and other entities
  • The LLC is a great way to hold real estate because it allows for easier distribution of assets without having to consider dividends or other forms of compensation to the business owners (C-Corp. and S-Corp. have to consider salary levels and distribution methods).”

If you are a sole proprietor considering incorporation, you may have considered using one of those companies that allow you to incorporate over the internet, taking advantage of some state’s liberal laws regarding incorporating. That’s an easy and inexpensive way to incorporate your business; however, there are some disadvantages:

“If a business owner wants to incorporate in a state other than the one in which the business operates, an ‘authority to do business’ form must be filed in the resident state,” Fulbright says. “That means two state returns would be required instead of one.”

Also, you should be aware that some states have passed laws intended to make it more difficult to file incorporation papers in a state other than the one in which the business resides. For example, California charges $800 a year for a license for a foreign corporation or LLC to operate in the state.

If you use the internet to research information on incorporation, consult with legal counsel familiar with the state laws in which the business will operate.

Sound complicated? It is. That’s why no single form of business structure can be said to be the best choice for every entrepreneur.

Sound complicated? It is. That’s why no single form of business structure can be said to be the best choice for every entrepreneur.

William J. Lynott is a veteran freelance writer who specializes in business management and personal and business finance.

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