Sole Proprietorships and Partnerships Legal Aspect

 Sole Proprietorships and Partnerships

•        Legal structure alternatives for business:

–       Sole Proprietorship

–       Partnership

–       Limited Liability Company

–       Corporation (C or Subchapter S)

•        Choosing the right structure depends upon:

–       Legal and tax ramifications

 Sole Proprietorships

•        Advantages of sole proprietorships:

–       Easy and inexpensive to create

–       100% of ownership+ profits stay with the owner

–       Complete decision making authority for the owner

–       Income is taxed only at the owner’s personal income tax rate

–       No major reporting requirements exist

•        Disadvantages of sole proprietorships:

–       Owner has unlimited liability for all claims against the business-all debts must be paid from the owner’s assets

–       Difficult for the owner to raise debt capital

–       Survival of the business depends upon the owner

–       Partnerships

      Partnership

 - two or more people agree to share the assets, liabilities, profits of a business

•        Advantages:

–       Have same advantages as sole proprietorships

–       Shared risk of doing business

–       Shared partner clout with multiple financial statements

–       Shared ideas, expertise, decision making

–       Partners receive pass-through earnings and losses taxed at their personal tax rates

•        Disadvantages:

–       Partners are personally liable for all business debts and obligations

–       Individual partners can bind the partnership contractually

–       Partnership dissolution results when a partner leaves or dies (unless otherwise stated in partnership agreement)

–       Partners can be sued individually for the full amount of partnership debt

•        Partnership Agreement

•        Based on the Uniform Partnership Act, it defines the relationship between partners in terms of…

–       business responsibilities

–       profit sharing

–       transfer of interest

•        Buy-sell Agreement:

–       Who is entitled to purchase the departing partner’s share?

–       What events trigger a buyout?

–       What is the price to be paid for the partner’s interest?

•        Key-person life insurance

–       Life insurance policy on principal partner members

–       Use of proceeds upon the partner’s death to buy out partner or keep the business going

•        Corporation

•        U.S. Supreme Court Definition : “An artificial being, invisible, intangible, and existing only in contemplation of the law.”

•        Powers include rights to:

–       Sue and be sued

–       Acquire-sell real property

–       Lend money

•        Owners rights:

–       As stockholders they invest capital in exchange for shares

–       No liability for corporation’s debts

–       Can only lose the money they invest

•        Advantages:

–       Limited liability for owners

–       Capital can be raised through sale of stock

–       Ownership is transferable

–       Binding contracts do not need individual owner signature

–       Enjoys status and deference in business circles

–       Employee access to retirement funds, defined-contribution, profit-sharing and stock option plans

–       The entrepreneur can hold personal assets which can be leased back to the corporation for a fee

•        Disadvantages:

–       More complex to organize

–       Subject to more governmental regulation

–       Cost more to create

–       Stockholders do not receive benefit of losses

–       Ownership control passes to the board of directors

•        Where to incorporate:

–       In the state in which the business is located

–       In states with favorable tax laws

–       Delaware - if seeking venture capital

–       S-Corporation

•        Advantages:

–       Business losses can be passed through for taxation at entrepreneur’s personal tax rate

–       Avoids double taxation of income

•        Disadvantages:

–       Retained earnings no longer available for expansion or diversification

–       No deductions on medical reimbursements or health insurance plans

•        Professional Corporations

•        Licensed service professionals’ corporation organized to provide their services

–       Limited Liability Company

•        Privately held companies which incorporate under strict guidelines

•        Advantages:

–       Tax and liability pass through obligations

–       Limited liability

–       Continuity of life

–       Centralized management

–       Free transferability of interests

–       No limits on number of members or status

•        Disadvantages:

–       Formation filing fee is obligatory

–       Consensus is difficult if there are many members

–       It is not a separate tax-paying entity

–       Members must file quarterly IRS statements

–       Can be obliged to register with the SEC

–       May not have foreign ownership rights

•        The Nonprofit Corporation

•        A corporation established for charitable, public, religious purposes or for mutual benefit as recognized by federal and state laws.

•        Advantages:

–       Attractive to corporate donors for business expense deductions

–       Can seek cash and in-kind contributions of equipment, supplies, personnel

–       Can apply for grants from government-private agencies

–       May qualify for tax-exempt status

•        Disadvantages:

–       Profits cannot be distributed as dividends

–       Corporate money cannot be contributed to political campaigns or for lobbying

–       Entrepreneur gives up proprietary interest in the corporation

–       Upon dissolution, all assets must transfer to another tax-exempt nonprofit organization

–       Substantial profits must come only from related activities

–       It must pay taxes on profits

•        Making the Decision About Legal Form

•        Ask the right questions

–       Does the founding team have the necessary operational skills?

–       Do the founders have the required start up capital?

–       Will the founders be able to run the business and cover the first year’s living expenses?

–       Are the founders willing/able to assume personal liability for claims against the business?

–       Do the founders wish to have complete control over operations?

–       Do the founders expect initial losses?

–       Do the founders expect to sell the business some day?

•        Choosing the right form at each milestone:

–       Know the strategic plan from the outset

–       Know the possibilities for changing legal form

–       Know the expected capital and liquidity needs

–       Know the tax implications for owners-members