Rob Cummings writes, reviews, and refines business plans that include partnership agreements, and helps create, analyze, develop and trademark names that become safe and sound brand names with the least chance for opposition.
When you are going into business, one of the first steps (and a very important step) is choosing the proper business type and structure – the legal structure for your company.
A more important step is to be sure of the name you choose.
In being sure of your name (company, product or your own name) and/or what people could find out about you on the Internet, or be mistaken, I suggest you Google all of the email addresses you use, your own name, and other relevant names such as product and company names you use, or plan to use – and see what you find in the results. There are people like Michael Fertik, who are dedicated to protecting you and your company’s digital reputation.
Most businesses will need some sort of credit at some point, and so knowing your credit score is important now and in the future. Also, if you plan on establishing a corporation or LLC, consider separating your business and personal credit profiles.
You can and should avoid partnership problems by addressing all issues at the outset and building solutions into the partnership agreement.
What type of business structure is best?
There are a number choices. Each has advantages and disadvantages that should be weighed based upon many factors, the main factor being the solution that is most advantageous for your specific business.
The basic business entity types:
- Sole Proprietorship
- General Partnership
- Limited Partnership
- C Corporation
- S Corporation
- LLC (limited liability company)
The two main factors typically involve legal liability and tax considerations in relation to the details of the business, yet there are other considerations to take into account.
A brief explanation of each business type:
A sole proprietorship is the easiest way to set up a business operation. A sole proprietorship has many advantages for the small business owner.
A sole proprietorship means that you are the sole owner. Nearly everything you need to do to create a sole proprietorship is fairly simple and does not typically require an attorney, accountant, or business consultant regardless of the state in which you are doing business. However, in all cases, some professional help insures a better outcome.
As the sole proprietor, you have full control and responsibility for the business and its operation. An exception to this may be community property states in which your spouse is automatically vested with a one-half interest.
In a sole proprietorship, your business is controlled by you, all of the profits come to you, and you make all the decisions. With this type of business entity, you have complete freedom over operating your business. In most of the other business types you have to report to other people and share in any decision making.
As a sole proprietor, you are less burdened by government restrictions and control, and you have less to do in terms of reporting and taxes.
The disadvantages of a sole proprietorship include unlimited liability. If your business is sued, you and your personal assets are at risk. Also, a sole proprietorship may incur greater difficulties in raising capital, and you may have to use your own money or personal loan for the business.
Since sole proprietorships involve no stock shares, it may be more difficult to find employees who want to own a portion of the company they are working for.
- No blanket prerequisites
- Minimal start up costs
- Controlled by the sole proprietor who makes all decisions
- Easy to form
- Fewer government restrictions, less to report
Some minor formalities may require you to:
- obtain an occupancy permit for your place of business
- secure a business license
- apply for a franchise or registration number for your operation. This registration number will be used by the state agency to monitor the collection of sales tax and other regulatory matters.
In certain cases, Rob Cummings believes that agreements of mutual benefit between individuals (where individuals remain sole proprietors yet agree to work together) may be the best way to start a business, and may be the best way to maintain a business.
Avoid partnership problems by addressing all issues at the outset and building solutions into the partnership agreement.
Other types of businesses require other structures such as:
A partnership is an association of two or more people sharing ownership and control over the business.
Like a sole proprietorship, a partnership is fairly easily formed.
In simplest terms, a partnership is like a marriage, and like a marriage, many aspects should be considered, discussed and resolved before forming a partnership.
To avoid disagreement regarding the amount of time and energy each partner invests in the business (and other aspects), it’s a good idea to create a legally binding partnership agreement between all of the partners.
The partnership agreement should cover:
- how decisions are to be made
- how and when the profits should be distributed
- how disputes will be resolved
- how new partners might be admitted
- steps necessary to dissolve the partnership
- amount of capital each partner is expected to contribute initially
- rights, duties, responsibilities of each of the partners
- method for sharing profits and losses
- authorization process for cash withdrawals and salaries
- how existing partners can exit
Upside of a partnership:
- easy formation
- profits flow directly to the partners
- more than one person operating the business
- increased chance of raising capital
Downside of a partnership:
- liability of all of the partners in event of legal judgment against the business
- partners are liable for the other partners’ actions
- profits of the business have to be shared with other people
- disagreements could occur between partners
- partnership may dissolve on death or withdrawal of one of the partners
A corporation, sanctioned by the state, is considered a separate entity from those who own it.
