Sole proprietorships are the most common type of business in the U.S. They are most commonly chosen because they are the easiest type of business to set up and give the sole owner of the company complete control of the company. There are many benefits to a sole proprietorship in regards to control, profit retention, and convenience.
In regards to control, the owner of a sole proprietorship has the final say in any decisions. Due to the fact that there are no shareholders or other partners, the owner can make decisions regarding the direction of the company without having to answer to any other parties. If the owner wants to expand the company or move the business the owner has the ability to do so at any time.
Profit retention is also a big benefit to having a sole proprietorship. All profits from the company belong to the owner alone since the owner and company are considered to be the same person. The owner is able to use company profits for any use he deems necessary as he would with his own money. Any bank accounts belonging to the company would be the property of the owner even if they were in the businesses name.
Sole proprietorships are also the most convenient companies to own. Sole proprietorships are not required to produce profit reports or name officers. Sole proprietorships are not able to bring in partners or have shareholders, therefore removing the disadvantage of having to negotiate the sharing of profits or dispersal of dividends. There are some downsides to owning a sole proprietorship that make this an imperfect type of business. Some of the downsides of this type of business are liability, income taxes, and longevity of the business.
Liability is a major issue in a sole proprietorship due to the fact that the company and the individual are considered the same entity. This means that the owner of the company is liable for any and all debts the company may accrue and is liable for any lawsuits brought against the company. With no protection from liability the creditors are able to go after the owners personal assets when the company is unable to meet its financial obligations. In cases of lawsuits, if the award from a lawsuit is higher than any insurance policy the company holds, the owner would be financially responsible for the remaining amount.
Income taxes can be an issue in a sole proprietorship where the business produces higher profits. Since the business and individual are considered the same, any income would be treated as personal income and would be taxed as such. This can lead to paying higher income tax than a corporation may pay.
When the owner of the business and the business are considered the same this also leads to longevity issues with the company. If the owner suddenly dies the business would die with them. An executor could be appointed to handle any debts and assets of the company, but the company itself would cease to exist. General Partnership
General partnerships are formed when two or more individuals share equal ownership in a business and share the responsibility of running the business. Most partnerships are formed when two people each have a useful skill they can bring to the business that the other individual needs. When a partnership is formed, both members share the profits of the company, as well as any losses of the company.
Some of the benefits of a general partnership include; profit retention, convenience, and income tax. Similar to a sole proprietorship, in a general partnership all profits of the company belong to the owners of the company and are split between the owners. The owners are able to use their profits how they wish without having to be checked by a board of directors or shareholders. Although the profits are now split between the partners, all of the profits still belong to the partners alone.
General partnerships also are more convenient than a larger corporation. All that is required to operate the business are any permits required by the state and in most cases, articles of partnership. Articles of partnership are used to formally form the partnership and spell out the agreement between the partners (Lau & Johnson, 2013). When splitting the profits in a general partnership you are also splitting the income tax that needs to be paid. Depending on the profits of the business this may drop you into a lower tax bracket than if a single person had filed for all of the profits. This also drops the amount of income tax paid by each person resulting in lower individual taxes paid.
General Partnerships are not without their disadvantages. Without being an incorporated company the owners are still subject to issues such as liability, control, and location issues. Many believe that liability is a biggest issue in a general partnership than in a sole proprietorship. The owners of the company are still fully liable for any debts the company may accrue as well as the liability for any lawsuits that may be brought against the company. However, the bigger issue in a partnership is that now each partner can be liable for the other partner’s actions.
If one partner is sued for malpractice, the other partner may suffer because of it. In a general partnership there is also the issue of control. Whereas in a sole proprietorship the sole owner has full control in the business, in a general partnership the control is split equally between the partners. This can lead to issues when the partners do not agree on the direction they want to take the company in regards to growth or other business decisions. Location can also cause issues in a general partnership. Each state may have different rules as to how the partnership can function or how to form a partnership. This may lead to restrictions on expansion and or even lead to extra paperwork that needs to be filled out in each state. In a general partnership, since the partners are also liable for income tax, this may even lead to paying extra taxes in the states where business is done. Limited Partnership
A limited partnership is very similar to a general partnership; however, one of the partners is only involved in the business in a limited sense. In this type of partnership there are still general partners and at least one limited partner. The difference between the types of partners is the amount of control and liability the partners share. As with a general partnership, the general partners are subject to full liability for the debts of the company, however, the limited partner is only liable for the amount of his investment of the company.
This offers some protection to the limited partner in cases where the general partners would have none. Limited partners are eligible for a portion of the profits of the company. This portion is usually spelled out in the articles of partnership when it is formed. One benefit of being a limited partner is that if the limited partner dies, their executor is entitled to a buyout of their share in the company. However, unlike with a general partner, if the limited partner dies, this does not immediately end the partnership for all partners. This ensures continuity for the business and is a major benefit for the general partners. As with a general partnership, the general partners still maintain shared control of the business. However, the limited partner has no control over the day to day operations of the business.
