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Business Formation

SELECT THE TYPE OF BUSINESS STRUCTURE

There are several forms of business structures for you to consider. Selecting the business entity which is right for you will involve tax, business and estate planning, and financial considerations. In this section, we discuss the various structures and identify the advantages and disadvantages of each. The legal structure you choose will determine the organization, debt liability, and tax requirements as well as other aspects of business questions.

Sole Proprietorship

Partnerships

Corporations

Limited Liability Company

Legal Issues

Sole Proprietorship

Sole proprietorship means that one person independently owns and operates an unincorporated business for profit. The business is considered an extension of the owner rather than as a separate legal entity. For tax purposes, the profits/losses of the business are combined with other owner income sources.

Advantages:

  1. Simplest form of ownership to establish and operate
  2. One owner
  3. Owner has complete control over management decisions and policies
  4. Use of all profits at the discretion of the owner
  5. Limited paperwork to state and federal agencies
  6. All losses are incurred by the owner (owner’s income directly linked to success/failure of business

Disadvantages

  1. All management decisions—staffing, policies, problems—must be handled by owner
  2. Owner personally liable for all debts, taxes, and claims incurred by the business
  3. May be difficult to raise capital (i.e., will depend on owner’s credit history)
  4. Continuity of business disrupted by owner death or disability
  5. Combined with other income sources, profits taxed at owner’s individual tax rate

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Partnership

A partnership is a legally recognized entity between two or more people who agree to contribute money, labor, property, or skills and share in the business profits, losses, and management decisions. There are two types of partnerships—general and limited.

General Partnership: each partner is held personally liable for all debts, taxes, and other claims against the partnership.

Limited Partnership: has both general partners and limited partners. It restricts the amount of personal liability to a limited partner. It allows investors to contribute but will expose them to a limited amount of liability AND management control. A limited partner is only personally liable up to the amount of investment made.

Advantages:

  1. Simplest form of business for two or more owners
  2. Business can be established with minimal formal documentation (However, it is recommended that partnerships have a formal written agreement with provisions for death, disability, liability, compensation, benefits, and dissolution)
  3. Profits and losses belong to the partners
  4. Partners have freedom to operate the business on behalf of the partnership (i.e., they can hire/fire employees, borrow money, or enter into contracts)
  5. No income tax on partnership entity (it’s passed on to individual partners)
  6. Buy/sell agreements
  7. Availability of resources/skills from all partners
  8. Limited liability partners enjoy lower risks

Disadvantages

  1. General partners liable for all debts and actions of the partnership (joint and several liability)
  2. Limitations apply to raising investor capital (e.g.,
    all investors would be partners)
  3. Responsibilities and actions of partners, if not specifically written out, can overlap or contradict one another
  4. Partnership income added to other sources of income and taxed at owner’s personal tax rate
  5. Complications with taxes arise if fiscal year varies from calendar year
  6. Partnership entity lacks perpetual existence in the event of death, disability, or withdrawal of a partner (provisions must be made in advance)

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Corporations

There are three types of corporations: subchapters S, C corporations, and limited liability companies. The major differences are centered around taxation, initial profitability, shareholder compensation, and deductibility of fringe benefit payments. After completion of the incorporation process, a
corporation is automatically classified as a C corporation by the IRS. Board of Director approval is required, and a form 22 must be submitted to the IRS to change the status to subchapter S corporation. This action must occur within the first 75 days of incorporating the business. Use IRS form #2553.

A corporation is a legal entity that exists under the authority of state law and separate from the people who own, manage, and control its operations. Corporations acquire assets, incur debt, pay taxes, enter into contracts, sue/are sued, have perpetual existence, and issue shares of stock as evidence of ownership. To incorporate, articles of incorporation are filed with the Secretary of State’s office. These articles define the structure of the business (including its business purpose, amount of capital stock authorized, number of shares, and organization of a board of directors). The responsibility of the board of directors is to create by-laws and oversee major corporate policies and practices. An accountant and a lawyer versed in the legalities and organizational structure are recommended

 

Advantages

  1. Can provide a single business owner with limited liability
  2. Separate legal entity (with rights and responsibilities of a legal “person”)
  3. Limited liability for owners/shareholders
  4. Transferability of ownership (i.e., shareholders may trade or sell stock)
  5. Continuity of existence beyond original founders or shareholders
  6. Absence of “mutual agency” (i.e., stockholders, acting as owners, may not enter the corporation into contracts or agreements)
  7. Ability to raise large amounts of capital by issuing stock