Since a corporation is considered a separate ‘entity’ in most cases, it can be taxed, sued, and can enter into contractual agreements.
Separating business and personal obligations is one of the major advantages of a Corporation.
Many creditors will want a personal guarantee from one of the officers when dealing with a new corporation. Therefore, it’s a good idea to work towards completely separating your business and personal credit when you form a corporation. Leading financial institutions offer a variety of business credit card programs. No matter which financial institution you choose, separating personal credit from business credit helps build the corporations’ own credit and keeps business and personal charges separate for accounting purposes.
A corporation is formed by selling shares to its owners. These owners elect a board of directors to oversee the company. A corporation does not necessarily dissolve when ownership changes.
In general (though not always), shareholders cannot be held liable for a corporation or its debts, up to their investment in the company.
A corporation’s officers can be held liable for their failure to perform an action, such as paying taxes, and for other improprieties. As with Enron (and others in the news), a corporation does not always entirely shield its officers.
Corporations can raise money by selling stock. A corporation can also deduct the cost of benefits for its officers and employees.
In certain circumstances, a corporation can elect to become an S Corporation.
An S corporation is taxed in a way similar to a partnership. Shareholders can treat earnings and profits as ‘distributions’. Distributions pass directly to the ‘shareholders’ personal tax returns. However, if you are an employee, you have to pay yourself ‘reasonable compensation’ for any work you perform for the company.
Disadvantages of a corporation include:
- double taxation for some owners
- taxation at the corporate level and at the personal level, for any dividends paid
- significant paperwork and time to form
- significant expense (in most states) to form
- more complicated administration
- close monitoring by all levels of government
Limited Liability Company (LLC) and Limited Liability Partnership (LLP)
Limited Liability Companies can combine the advantages of corporations of limited liability with the control and tax advantages of a partnership.
Forming a Limited Liability Company is more complex than a normal partnership. A limited partnership is like a general partnership with some significant differences.
The owners of an LLC are the ‘members’. In general, the LLC is taxed as a partnership.
Advantages of an LLC include:
- the limited liability of its controlling parties. If the LLC is sued, (often but not always) the owners do not have their personal assets at risk. In a general partnership, the owners’ assets can be at risk if the company is sued.
The limited partner is protected by law because the limited partner’s legal liability in the business is generally limited to the amount of his or her investment. It enables this special type of investor to share in the partnership profits without being exposed to its debts in the event the company goes out of business. This protection exists as long as the limited partner does not play an active role in the partnership operation.
The disadvantages of an LLC include:
- strict IRS rules as to when you can be taxed as an LLC
- the rules you need to meet in different states to become an LLC
More about Corporations and LLCs
A corporation is considered to be a separate ‘entity’ from those who created and operate it. A corporation can be formed with just one ‘incorporator’ and incorporation is accomplished by filing an application for a charter with the respective state. This application typically includes:
- the purpose of the intended corporation
- names and addresses of the incorporators
- amount and types of capital stock the corporation will be authorized to issue
- rights and privileges of the holders of each class of stock
Operating as a corporation has certain disadvantages in certain situations:
- additional record keeping requirements and administrative
- additional tax burden (in some cases)
- initial costs of setting up the corporation
Many choose to form a corporation so that, as shareholders, the partners are not as legally liable for the actions of the corporation i.e. as a separate entity, the corporation is legally seen to be apart from those who operate it.
There are a number of other benefits:
Unlimited life. Unlike proprietorships and partnerships, the life of the corporation is not dependent on the life of a particular individual or individuals. It can continue indefinitely until it accomplishes its objective, merges with another business, or goes bankrupt. Unless stated otherwise, it could go on indefinitely.
