Business 101: Getting to Know Corporate Entities
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Not many things incite more emotion from budding entrepreneurs than the opportunity to start their own business. Common questions are often associated with the excitement: what will the size of my company be? Who do I have to go through to set up the business? Will I need outside investors? A decision of this magnitude shouldn’t be made based on assumptions or misinformation. Before you open for business, you need to know what kind of business you want to be.
A sole proprietorship is owned by one person. It’s the simplest type of business entity to form and operate. Sole proprietorships are best suited for small specialty businesses. Cookie company Famous Amos began as a sole proprietorship owned by Wally Amos in 1975.
“One of the perceived advantages of a sole proprietorship business form is the ease of starting the business. All that is necessary is a business idea and the desire to own your own business and be your own boss,” said Paul Franklin, Associate Academic Department Chair for the Associate Division of Accounting and Finance at Kaplan University School of Business. “The sole proprietor keeps all the profits earned by the business. These profits are taxed as the ordinary income of the proprietor, and the business is not required to file state and federal income tax returns.”
- Unlimited Personal Liability: The owner is responsible for all debts of the business and any potential liabilities that may arise from operation of the business.
- Limited Life: If the sole proprietor dies, retires, or stops operating the business for any reason, the business will cease to exist. “The availability of operating funds is limited to the creditworthiness of the sole proprietor,” Franklin said. “The amounts of money that can be raised and/or borrowed are dependent on the ability of the sole proprietor to borrow or use personal funds to provide operating funds for the entity.”
- Limited Skills: Franklin said many small business owners have special skills that are the core of the business but lack broader management skills or experience.
General and Limited Partnerships
A general partnership is a voluntary association of two or more people to conduct business as co-owners for profit. All partners share the responsibilities of operating and managing business activities on a day-to-day basis.
A limited partnership consists of one or more general partners and limited partners who invest in a business entity but do not share in the management of the business or the day-to-day operation of the business. These are typically formed for a specific project or purpose, and limited partners assume no liability for the business entity beyond their investment in the partnership. Limited partners might also be referred to as “silent partners.”
“Some partnerships are formed through a handshake agreement,” Franklin said. “When a business entity is organized as a partnership, a formal partnership agreement, called the Articles of Partnership, should be executed. If a partnership is formed with no formal partnership agreement, all matters coming into question relating to the operation of the partnership or disagreements that might arise will be resolved according to the U.S. Uniform Partnership Act.”
Partnerships are best for businesses in which the skills and expertise of more than one individual is essential to the success of the entity. Examples of successful business partnerships are Warner Bros., founded by brothers Jack, Albert, Harry and Sam Warner; Hewlett-Packard, founded by friends Bill Hewlett and David Packard; Ben & Jerry’s Ice Cream, founded by childhood friends Ben Cohen and Jerry Greenfield; and A&W Root Beer, founded by Roy Allen and Frank Wright.
Differences Between General and Limited Partnerships
Limited partnerships are more complex. The main thing that differentiates a limited partnership from a general partnership is the role of a limited partner. They are commonly thought of as investors for the business entity by providing capital. In exchange for their investments, limited partners enjoy the tax benefits of the partnership investment.
- Ease of startup: Partnerships are generally inexpensive and easily formed, with a majority of the startup time spent developing the partnership agreement.
- Individual legal entity: The entity is not required to pay state and federal taxes on the income of the entity.
- Profits Taxed as Ordinary Income: Business profits are passed through to the owners of the business and taxed as ordinary income. Because of this, the entity is not required to pay state and federal taxes on the income of the entity.
- Unlimited Liability: Excluding any limited partners, all the debts of the business will fall on the owner. A partner can obligate the partnership to a debt or liability and potentially obligate the remaining partners for a debt or liability.
- Easy Dissolution: Partnerships can be dissolved as a result of a management disagreement, making this type of business a volatile entity. The partnership entity will cease to exist when a partner leaves for any reason or a new partner is added, which will require a legal restructuring of the business.
C and S Corporations
A C Corporation is often defined as an artificial person. A C Corporation’s profits are taxed separately from its owners. A corporation has many of the legal rights of an individual: a corporation can start a business, own and sell property, can sue/be sued, borrow money, and contract.
