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SOLE PROPRIETORSHIP The sole proprietorship is the most common business form; “there are over 17 million sole proprietorships in this country, representing over 73 percent of all businesses” (Stevick, p. 1.7). Sole proprietorships are basically what they sound like – there is a sole proprietor, a sole owner with all control, all profits, all resources, and liability. Advantages Control o Unlimited control, or “autonomy,” is, perhaps, the most attractive reason for an individual to start their own business, and is a major advantage of the sole proprietorship; the sole proprietor has complete control over their business. There is no boss to answer to, no partner to run ideas by, and no board or shareholders to seek approval from. The sole proprietor can decide on changes at any time to their company in almost any way, so long as they are capable of producing the changes. Profit Sharing o Similar to unlimited control, and just as attractive, is the advantage that the sole proprietorship has where the sole proprietor is the only benefactor of profits and gains. Just as there is no partner to share control with, there is no partner to split profits with. Convenience o Convenience and simplicity is another major advantage of the sole proprietorship, putting it within reach of most individuals. According to Stevick, “the only legal formalities are applying for appropriate state or local permits and licenses and filing a special certificate if the sole proprietor intends to operate the business under a name other than his or her own” (p. 1.9). Furthermore, terminating the business is just as easy – easier, in fact. The proprietor simply concludes all business agreements and outstanding commitments, and ceases to do business. Taxation o Pass-through taxation is a great advantage of the sole proprietorship. With this form of taxation, the proprietorship, the company, is not subject to income tax, but rather this is passed-through to the owner, who then pays any of the taxes with their personal income taxes. This is a great advantage, because it means that the profits are taxed once through the owner, rather than being taxed twice – once through the company and again through the owner. Furthermore, the proprietor may charge costs of doing business and depreciation as “expenses” to the company, and because this is a pass-through taxation entity, the proprietor may therefore reduce the taxable income. Disadvantages Liability o The owner is solely responsible for the liability of his/her company, thus “unlimited liability.” This is considered to be a disadvantage, as this puts a huge burden on the one individual. This is a two-edged sword for the owner, because they have unlimited control as listed above, but they also have the unlimited liability. Firstly, the burden of liability belongs solely to the proprietor; there is no sharing of liability between multiple parties. Secondly, and possibly more crucial, is the fact that unlimited liability has no distinction between business assets/liabilities and personal assets/liabilities. In other words, any debts owed by the company must be paid not only by the company’s assets and profits, but also by the owner’s private assets and profits, if the company’s assets cannot cover the debts. So, a company in debt could completely wipe out personal assets such as private vehicles, personal profits, and even the proprietor’s home. Longevity o The life-span, or longevity, of a sole proprietorship is widely-viewed as the most significant disadvantage to this form of business. The life-span of the sole proprietorship lasts only as long as the sole proprietor is alive, or mentally/physically able to run the business. Upon death, the company is dissolved unless extensive measures are taken in the owner’s Last Will and Testament, specifying that the business should continue. However, even with this provision, most individuals do not have adequate planning and resources to continue the business after his/her death. The largest reason this is a disadvantage is because it leaves the owner’s family with no source of income, and the assets are generally distributed “under the supervision of the appropriate courts” (Stevick, p. 1.11). Because most individuals start sole proprietorships in order to have autonomy, independence, and self-reliance, leaving the family with no income or company assets is a considerable disadvantage. o In addition to the legal guidelines that determine the longevity of a sole proprietorship, another aspect of longevity is the fact that the resources, funds, and other capital come from the sole owner – there is no pooling of resources between multiple individuals. Because of this, sole proprietors may find that their business fails before it has a chance to succeed because they run out of funds and cannot get lines of credit on their own merit. GENERAL PARTNERSHIP General partnerships are formed when 2 or more individuals join efforts, resources, and capital to form a business. General partnerships are fairly similar to sole proprietorships in terms of liability and taxation, but differ from sole proprietorships in that control and profits are shared between the partners. A main reason individuals join together in a partnership is the pooling of resources and capital that results. Advantages Profit Sharing o Profit sharing is often tied to that of control. Where control is divided amongst individuals, profits generally are, also. As with the control in general partnerships, the partners also share the profits, either equally, or at a mutually agreeable proportion. While this could be a disadvantage in and of itself, it is offset by the advantage that partnerships offer more resources and capital in order to increase profitability. Convenience o General partnerships are fairly simple to create – a distinct advantage; in addition to the business license required, all that is needed is a contract. While oral contracts are acceptable and have been upheld in court, best practice calls for written contracts. The creation of a partnership may become a little more complicated than a sole proprietorship