Transferability of shares. The ownership interest you have in a business can be readily sold, transferred, or given away to another family member in the form of shares.
The process of divesting ownership in proprietorships and partnerships can be cumbersome and costly. Property has to be re-titled, new deeds drawn, and other administrative steps taken any time the slightest change of ownership occurs.
With corporations, all of the individual owners’ rights and privileges are represented by the shares of stock they hold. The key to a quick and efficient transfer of ownership of the business is found on the back of each stock certificate, where there is usually a place indicated for the shareholder to endorse and sign over any shares that are to be sold or otherwise disposed of.
Ability to raise investment capital. It is usually much easier to attract new investors into a corporate entity because of limited liability and the easy transferability of shares. Shares of stock can be transferred directly to new investors, or when larger offerings to the public are involved, the services of brokerage firms and stock exchanges are called upon.
There are pros and cons to operating your business as a corporation. One of the greatest tax disadvantages for the ordinary C corporation is double taxation. Many business owners opt for electing to operate their corporations under subchapter S of the Internal Code. Also known as an S corporation, this entity allows income to pass through to the individual shareholders.
The Limited Liability Company (LLC):
Many practitioners believe an LLC may be the preferred choice where:
Legal liability protection is a primary concern
A simplified “one time” tax on the owners is preferred to dealing with cumbersome corporate tax liability
The entity cannot qualify for subchapter S status
An LLC is a hybrid entity with:
legal protections of a corporation
the ability to be taxed (one time) as a partnership
LLCs are treated in a similar manner to S corporations for tax purposes.
Some additional advantages of LLC’s over S corporations (in some situations):
LLC usually offers more leeway for owners who wish to write off business losses in a business that relies on entity-related debt that is incurred
LLC allows greater flexibility for the owner to take assets out of the company without incurring unplanned tax liability
You can form an LLC for any lawful business as long as the nature of the business is not banking, insurance, and certain professional service operations.
We certainly recommend that you consult with a lawyer and accountant about the advantages and disadvantages of each option in your particular state.
Up front cost to form a corporation versus an LLC
In some states an LLC could be established by filing a simple, one-page document with the secretary of state, which includes the Articles of Organization of the LLC
By simply filing articles of organization with the respective state agency, an LLC takes on a separate identity. Similar to a corporation, but without the tax problems of the corporation, it will be taxed like a partnership.
Some ‘organizations’ are comprised of a number of LLCs.
For example, a company might create one LLC that is the primary management company of others.
The management company LLC may have individual and separate LLCs for individual companies ‘under it’ – Sub LLC 1, Sub LLC 2, etc.
In the event of the failure of one or more of the individual LLCs, the risk to the management LLC may be minimized.
In addition, this enables these ‘sub LLCs’ to offer stock shares and other benefits specifically related to the individual LLC they are issued by without being associated with the primary LLC, in this example, the management company.
There are many ways to start a business, and many ways to structure it.
Rob Cummings believes that partnerships can work as long as the responsibilities of each of the partners is clearly spelled out and understood, and the partners have assessed all of their personal and professional interests. It’s a critical component often overlooked, and a leading cause of business failure. Therefore…
In addition to helping partners agree in advance, Cummings will:
Help inspire innovative thoughts in relation to ways of forming businesses
Work with Accountants and Attorneys in drafting better agreements
Help create businesses that function better
Avoid partnership problems – learn more >>
We believe that many businesses fail due to ‘poorly founded’ partnerships and agreements between people – as opposed to operational problems.
To avoid potential partnership problems, we act as partnership counselor in developing better partnership agreements that help insure 100% partnership satisfaction by addressing the personal and professional needs of each individual partner.
While better Attorneys and Accountants help make agreements legal and proper, with creativity in terms of organization and applicable laws, we go to the next logical step by helping the partners to create agreements that insure the greatest longevity and minimize professional and personal dissatisfaction.
Avoid partnership problems by addressing all issues at the outset and building solutions into the partnership agreement. Learn more >>
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