Disadvantages

  1. Cost related to setting up the corporation and filing the required forms with the Secretary of State’s office.
  2. Formalities required by law (e.g., maintaining corporate minutes, having a board of directors, recording shareholder rights, maintaining corporate records and filings)
  3. Considerable organizational costs
  4. May take considerable time to set-up and organize corporation
  5. Greater amount of regulation and supervision by governmental agencies
  6. Corporations are subject to real estate, personal property, and franchise taxes
  7. C corporations are subject to double taxation (corporation and shareholder earnings taxed)
  8. Subchapter S corporation requirements:
    • It must be a domestic corporation
    • It must not have more than 75 shareholders (if stock is purchased jointly, a husband and wife reconsidered one shareholder)
    • Citizens or resident aliens must own all stock
    • It must have individuals, estates, and certain trusts as shareholders
    • It must have only one class of stock
    • It must have an election with all shareholders present

Advantages of Subchapter S Corporation

  1. Limited liability
  2. Avoids double taxation
  3. Retains advantages of a corporation with respect to business obligation
  4. Maintain status of corporation with assets and unlimited life separate from its owners
  5. Owners can participate in management
  6. No restrictions on the right to transfer ownership

Disadvantages of Subchapter S Corporations

  1. 70 or fewer stockholders; only one class of stock
  2. Stockholders limited to individuals, estates, or trustees
  3. Must be a domestic organization and not a member of an affiliated group
  4. Stockholders limited to citizens or resident aliens of the United States

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Limited Liability Company (LLC)

A limited liability company has a combination of partnership and S corporation characteristics. An LLC has the corporate characteristic of limited liability and the tax advantages and flexibility of partnerships. Under the law, an L LC is considered a separate legal entity and is formed by filing Articles of Organization with the Tennessee Secretary of State. Two or more owners, or “members,” must submit the appropriate paper work. LLCs merit a word of caution to potential business owners. There is a lack of public, judicial, and administrative authority and familiarity regarding the classification and operation of an LLC. An accountant and a lawyer versed in the legalities and organizational structure are recommended. 

LLC Advantages

  1. LLC is considered a separate legal entity
  2. Unlimited number of shareholders unlike the S corporation limit of Subchapter S corporation requirements
  3. It must be a domestic corporation
  4. It must not have more than 75 shareholders (if stock is purchased jointly, a husband and wife are considered one shareholder)
  5. Citizens or resident aliens must own all stock
  6. It must have individuals, estates, and certain trusts as shareholders
  7. It must have only one class of stock
  8. It must have an election with all shareholders present

LLC Disadvantages

  1. Significant cost involved
  2. Requires time to file appropriate paperwork
  3. Legal and accounting assistance recommended
  4. Requires at least two members
  5. Lack of familiarity by public, professional advisors, judicial, and administrative authorities
  6. LLC has a finite existence (30 or fewer years)
  7. Congressional investigation could potentially change LLC tax status
  8. Lack of legal precedent (i.e., no past history indicating how a court is likely to interpret the law)

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Legal Issues
 

  1. INSURANCE BENEFITS PLAN
    Most employees today expect some kind of benefit package. There are always costs associated with these plans. We recommend you seek professional advice to help you evaluate the options available to you.
  2. REGULATIONS
    A few common agencies you may encounter are: OSHA: The Occupation Safety and Health Act. This agency sets guidelines for worker safety. Failure to comply with OSHA regulations can result in severe financial penalties. Compliance with these regulations is not optional.
  3. AMERICANS WITH DISABILITIES ACT:
    As an employer, you cannot discriminate against the disabled. This applies to your work force as well as your facilities if you are open to the public. You are encouraged to get copies of the regulations and determine which sections apply to your business.
  4. HARASSMENT:
    The government and the courts are taking a strong position in trying to discourage harassment in the workplace. Harassment, including sexual harassment, can take many forms. An employee policy which specifically addresses these issues and provides for enforcement can help you avoid problems in this area.
  5. CONSUMER PROTECTION:
    Federal and state governments have passed laws to protect the consumer. These regulations affect everything from consumer credit to warranties.
  6. ENVIRONMENTAL LAWS
    In the past 30 years, several environmental acts have been passed which impact virtually every business and real estate transaction.

OTHER ISSUES:

  1. Employee Responsibilities
    No matter what form of business you decide to enter, if you plan to have employees you will face certain employee responsibilities; including payroll taxes, unemployment taxes, employee insurance and benefits, and providing a safe workplace.
  2. Payroll Taxes and Employment Taxes
    The Internal Revenue Service provides excellent publications by request or from their Web site www.irs.gov. These publications specifically address critical tax and payroll issues that new business owners must understand and comply with.
  3. Business Insurance
    All businesses will need a basic business liability insurance policy covering accidents, fire and theft. Optional liability insurance can be obtained for flood, vandalism, employee theft, loss of income. Loss of key persons, product problems, errors and omissions and protection for the board of directors. Customer protection and performance bonds are also available, if desired or required. Contact local insurance agent for pricing and options.

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