if the articles of partnership within the contract are fully covered, as this takes some discussion and negotiation. These items, discussed by Stevick, are such things as: “Names of the partners Name of the partnership Nature of the business to be conducted Capital and property of the firm Capital contribution of each partner Share of each partner in the profits and losses Provisions for settling differences Drawing account arrangements (technically, partners do not receive a salary)” (p. 1.14) Taxation o Like sole proprietorships, pass-through taxation is a great advantage of partnerships. With this form of taxation, the company is not subject to income tax, but rather this is passed-through to the partners, who then pay any of the taxes with their personal income taxes. Disadvantages Control o In a general partnership, control is divided equally between the partners. Furthermore, mutual consent is needed by all members in order to allow another individual to become a member of the partnership. Control, however, could be seen as a disadvantage for general partnerships, because each partner is an acting agent for the company, and may conduct business and enter agreements for the company – even if the others in the partnership are not aware at the time of the transaction. Liability o Liability with general partnerships is almost identical to that in sole proprietorships. Every partner is personally and individually liable for debts incurred by the company – again, “unlimited liability.” While the burden of liability lies solely on the owner in a proprietorship, it is shared to some extent in a general partnership, but this can be more of a risk than the sole burden of a proprietorship, because each partner is liable for every other partner. Because unlimited liability extends not just to business liabilities, but personal liabilities as well, “the personal insolvency of any partner can jeopardize the entire partnership business…[as] the personal creditors can force a liquidation of the partnership interest in order to satisfy their claims” (Stevick, pp. 1.17-18). Longevity o For general partnerships, a buy-sell agreement (also known as an ownership transfer plan) must be executed if the partners desire the partnership to continue after the death of a partner. If there is no buy-sell agreement, the partnership legally must be terminated. If, however, there is an agreement in place, this allows the heirs of the deceased partner to sell their interest to the remaining partner(s) to continue the business. LIMITED PARTNERSHIP With almost the same characteristics of general partnerships, limited partnerships include at least one general partner and at least one limited partner. The general partner retains almost the same characteristics as they would have under a general partnership, but the limited partner is where the main differences are. The limited partner is essentially an investor, providing capital for the company and sharing the profits, without the liability or control of a general partner. Advantages Control o The control in a limited partnership is kept strictly to the general partners. Limited partners do not have control in the company, do not make decisions, and have no voice in day-to-day management of the company. Remember that limited partners are essentially investors, so they do not act in the regular business activities. Profit Sharing o As with a general partnership, the profits in a limited partnership are shared among the partners. As more resources are pooled, this means that there is greater potential for higher profits to divide. Convenience o Limited partnerships are simple to create, just like general partnerships. A contract with articles of partnership outlining the same items as listed under “general partnerships,” along with the business license, are what is needed to create the limited partnership. Taxation o Like sole proprietorships, pass-through taxation is a great advantage of partnerships. With this form of taxation, the company is not subject to income tax, but rather this is passed-through to the partners, who then pay any of the taxes with their personal income taxes. Disadvantages Liability o Liability with limited partnerships is a mixture of unlimited liability and limited liability. As limited partnerships have at least one member who is a general partner, liability for that individual is unlimited, in the same way as sole proprietorships and general partnerships. As for the limited partners, this is an advantage to them, because they have limited liability. They “shall not be bound by the [financial] obligations of the partnership beyond the extent of their investment” (Stevick, p. 1.20). This allows general members to get the investment and capital they may need, because it is lower-risk to the limited member than if they joined as a general member. Longevity o Unlike a general partnership, the death of a limited partner does not terminate the business. This holds true only for the limited partner(s), however, as death of a general partner follows the same stipulations as those for a general partnerships. While death of the limited partner does not terminate the company, the personal representative of the limited partner will receive the portion of assets and profits owed to the limited partner, so they can distribute these and settle the affairs. So, limited partnerships are a mixed-bag of advantages and disadvantages with regard to longevity, because on the one hand the business stays intact at the death of the limited partner, but on the other hand it is still susceptible to the disadvantages of the general partnership. C-CORPORATION Corporations differ from proprietorships and partnerships largely in that they are themselves their own entity, independent and separate from the owners. Corporations have longevity in mind, and they do not cease to exist at the death of an owner, but have boards of directors and shareholders that continue the existence of the entity. Additionally, a corporation is created by law with a charter granted and approved by the proper official, and “as an entity, it is viewed as an artificial person and is