The general partners are left to manage the business while the limited partner has no say in the matter. Limited partnerships are also treated the same as a general partnership for tax reasons. The partnership is not considered an entity therefore the tax burden falls onto the partners. All of the partners pay their respected income tax based off of the amount of income they received from the partnership. One of the downsides to a limited partnership is the challenge of compliance. When creating a limited partnership you must form a partnership agreement to spell out each partner’s role in the business and profit retention. You must also regularly release reports to the limited partner on the state of the company and also hold annual meetings that are not required in a general partnership. C-corporation
“Unlike a sole proprietorship or general partnership, a corporation is a separate legal entity, separate and distinct from its owners” (Lau & Johnson, 2013). Corporations offer many benefits for larger businesses that are otherwise unable to operate as a partnership or a sole proprietorship. One of the biggest advantages of a corporation is that all owners, or shareholders, receive limited liability protection. As with limited partners in a limited partnership, the most that a shareholder can lose would be their initial investment in the company.
Although corporations offer more protection to the shareholders, in corporations with very few shareholders this protection can be removed if the shareholders interact with the business improperly. “If sole proprietors fail to respect the legal corporation with an arm’s-length transaction, then creditors can ask a court to pierce the corporate veil” (Lau & Johnson, 2013). If the shareholders use company money for their own expenses, creditors can then go after personal assets that would otherwise be off-limits. In corporations, profits from the company no longer belong to the individuals but rather to the company itself. Individuals can no longer use the profits for whatever they chose but must use it in the best interest of the company.
The corporation, being considered a separate legal entity, is now liable for the income tax that the sole proprietor or partners were bearing. One advantage to this is that historically, corporate tax rates are lower than personal income tax rates. These savings can be kept with the company to use for business needs. This does not mean that the shareholders do not have to pay income tax off of their earnings from a corporation; however, these earnings or dividends are usually smaller than the profits of the corporation. Being a separate legal entity, a corporation also has the added benefit of longevity. In a sole proprietorship or partnership, when one of the partners or the proprietor dies, the company dies with them. However, a corporation can continue on after one of the shareholder dies with no issues. This longevity leads to more investor confidence without the risk of the business suddenly closing.
One of the disadvantages of a corporation is the difficulty of moving to new locations. When the corporation is initially formed, its articles of incorporation are only filed in one state as a domestic corporation. If a company wants to do business in another state it has to file as a foreign corporation in each state. This is a very costly process that can severely limit the corporation’s ability to expand or move its business.
Control of a corporation can be a tricky situation. Corporations include a board of directors that develop an overall direction of the company, including company policies, and appoint company officers to oversee the day to day operations of the company. Although the board does not directly manage the company it is able to remove company officers from their positions at any time. This can lead to issues when the board attempts to intervene in company operations or the officers attempt do not keep the company in line with the company vision. S-corporation
S-corporations are very similar to regular corporations in their basic function. As with a normal corporation, S-corporations offer the protection of limited liability and the longevity of a normal corporation. Shareholders in S-corporations are not liable for losses beyond their initial investment in the business. S-corporations also do not end when one of their shareholders dies. Like a normal corporation, an S-corporation is viewed as a separate entity and not as part of the shareholder. S-corporations have the same issue with location as regular corporations.
S-corporations must also register in each state that they wish to do business and pay any applicable fees. Control over an S-corporation is also similar to a regular corporation. The shareholders do not have total control over the business but rather appoint a board of directors to run the company. Profits are handled somewhat differently in an S-corporation than in a regular corporation. Profits are passed straight through to the shareholders of the company in the form of dividends, instead of being considered the profits of the company.
However, the income taxes on the profits of the company are handled differently than in a regular corporation. In a S-corporation, the company no longer pays corporate tax on its income, but the shareholders pay taxes on the dividends they were paid. Since the profits are no longer subject to corporate tax rates, S-corporations retain higher profits to be paid out to the shareholders. This is the main difference between regular corporations and S-corporations.
There are restrictions on what types of corporations are able to be classified as an S-corporation. These restrictions are mainly around the amount of shareholders the corporation can have and the class of stock the subject is able to sell, thereby limiting s-corporations to only smaller, closely held corporations (Lau & Johnson, 2013). Limited Liability Company
Limited liability companies or LLCs are becoming much more common and combine many of the benefits of corporations with the benefits of a sole proprietorship or partnership. Like a sole proprietorship or a partnership the control of the business remains with the owner, or member, of the company. LLCs do not require more than one person, such as with a partnership, but can be formed by just one person if needed.
As the name implies, LLCs offer the same protection from liability as a limited partnership or a corporation. An LLC is viewed as a separate legal entity and protects the members from liability beyond their initial investment in the business. LLCs also offer an added benefit when it comes to taxes. Each year the LLC can decide to be taxed like a corporation and pay corporate tax or taxed as a partnership where the individual members pay the tax. This allows the business to adjust to current tax rates and choose the route that is best for the business.
Like corporations, members of LLCs must be careful with how they interact with the company. If members of the LLC do not treat the LLC as a separate entity, this can result in the members losing their protection against liability. Members must remember that profits from the business belong to the LLC and cannot be used for reasons other than in the best interest of the business. Members of the LLC can only profit through their earnings from the company and not use the other profits for personal use.
