Learn more about the different ways to incorporate a business.
Whether you've purchased an existing business or started one from scratch, you must decide which form of organization is best for your company. The decision can be difficult to make, since each form (sole proprietorship, partnership, corporation, S corporation, or limited liability company) has its advantages and disadvantages. Make sure that you consult with your attorney or accountant before making a final decision.
Remember, if the circumstances of your business change, you can always change the form. For example, you may start your business as a sole proprietorship, but as your business grows, you may decide to incorporate or to take on a partner and become a partnership.
In this column, the first of a three-part series, we'll discuss the two most commonly used forms for small business operations: the sole proprietorship and the partnership. In later columns, we'll discuss corporations and LLCs.
The easiest and least expensive way to begin operating a business is as a sole proprietorship. There are no documents or forms needed, unless the business will operate under a name other than the owner's name. (You may also have to file forms if you need a business license, but that's a separate issue).
One advantage of this form is that the business is not treated as a separate taxable entity. The business income is reported on Schedule C of the owner's individual tax return and is therefore taxed only once to the business owner. The owner may be subject to self-employment (Social Security and Medicare) taxes on all profits of the business.
On the other hand, sole proprietorships make the owner personally liable for any obligations of the business. This means that creditors of the business may go after your personal assets if the business assets are not sufficient to cover the business debts. Likewise, your personal creditors can go after your business assets to satisfy your personal debts. If your business is of a type that frequently faces lawsuits, you can limit your exposure by purchasing business insurance. Alternatively, you might want to consider a different business form that would provide greater liability protection, such as a corporation or a limited liability company.
A sole proprietorship by definition is limited to one person. Thus, if the owner wants to admit another owner, such as a spouse, family member or friend, the sole proprietorship would have to end. A new business arrangement, such as a partnership, would be created either by default or by intent.
If a business is going to be owned by more than one individual, the simplest business form to create and operate is a general partnership. In fact, if two or more people go into business together without incorporating, the law will presume they are a partnership even if they do nothing to set one up.
General partnerships. Forming a partnership entails an agreement between two or more prospective partners. The agreement can be oral, but we never recommend that you rely on an oral agreement. The partnership agreement should be written up and signed by all partners to avoid later conflicts. Your lawyer can help you make sure that your agreement covers all the bases and is enforceable in your state.
Virtually anyone can be a partner. A partner can be an individual, a partnership, a limited liability company, a corporation or a trust.
The flexibility of a partnership allows the business to operate in a manner that best suits the business's needs at the time the business starts and later when the business has matured. Each partner can contribute different things to the partnership, and in return, the partners' interests in the business need not be identical. For example, two partners may agree to split the partnership income 60/40, if one partner contributed more capital to the business. Later, when the business has grown, new partners can be admitted, yet their management capacity can be limited to prevent the new partners from usurping the original partners. In some businesses, there is an agreement that key employees will obtain a partnership interest over time as compensation for their services.
When a partner contributes capital to a partnership, the partner receives an ownership interest in all assets of the partnership, not just in the property contributed. A partnership interest is a capital asset that can be bought or sold (with permission of the other partners), and that can increase or decrease in value over time.
Partnerships do not themselves pay federal income taxes. Instead, all the profits, losses, credits and certain other tax items flow through the partnership to the individual partners, and are taxed on the partners' returns. Note that losses can be deducted only to the extent of the partner's adjusted tax basis in the partnership; any additional losses can be carried over to be deducted in subsequent years.
One of the chief disadvantages of partnerships is that each partner is personally liable for all the obligations of the partnership. Any partner can enter into a contract on behalf of the partnership. By doing so, a partner can bind all partners in an unfavorable contract, since all partners are jointly and severally liable for the obligations of the partnership. Obviously, it's imperative that you form a partnership only if you trust all your partners!
To protect the partnership and the remaining partners, consider setting up buy/sell agreements and key person life insurance policies on the partners. Such an agreement specifies how the value of a partner's interest will be determined if a partner wants to leave the partnership, minimizing disputes over value and providing a way to purchase the withdrawing partner's interest by the partnership or other partners.
Limited partnerships. A limited partnership is a partnership with two classes of partners: general partners and limited partners. The general partners operate the business and are personally liable for all obligations of the partnership. The limited partners are similar to shareholders of a corporation, in that they do not have any control over the business, other than to determine who will manage it. Limited partners share in the profits of the partnership, but their potential losses are limited to the amount of their contributions to the partnership.
A limited partnership is a creature of state law. As such, a limited partnership does not exist until the requirements specified in the state law are met. Generally, a certificate of limited partnership is required to be signed and filed with the secretary of state's office, and in some instances a limited partnership agreement is also required to be filed. If the requirements are not met, the business will be treated as a general partnership or an association taxable as a corporation.
Limited partnerships are generally not the best choice of entity for a new business because of the required filings and administrative complexities. For a new business with two or more working partners, a general partnership would be much easier to form. If a limited partnership is needed at a later date, the general partnership can easily convert to a limited partnership. If many passive investors will be needed, the corporate form generally offers more flexibility.
If you are interested in forming a partnership, make sure that you consult with your attorney before making a final choice. If you decide to form a partnership, you should have your attorney draft a partnership agreement for you that spells out the rights and responsibilities between you and your partners.