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The legal structure
When organizing a new business, one of the small business owner's most important decisions is choosing the legal form of the business. This decision will have both tax and legal implications for the business and its owners.
Most small businesses start out as either a sole proprietorship or a partnership, but many eventually transition to another structure. Some of the factors that influence this decision include the owner's personal management style, capital needs, legal restrictions, the type of business operation, number of employees, and tax advantages or disadvantages. The following are some of the most common types of business structures.
Sole proprietorship
The sole proprietorship is the simplest and least regulated business structure. An individual who is responsible for all aspects of the business, including any debts, even in excess of the amount invested, owns it. In addition to potential personal liability for the owner, there is the possibility of dissolution of the business upon the owner's death. On the other hand, the sole proprietor has total control of the business and receives all profits.
When establishing a sole proprietorship, there are likely to be fees to obtain business name registration, a fictitious name certificate, and other necessary licenses. Any potential attorney's fees for starting the business, however, will be less than the other business forms because less preparation of documents is required.
To finance the sole proprietorship, the sole owner must contribute or borrow all of the capital needed to start the business. Any outside funding sources must be in the form of loans.
As a sole proprietorship, the business itself does not pay income tax. The profit or loss of the business is taxed as personal income and is included on the owner's individual tax return.
Partnership
Like the sole proprietorship, a partnership is relatively easy to form. As a legal entity that is jointly owned by two or more people, a partnership allows for additional financial resources. The two most common types of partnerships are: general and limited.
A general partnership can be formed by an oral agreement between two or more persons. However, a legal partnership agreement drawn up by an attorney is usually recommended. As in the sole proprietorship, the partners or owners are personally responsible for all debts of the business, even those in excess of the amount invested in the business. Each partner is an "agent" for the partnership and can hire employees, borrow money, and operate the business.
A limited partnership is a special arrangement that allows limited partners to avoid personal liability for claims and debts against the partnership because liability is fixed at the amount they have invested. Limited partners, however, do not have input in the day-to-day operations of the business. This type of partnership must also have at least one general partner. Because partners are responsible for any other partner's business actions, as well as their own, a written agreement is essential. Limited partnerships must be registered and must pay a franchise fee.
A partnership files an informational tax return telling the IRS how much each partner earned. The partnership does not pay tax on this income, and all profits are taxes as personal income. Each partner reports his or her share of income (or loss) on Schedule E, Supplemental Income and Loss and files it with Form 1040.
General corporation
The corporation is the most complex of business structures because it acts as a legal entity that exists separately from its owners. In other words, a corporation is a business that is formed and authorized by law to act as a single person and is legally endowed with rights and responsibilities. In order to form a corporation, the business must file Articles of Incorporation with the Secretary of State in Raleigh, North Carolina. An attorney is not required to file the Articles of Incorporation. The Department, however, encourages legal consultation. Its Guidelines for Incorporation are available online or by writing “Guidelines for Incorporation,” 300 N. Salisbury St., Raleigh, NC 27603-5909, or calling 919-733-4201.
The owners of a corporation are known as stockholders who invest money or other assets in the new business in return for shares of stock. Control depends on stock ownership and is exercised through regular board of directors’ meetings and annual stockholders’ meetings. Generally, the stockholders are at risk only for money they have invested in the stock of the corporation, except where fraud is involved. Officers of a corporation can be liable to stockholders for improper actions.
Depending on the business, a corporate structure may be advantageous because it allows capital to be raised more easily through the sale of stocks or bonds and can continue to function even without key individuals. It also enables employees to participate in various types of insurance and profit sharing plans.
As a separate entity, the corporation files income tax returns and pays taxes. This creates “double taxation” because the profits of a corporation are taxed first as income to the corporation and then as income to the shareholder. However, all reasonable business expenses, such as salaries, are deductions against corporate income and can minimize the double tax. For example, in many small corporations, the shareholders are employees who receive all profits of the business in the form of salaries and bonuses, which are tax-deductible by the corporation as a business expense. In that situation, the corporation would have no taxable income. Not all small corporations, however, are able to pay out their income in the form of salaries and bonuses and thus must pay a corporate income tax.
If a corporation expects to have taxable income, the corporation must make periodic deposits of its estimated income taxes. If the owner is an employee of a corporation (as is almost always the case with an owner of a small business corporation), taxes and Social Security payments must be withheld from the owner's paychecks. In addition, if a shareholder performs substantial services for the corporation, the shareholder is considered an employee for tax purposes. Corporations must also pay an annual corporate license fee, which is based on capital stock and paid-in surplus of the corporation.
S corporation
Many entrepreneurs and small business owners take advantage of the S corporation structure because it combines a lot of the advantages of the sole proprietorship, partnership, and corporate forms of business.
The S corporation is not really a different type of corporation; it is a special tax designation applied for and granted by the IRS to corporations that have already been formed. To become an S corporation, the business first must form a general or professional corporation in North Carolina. Second, the business must obtain formal consent from the corporation's shareholders, which should be noted in the corporation's minutes. Finally, the company must complete Form 2553, Election by a Small Business Corporation, which should be filed with the IRS.
S corporations have the same basic advantages of the general corporation. The main difference between the two is tax liability because the S corporation does not file or pay federal taxes on profits of the corporation. Instead, the IRS allows all profits to “pass through” to the individual shareholder's personal tax return. This means that S corporations avoid the “double taxation” of general corporations. Form 1120S filed by an S corporation is an informational return telling the IRS how much each shareholder earned.
The following restrictions apply to the S corporation:
- It can only be a domestic corporation;
- It cannot have more than 75 stock shareholders;
- Only individuals can be stockholders; and
- Each stockholder must be a citizen of the United States.
Limited Liability Company
A limited liability company (LLC) is an unincorporated business association that provides its owners limited liability, flexible management, and financial alternatives. An LLC is a cross between a partnership and a corporation because it is treated as a partnership for federal income tax purposes, but it provides owners the limited liability of a corporation.
Owners of limited liability companies are called "members," which are comparable to stockholders in a corporation or limited partners in a limited partnership. The LLC provides for members to contribute money or other consideration to the company. These members share in profits and losses and can participate in its management.
The LLC is created by two documents: the Articles of Organization and an operating agreement. The Articles of Organization are similar to corporate Articles of Incorporation and must be prepared and signed by the organizers of the LLC; they must also be approved by and filed with the North Carolina Secretary of State. The LLC must have a registered office and a registered agent — the person who receives the legal documents required to be served on LLCs. The registered agent
should be either an individual or a corporation. The operating agreement is the governing instrument of the LLC and must be adopted by all members.
A single-member LLC is normally taxed as a sole proprietorship. An LLC that has two or more members, unless the owners choose to have the business taxed as a corporation, will be taxed as a partnership and will file an informational return that tells the IRS how much each member earned. The LLC does not pay taxes on its income, but, as with a partnership, each member reports his or her share of income (or loss) on Schedule E, Supplemental Income and Loss, which is filed with Form 1040. LLC’s file the same type of return (corporate or partnership) with North Carolina as they file with the IRS.
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Obstacles
In his book "Small Business Management," Michael Ames give the following reasons for small business failure:
- Lack of experience
- Insufficient capital (money)
- Poor location
- Poor inventory management
- Over-investment in fixed assets
- Poor credit arrangements
- Personal use of business funds
- Unexpected growth
Gustav Berle adds two more reason in "The Do It Yourself Business Book:"
- Competition
- Low sales
Also, understanding the difficulty of starting a business is one of the biggest obstacles entrepreneurs face.
Success can be yours, however, if you are patient, willing to work hard, and take all the necessary steps.
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