subject to many of the privileges and restrictions of a natural person” (Stevick, p. 1.24). C corporations, specifically, potentially differ very little from proprietorships, except with key characteristics such as limited liability and increased tax benefits. Furthermore, the owners/shareholders in C corporations are also employees who receive salaries. Advantages Taxation o Unlike S corporations, C corporations are taxable as an entity, so the net income of the business is taxed before it is passed to the individual owners for further taxation. The net income is after all deductions, such as salaries and fringe benefits. Any profit distributed from net income is considered dividends, which are further taxable and are not deductible, and because of this, C corporations attempt to reduce or avoid dividends. It should be noted, however, that the IRS has strict rules in place that must be followed in regards to dividends. Liability o Similar to the limited liability of a limited partner, stockholders are held liable only in as far as they have investment, but their personal assets cannot be held for company liabilities. The corporation itself is held liable for its employees and debts. Longevity o Corporations are terminated either as a result of a “vote of stockholders, bankruptcy, [or] violation of certification incorporation (by court)” (p. 1.47). With good management, policies, and ethics, these can generally be avoided. And, unlike the previous forms of organization discussed, the death of a stockholder does not affect the continuation of the business. This is a huge advantage, and is a main determinant in why companies choose to incorporate. Disadvantages Control o Control is greatly diffused and distributed in many corporations. Unlike the previous forms of organization where control and management is directly in the owners’ hands, corporations have officers that manage the company, make decisions, and handle the majority of the control. These officers are selected by the board of directors. The board of directors, in turn, is composed of individuals elected by the shareholders. It should be noted that it is possible for the shareholder to also be the acting officer, and in this case the control would be identical to that of sole proprietorships. Profit Sharing o Corporations have a board of directors responsible for the profit sharing. After all salaries have been paid and deductions have taken place, the board decides how the remaining profit, the dividends, will be paid or kept. Convenience o C corporations are very likely the most burdensome of all forms of business to create. Not only must the company obtain a standard business license in order to operate, but in order to be an incorporated entity, a certificate of incorporation must be filed with the state. At that point, filing doesn’t guarantee incorporation – the proper official (generally Secretary of State) must approve the charter. Furthermore, any violations of the certificate of incorporation will terminate the company’s incorporation status. S-CORPORATION With the same characteristics as general corporations, S corporations are further distinguished with features that are similar to partnerships. For instance, both forms for business are passthrough taxation, so the tax is paid on earnings by the owners rather than by the company itself. As taxation is a major attribute of S corporations, “the popularity of S corporations fluctuates with changes in income tax law and the tax status of individuals and their businesses…decisions to incorporate as a C or S corporation will often vary based on the relative income tax brackets of the individual owner(s) and the corporation” (Stevick, pp. 1.35-36). Advantages Taxation o S corporations are similar to sole proprietorships and partnerships, in that S corporations are a pass-through entity. With this form of taxation, the company is not subject to income tax, but rather this is passed-through to the individuals, who then pay any of the taxes with their personal income taxes. This is a nice advantage as the profits are not taxed twice. Liability o The liability for S corporations is the same as C corporations – namely, the corporation is held liable, but the stockholders are only liable as far as they have investments. Longevity o Corporations are terminated either as a result of a “vote of stockholders, bankruptcy, [or] violation of certification incorporation (by court)” (p. 1.47). With good management, policies, and ethics, these can generally be avoided. And, unlike the previous forms of organization discussed, the death of a stockholder does not affect the continuation of the business. This is a huge advantage, and is a main determinant in why companies choose to incorporate. Disadvantages Control o Control is handled the same way C corporations handle it. Through officers, appointed by the directors, who were elected by the shareholders. Profit Sharing o Corporations have a board of directors responsible for the profit sharing. After all salaries have been paid and deductions have taken place, the board decides how the remaining profit, the dividends, will be paid or kept. Convenience o S corporations, like C corporations, are required to file a certificate of incorporation with the state, and must have the same approval by the appropriate official. They do not, however, need to file a business license like C corporations must. LIMITED LIABILITY COMPANY Limited Liability Companies (LLC) are somewhat of a conglomeration of all business types, and are rapidly growing as they seem to combine many advantages of different business forms without all of the disadvantages. LLCs combine aspects of the simplicity, control, and tax benefits of partnerships/proprietorships with the limited liability and potential longevity of corporations. Advantages Control o Control has similar advantages as that of sole proprietorships and partnerships. There are no stockholders and board of directors with which to share management and control, and therefore the members have a more hands-on, direct approach with the company. Frequently, the members actively manage the company on a day-to-day