An S Corporation is a type of business ownership in which the business is able to avoid double taxation because it is not required to pay corporate income tax on the profits of the company. S Corporations share the same attributes as C Corporations, with some limitations: S Corporations can have no more than 100 stockholders; stockholders must be individuals, estates, or certain trusts; there can only be one class of stock; and the entity must be a domestic corporation. Partnerships, corporations, and non-resident aliens are prohibited from being stockholders in S Corporations.
- Limited Liability of Stockholders: The stockholders of a corporation do not have any personal liability for the debts or obligations of the business entity.
- Ease of Raising Capital: Raising capital is an advantage to large publicly traded corporations in the ready markets that exist for the sale of their stock.
- Ease of Transfer of Ownership: Ownership in a corporation is evidenced by shares of stock that can be sold at the will of the owner without disrupting the entity’s structure, thus resulting in continuity of life for the organization. A corporation can hire individuals with specialized skills without having to relinquish ownership to attract talent.
- Arduous Procedures: Corporations face government regulations and filing requirements that are not necessary for other forms of business organizations. Corporations must adopt certain bylaws, keep record of meeting minutes with shareholders and board of directors, file annual reports, pay annual fees and issue stock. Establishing a business as a C Corporation or an S Corporation requires legal expertise. Corporations are required to file Articles of Incorporation and fill out an application for charter, which details the major components of a company such as its objectives, structure, and planned operations. The charter must be filed with the secretary of the state in which corporation is sought. Publicly traded corporations are required to file financial statements with the U.S. Securities and Exchange Commission.
- Double Taxation: C Corporations are subject to double taxation (once on the income and again when dividends are paid to their shareholders), and losses do not pass through to shareholders.
Limited Liability Company
A Limited Liability Company (LLC) is a relatively new form of business organization that provides the limited liability features of a corporation and tax efficiencies and flexibility of a partnership. LLCs are available in all 50 states, but states may have slight variations in the laws relating to the organization, operation, and structure of the entity. Owners of an LLC are referred to as members. LLCs are best suited for small businesses seeking limited liability protection for its members, such as medical practices and law firms.
An LLC differs from a corporation in that ownership in a corporation is evidenced by stock ownership. This is not required in an LLC because all owners are considered members of the organization. One company or LLC may be a member of another LLC. All profits and losses are passed through the business to each member of the LLC.
- Pass-Through Tax Status: An LLC’s profits and losses are passed through directly to the members.
- Limited Liability: Limited liability is provided for the actions, debts, and business decisions of the company. In the case that the LLC is sued, the personal assets of the members are typically exempt.
- Flexibility and Ease: In regard to management structure, taxation, the distribution of assets, and allocation of income or losses, LLCs offer flexibility to its members. LLCs are run by an operating agreement that determines and allocates the rights of members. It’s up to the members themselves to decide who earned what percentage of the profits or losses. They may distribute the profits as they see fit.
A major disadvantage of LLCs is that members are subject to pay self-employment tax. (They are, after all, considered to be self-employed.) The laws for LLCs can vary from state to state, causing a lack of uniformity among LLC statutes. For example, in many states, when a member leaves an LLC, the business is dissolved and members are left to fulfill the legal and business obligations to close the business. They can decide to start a new LLC or call it quits.
Before establishing any type of business entity, you should always consult an attorney. Franklin said that legal advice should be sought before any final decision is made as to the form of ownership and the structure of the business. Some areas you should remember to discuss with your lawyer:
- Partnership agreement
- Incorporating a business
- Stock registration
- Obtaining or protecting a trademark, trade name, patent or copyright
- Filing for licenses and permits and complying with local, state, and federal requirements
- Purchasing or selling a business
- Creating contracts
- Collecting debts
It’s exciting to start a business, especially if it’s your first one. But elation can easily turn to dejection if you make the wrong choice when it comes to which entity will best suit your business’s purpose. Making the wrong decision could be costly to the entire organization. With the right preparation, though, you’ll be that much closer to success.