SELECTING THE LEGAL STRUCTURE FOR YOUR BUSINESS
There are many reasons for owners of small businesses to examine the available forms of business organization. The changing tax laws, the
limitation of personal liability for business debts and obligations, and fluctuating availability of capital are the three main reasons owners
should review what legal structures best meet their needs. Your choice of business form will affect your exposure to personal liability, how
you draw profits and pay taxes, your ability to raise capital, and how you run your business.
This handout will provide you with a brief summary of some of the advantages and disadvantages of the different kinds of business structures.
Most new small business owners select a sole proprietorship which is defined as a business owned and operated by one person. However,
SCORE strongly recommends obtaining professional assistance from both a lawyer and an accountant in connection with your decision as
to which form of entity best suits your business and tax planning needs.
Generally, all businesses fall into one of these broad categories: sole proprietorship, partnership, corporation, S corporation or limited liability
corporation.
The Sole Proprietorship
A sole proprietorship is an unincorporated business owned by one individual. It is the simplest form of business organization to start and
maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities, and you undertake the risks of
the business for all assets owned whether used in the business or personally owned. You are required to include the income and expenses of
the business on your personal Federal income tax return.
Advantages of the Sole Proprietor:
Ease of formation: There is less formality and fewer legal restrictions associated with establishing a sole proprietorship. It needs little or
no governmental approval and is less expensive than a partnership or corporation.
- Sole ownership of profits: The owner does not share profits with anyone.
- Control and decision making vested in one owner: There are no co-owners or partners to consult.
- Flexibility: Management is able to respond quickly to business needs in the form of day-to-day management decisions.
- Relative freedom from government control and special entity level taxation: Federal taxes are reported on your individual income tax
return. There are no Tennessee state taxes, but there are county and city licenses and taxes.
Disadvantages of the Sole Proprietor:
- Unlimited liability: The owner is responsible for the full amount of business debts and legal obligations. This liability extends to all the
proprietor's assets such as a house and car. Certain business liabilities may be lessened by obtaining proper insurance coverage.
- Unstable business life: The business may have to be terminated upon illness or death of the owner.
- Less available capital, ordinarily, than in other types of business organizations: Capital is dependent on the individual's assets and
credit. Long-term financing may be relatively difficult to obtain.
The Partnership
A partnership is a legal entity existing between two or more persons who join to carry on a trade or business. Each person contributes money,
property, labor or skill, and expects to share in the profits and losses of the business. A partnership is not generally taxable at the entity level
from a federal income tax viewpoint, and each partner includes his or her share of the income or loss on his or her federal income tax return.
General partners share unlimited personal liability for all entity debts and obligations, and each is usually responsible for the acts of the other.
Limited partners usually risk only his or her agreed investment in the business. Partnerships can exist with just general partners (e.g. a general
partnership) or a mixture of both general and limited partners.
Advantages of the Partnership:
- Ease of formation: More difficult than a sole proprietorship. Needs a written partnership agreement and a certificate for limited partnership.
- Direct rewards: Partners are motivated to apply their best abilities by direct sharing of the profits.
- Growth and performance facilitated: More capital and a better range of skills than in a sole proprietorship.
- Flexibility: Decision making is less flexible than a sole proprietorship.
- Relative freedom from government control and special taxation: Federal tax on distributions. Tennessee tax on distributions only if
partnership interest evidenced by a certificate (similar to a stock certificate). Partnership has to file with the IRS showing "flow-through" of
income and losses. County and city licenses and taxes have to be paid.
Disadvantages of the Partnership:
- Unlimited liability of general partners: Liability may be lessened by insurance.
- Unstable life: Elimination of any general partner may result in dissolution of the partnership. The business may continue to operate based
on creation of a new successor partnership. Partnership insurance should be considered.
- Relative difficulty in obtaining large sums of capital: Is better than sole proprietorship, but can be less than a corporation which can
undertake an initial public offering.
- Firm bound by the acts of all general partners: This applies to contracts, torts, etc.
- Difficulty of disposing of partnership interest: The buying out of a partner may be difficult unless specifically arranged for in the written
partnership agreement.
The Corporation
A corporation is a distinct legal entity, distinct from the individuals who own it. Usually, a corporation is formed by the authority of a state
government. First, approval must be obtained from the Secretary of State in the state in which the corporation is to be formed. This approval
is in the form of a charter for the corporation stating the powers and limitations of the particular enterprise. Subscriptions for capital stock
must be taken and a tentative organization created in order to form a corporation.
Advantages of a Corporation:
- Stockholder's liability is generally limited to a fixed amount of investment, absent a "piercing of the corporate veil" by a court.
- Ownership of shares is readily transferable.
- Separate legal existence.
- Stability and relative permanence of existence: In the case of the illness, death, or other cause for loss of an officer of the corporation,
the corporation continues to exist and do business.
- Relative ease of securing capital in large amounts: Capital may be acquired through the issuance of various stocks and bonds.
Disadvantages of a Corporation:
- Forming a corporation is expensive.
- Activities are limited by the charter and by various laws: Some states, such as Tennessee, allow very broad charters.
- Extensive government regulations and required local, state, and federal reports: Corporations in Tennessee are governed by the
Tennessee Business Corporation Act. You need a charter, bylaws, organizational minutes and a stock subscriptions agreement. You must
file a Corporation Annual Report with the Tennessee Secretary of State.
- Governmental taxes are significant and complex: For the federal government, the C type corporation is taxed directly at the entity level
and shareholders are taxed on dividends or distributions. For S type corporations the federal government taxes the shareholders on their
allocable shares of corporate income and the corporation is taxed at the entity level on some corporate distributions. Tennessee has a franchise
tax on corporate assets (25 cents per $100 in corporate assets); an excise tax of 6% on income; and an income tax on all dividends and
distributions to shareholders. The cost of individual Social Security contributions, unemployment contributions, and workers' compensation
will be higher in a corporation.
Limited Liability Companies (LLCs)
The Limited Liability Company is a relatively new legal form of Tennessee business enacted in 1994. An LLC is a form of entity which
provides the advantageous flow-through tax treatment of a partnership with the limited liability protection of a corporation. Income and income
tax are distributed among the owning members, but members are not personally liable for debts of the business.
Advantages of a Limited Liability Company:
- Members liability is limited to a fixed amount of investment.
- Separate legal existence
- Taxes are only paid by the members: The federal government taxes the Limited Liability Company the same as a partnership.
- Has the same advantages as a Partnership and a Corporation: However, the relative ease of securing capital in large amounts may, in
some instances, be less than a corporation.
Disadvantages of a Limited Liability Company
- Is a new legal entity: There are still some aspects of a Limited Liability Company that have not been decided by the courts.
- Ease of formation: Is more difficult than a sole proprietorship and more difficult than a corporation.
These materials are not intended to constitute the rendering of legal or tax advice. In view of the important legal, tax and business
planning issues involved with respect to the formation and operation of a business organization, the reader of these materials is
strongly advised to consult with a competent attorney and certified public accountant with respect to obtaining appropriate advice
on such matters.