basis. Profit Sharing o Profit sharing is similar to that in partnerships. While corporations must share the profits with the stockholders, profits in LLCs are divided among the members, proportionate to the amount of their interest. Convenience o According to Stevick, LLCs are established by filing articles of organization with the state (p. 1.46). Taxation o Taxation for LLCs is determined by specific characteristics to see if it falls in line more with a sole proprietorship, a partnership, or a C corporation. For example, “a business with only one owner can elect to be taxed as a sole proprietorship or as a corporation. Businesses with two or more owners can elect a partnership or corporate tax status” (Stevick, p. 1.41). Liability o Similar to corporations, LLCs have limited liability (hence, the name). Whereas partnership members are liable for the negligence of other members, LLC members are liable only for their own actions and their own contribution to the LLC. Furthermore, unlike limited partners in a limited partnership, members of an LLC are permitted to actively manage and control the company. Disadvantages Longevity o Similar to proprietorships and partnerships, death can dissolve the company, in most states. However, most states also permit the surviving LLC members to vote on the LLC’s continuance – either a unanimous decision must be reached, or a certain percent of members must be in agreement (depending on the operating agreement or state law). Memorandum To: Manufacturing Business Owner From: Katie Gardner Date: 2/11/2012 Re: Recommended business organization From what you have told me, your main concerns with your business organization are: 1. Liability – you want to protect your personal assets from the liability of anything that happens to the company. 2. Profitability – you wish to increase your capital and grow your company. 3. Profit-sharing – you want to maximize the profit that you personally can keep. 4. Income Tax – you want to maximize your income tax benefits. 5. Longevity – you want the business to continue in the event of your death, and want your family to continue to have a source of income. Sole Proprietorship You are already operating as a sole proprietorship, which does not offer you the protection and longevity you are looking for. It does offer the tax benefits and maximized profit as you are the sole beneficiary of the income, however, so we want to maintain those items as best we can. General Partnership A general partnership would increase your capital, but still leaves you vulnerable to the unlimited liability you are currently subject to. In a business working with power tools, forklifts and other vehicles, and handling installations in homes, I believe that getting your company in a position where you are not personally held liable is of upmost importance. Limited Partnership If you were simply looking for more capital, I would recommend this form of business, because you would retain much of the profits and control of the company. However, this form still leaves you open to the unlimited liability that we are hoping to steer away from. C-Corporation A C-corporation is definitely something to consider as you could greatly increase your capital, increase your borrowing power, increase your profitability, and maintain the longevity of your company. It does not provide the pass-through taxation you currently have, however, and could potentially water-down your share of the profit as you would need to share the profits with shareholders, and answer to the board of directors. You have thought of having family members as acting officers, and that theoretically could work, but you do need to keep in mind that as you expand shareholders to increase capital, the likelihood of becoming a minority shareholder and/or losing shares if your family chooses to sell could end up shifting your family out of the business. S-Corporation If you do choose to incorporate, I would strongly urge you to consider an S-corporation over a Ccorporation. An S-corporation would still give you the benefits of being incorporated, namely longevity, increased capital and potential profits, etc. However, an S-corporation would give you the pass-through taxation that you are already enjoying, so your income and profits would be taxed once, rather than twice. Limited Liability Company Based on all of your concerns, I would recommend that you turn your business into a Limited Liability Company, because it combines the best of the forms for a small business such as yours. In terms of liability, LLCs protect you as well as a corporation, because the business is liable, and your personal interests and assets are maintained separately and kept protected. You still have the option to increase capital and profitability, depending on the members you have and the kinds of loans you will be eligible for as an LLC. Your profit-sharing will still be fairly strong – you may have to divide it between one or more members, but unlike the corporations, you would have no stockholders that take a piece of the pie, so to speak, leaving you with less. You also have the flexibility with income tax to act as a partnership or proprietorship, or as a corporation – this is a great advantage of LLCs. Lastly, although you do not have a guaranteed longevity with an LLC like you do if you are incorporated, if you have family members involved that you would like to protect in the event of your death, it can be arranged to give them the responsibility to decide whether or not the business should continue. Therefore, if it is necessary for their welfare that the business continues in your absence, they will be able to do so. To conclude this recommendation, “LLCs are attractive to family businesses that want to keep control in the family. How is this accomplished? Generally, ownership interests cannot be transferred without the consent of other members” (Stevick, p. 1.40). References Stevick, G.E. (2003). Essentials of Business Insurance: Financial advisor series: Product essentials. Bryn Maw, PA: The American College. Retrieved February 11, 2012 from http://www.theamericancollege.edu/pdf/fa251-class1.pdf.