This is a topic I cover more extensively in my audio program “Incorporating Brilliance – What the Rich do to reduce their taxes, protect themselves and increase their privacy”, but I want to discuss it here also because it so fundamental to your business life.
There are five forms or types of business structure: sole proprietorship, general partnership, Corporations – “S” and “C”, Limited Partnerships and Limited Liability Companies (LLC’s). Here are some of the major distinctions between them, especially as they pertain to small businesses.
A sole proprietorship is the simplest form of a business. It is established simply by making the decision to actually go into business. You don’t need to file any corporate documents (though you may still need a business license) – there are no corporate formalities. Just print up a business card (if you want to) and off you go to start your own company.
It’s simple, but fraught with danger and misjudgment. Here’s why. Sole proprietorships provide absolutely no asset protection from within or without. That means that if you are sued because of something business related (product liability, for example) you can lose everything you own. Now, most people realize that as business people, their investment and business assets are at risk. They are willing to accept that risk as part of the risk/reward calculation.
What many people don’t realize is that as sole proprietors, their personal assets are also at risk. A sole proprietor can be held personally liable for any business-related obligation. This means that if your business doesn't pay a supplier, defaults on a debt, or loses a lawsuit, the creditor can legally come after your house or other possessions. Which means if you are sued as the result of a business problem, not only can you lose your business, but you can lose your personal assets as well. That’s right, your home, your car, your bank accounts, etc. Virtually everything you own.
That’s foolish and a risk that is unnecessary to take. And there’s also a great tax reason NOT to have a sole proprietorship. It’s called self-employment tax. I call it the self employment tax penalty. Sole Proprietors are subject to self employment tax of 7% of approximately the first $85,000 in income. That’s about $6,000 per year! The cost of setting up and maintaining a corporation is a fraction of that amount, so it makes no sense to do business this way. In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. The fact that a sole proprietorship and its owner are one and the same means that a sole proprietor simply reports all business income or losses on his or her individual income tax return. So, remember to try not to do business as a sole proprietor!
A general partnership (often simply referred to as a partnership) is an association of two or more people carrying on a business with the goal of earning a profit. A partnership is viewed as being one and the same as its owners. There is little formality involved in creating a partnership. In fact, if someone can establish that you are in business with somebody else, then there is a general partnership. You do not have to have a written agreement to form one, and, much like a sole proprietorship, no formal filing is required.
Like a sole proprietorship, a partnership has only one level of taxation. A partnership is a tax-reporting entity, not a tax-paying entity. Profits pass through to the owners and are divided in accordance with what is specified in the partnership agreement. There are no restrictions on how profits are allocated among partners as long as there is economic reason, so there is latitude in allocating income according to which partners have the best tax rates.
It is also the most risky form of business there is. That’s because with a general partnership, you are responsible not only for your own mistakes and problems (like a sole proprietorship) you are also responsible for the mistakes and problems of your partner(s). Every time you add a partner, you increase the chance of a problem exponentially. In general, each partner in a partnership is jointly liable for the partnership's obligations. Joint liability means that the partners can be sued as a group. Several liability means that the partners are individually liable. In some states, each partner is both jointly and severally liable for the damages resulting from the wrongdoing of other partners, and for the debts and obligations of the partnership.
Three rules for liability in a partnership are:
Basically, the bad guys get to choose who they can enforce a judgment against, based on who has the deepest pockets and who has the most valuable assets for them to get their hands on. As a practical matter, you may have done nothing wrong, yet you are dragged into a lawsuit simply because you have more assets for the bad guys to attack. Once again, I suggest you never do business as a general partnership.
A corporation is a separate legal entity that is governed by state law. As a legal entity the corporation receives legal rights and duties. Five rights always exist for a corporation: the ability to sue and be sued (this gives the corporation access to the courts); the right to a common treasury (this gives the right to hold assets separate from the assets of its members); the right to hire agents (this gives the corporation the right to hire employees) the right to a common seal (this gives the corporation the right to sign contracts); and the right to make by-laws (this gives the corporation the right to govern its internal affairs). Governments and courts may add other rights and duties. These will vary from jurisdiction to jurisdiction. This would be one of the safest entities to structure a business by. It operates through its bylaws as well as through resolutions written and adopted by its shareholders and directors. It must not function as the alter-ego of its stockholders. Corporate formalities must be maintained in order to keep the corporation a separate legal entity. The state of incorporation has its own statutes, rules and regulations from which a corporation operates from. We will examine the difference between “C” corporations and “S” corporations in a later section, as well as ideas about choosing the state of incorporation.
Sincerely,
Drew Miles, The Tax Saving Attorney
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