“Unlike corporations, there is no requirement for an LLC to issue stock certificates, maintain annual filings, elect a board of directors, hold shareholder meetings, appoint officers, or engage in any regular maintenance of the entity” (Lau & Johnson, 2013). This means that LLCs are much easier to maintain than a corporation and are a much more convenient for smaller businesses. Without other shareholders or a board of directors, control of the company can remain with the members of the LLC as with a sole proprietorship or a partnership.
LLCs, like corporations, have to be filed in any state in which they wish to do business. Unlike corporations, it is much easier to form an LLC in most states. The process for forming an LLC typically requires only minimal information, such as the contact information of key members of the LLC, and a small fee. This makes forming an LLC very easy and much cheaper than forming a corporation and makes it possible for the members to form the LLC
without the need for legal aid.
Lau, T., & Johnson, L. (2013). The legal and ethical environment of business. (1st ed., p. 11.2-11.5). Flat World Knowlegde, Inc.
To: Business Owner
From: Mitchell Ply
Subject: Recommended business restructure
Manufacturing can be a very profitable venture when ran as a sole proprietorship. All of the profits remain with you; however, all of the liability remains with you as well. In your current situation, if an individual is injured by one of your products or on the job, you can be held liable for any damages that your insurance doesn’t cover. You also run the risk of your company not surviving if anything were to happen to you. Since legally you and the company are the same entity, if you were to die, the company would die with you. Taking into consideration your business size, desire to bring in partners, and desire for protection against liability, I would recommend forming a limited liability company or LLC. Benefits of an LLC
LLCs offer many useful benefits that would be great in your situation. As the name LLC implies, the best benefit for you will be protection against liability. If your company is liable for any debts, the most you could personally be liable for is your initial investment in the company. The LLC would be legally separate from you; therefore, creditors would not be able to go after any of your personal assets to cover business debts. Another benefit of an LLC is the ease of startup. In most states, all that is required is to file articles of organization along with a small fee to whatever agency controls businesses in the state.
LLCs even make it easy to do business in other states. You stated that you were considering building a second factory in an adjoining state. You would have to qualify to do business in that state, which in most cases is as simple as filing paperwork and paying fees that typically range from $100-300 (Mancuso, 2013). Ease of startup is not the only great thing about an LLC. Another benefit comes when it’s time to file taxes. Each year, an LLC is able to choose how it wants to be taxed; either as a corporation or as a partnership. This will give you the opportunity to chose which tax rate is best for the business and take advantage of any takes breaks that you may otherwise not be able to use.
Taking on partners in an LLC is easy as well. All that is needed is to determine each person’s rights and responsibilities in the company and what their share in the company is. If you would like to maintain control in the company you could take on an additional member in a limited capacity, but this would need to be spelled out in the LLC operating agreement. Along with ease of taking on additional members, if the time ever came and you wanted to take the company public, it is very easy to convert an LLC to a corporation to allow you to sell off stock in the company. You seemed to be worried about what would happen to your company in the event of your death.
One benefit of an LLC is its longevity over a sole proprietorship. Depending on how you write your LLC operating agreement, you can have the LLC dissolve in the event of the member’s death, or you can have your interest in the LLC pass on to another individual, or a trust, through a will. This means that your company can continue on long after your death and continue to provide for your family if you pass your membership along to them. Disadvantage of LLC
There are some disadvantages when it comes to an LLC. One of the main disadvantages is the ability to procure capital. In the beginning of the LLC, some lenders may require the members of the LLC to guarantee the loan. With an established business such as yours, this may not be such an issue. The profit control also may be somewhat of a disadvantage for you. Since the LLC would be considered a separate entity, any profits would belong to the company and could not be used for personal reasons.
Doing so could lead to loss of your limited liability and could lead to creditors being able to go after personal assets if the business was to fail. If you decided to take on additional members, one issue that has the potential to cause problems is the lack of an operating agreement. “LLC law is relatively new compared to corporation law, so the absence of an operating agreement can make it very difficult to resolve disputes among members” (Lau & Johnson, 2013). Although this can cause major issues, it can be easily avoided by setting up an operating agreement when the members are added. Summary
Although there is no “One size fits all” type of business, an LLC is the best choice for you at this time. It allows you to maintain most of the flexibility you have now with a sole proprietorship with the added protection from liability that a corporation would offer. An LLC provides better longevity than a sole proprietorship and can continue to provide for your family. The ease of incorporating from an LLC makes it even better if you ever decide to take the company public and sell stock in the company. Although there are some disadvantages of an LLC, they are far outweighed by the benefits.
Mancuso, A. (2013). Qualifying to do business outside your state. Retrieved from http://www.nolo.com/legal-encyclopedia/qualifying-do-business-outside-state-29717.html
Lau, T., & Johnson, L. (2013). The legal and ethical environment of business. (1st ed., p. 11.2-11.5). Flat World Knowlegde, Inc.
Courtney from Study Moose
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