Part of keeping your home-based business legal involves choosing the legal structure for it: sole proprietorship, partnership, or corporation. Aside from being necessary for government reporting and tax purposes, this can enable your business to operate more efficiently. Since each legal form has its own unique characteristics, your goal is to choose the form that works best for you.
A business owned by one person, who is entitled to all of its profits and responsible for all of its debts, is considered a sole proprietorship. This legal form is the simplest, providing maximum control and minimum government interference. Currently used by more than 75 percent of all businesses, it is often the suggested way for a new business that does not carry great personal liability threats. The owner simply needs to secure the necessary licenses, tax identification numbers, and certifications in his or her name, and you are now in business!
The main advantages that differentiate the sole proprietorship from the other legal forms are (1) the ease with which it can be started, (2) the owner’s freedom to make decisions, and (3) the distribution of profits (owner takes all).
Still, the sole proprietorship is not without disadvantages, the most serious of which is its unlimited liability. As a sole proprietor, you are responsible for all business debts. Should these exceed the assets of your business, your creditors can claim your personal assets–home, automobile, savings account, and investments. Sole proprietorships also tend to have more difficulty obtaining capital and holding on to key employees. This stems from the fact that sole proprietorships generally have fewer resources and offer less opportunity for job advancement. Thus, anyone who chooses the sole proprietorship should be prepared to be a generalist, performing a variety of functions, from accounting to advertising.
Sole Proprietorship: Advantages and Disadvantages
|It's easy to get started.||The amount of investment capital you can raise is limited.|
|You keep all profits.||You need to be a generalist. Retaining high-caliber employees is difficult.|
|Income from business is taxed as personal income.||The life of the business is dependent on the owner's.|
|You can discontinue your business at will.||You assume unlimited liability.|
|You're the boss.|
A business owned by two or more people, who agree to share in its profits, is considered a partnership. Like the sole proprietorship, it is easy to start and the red tape involved is usually minimal. The tax structure is the same as proprietorship except in the profits and losses of the partnership are divided by an agreed percentage by the partners.
The main advantages of the partnership form are that the business can (1) draw on the skills and abilities of each partner, (2) offer employees the opportunity to become partners, and (3) utilize the partners’ combined financial resources. It is also fairly simple and inexpensive to set up, making going into business with family and friends easy. Because two or more people are putting their assets together in a partnership, borrowing power is greater and capitalizing a business is simpler and stronger when many people put their resources together. Each partner also has the unique opportunity of specializing in their own area of expertise.
Partnerships also have their share of disadvantages. The unlimited liability that applies to sole proprietorship is even worse for partnerships. As a partner, you are responsible not only for your own business debts, but for those of your partners as well. Should they incur debts or legal judgments against the business, you could be held legally responsible for them. Disputes among partners can be a problem, too. Unless you and your partners see eye to eye on how the business should be run and what it should accomplish, you are in for trouble.
For your own protection, it is advisable to have a written partnership agreement that will spell out the specifics of the agreement. At the time of the formation of the partnership an agreement should be drawn up stating the percentage of shares each partner owns and under what conditions and in what manner shares can be disposed of. This should state
- Each partner’s rights and responsibilities,
- The amount of capital each partner is investing in the business,
- The distribution of profits,
- What happens if a partner joins or leaves the business,
- How the assets are to be divided if the business is discontinued.
The agreement can be modified later upon the approval of a majority. If there are problems between partners the agreement is the legal document that they should be able to fall back on. Things have a way of changing and people forgetting over time, so it is essential that there be a signed document that all abide by. Unless otherwise stated in an agreement the partnership must be dissolved upon the death of a partner, while the remaining partners must purchase or inherit the shares of the deceased partner unless otherwise stated in an agreement pertaining to succession.
However, a partnership is generally the least advisable way to go. It requires filing a separate partnership tax return, does not carry liability protection for general partners, and can lead into legal and personal disputes. A corporate form of ownership is generally recognized as preferable over partnership, because it can serve the same purpose while offering a cleaner and better protected structure for the owners. In a partnership, all partners are at risk for liabilities and all assets of the partnership are at risk in a limited partnership. In addition, if a partner wants to leave the partnership, the remaining partner may suffer financial loss.
Partnerships: Advantages and Disadvantages
|Two heads are better than one.||Partners have unlimited liability.|
|It's easy to get started.||Partners must share all profits.|
|More investment capital is available. ||The partners may disagree.|
|Partners pay only personal income tax.||The life of the business is limited.|
|High-caliber employees can be made partners.|
A corporation differs from the other legal forms of business in that the law regards it as an artificial being possessing the same rights and responsibilities as a person. This means that, unlike sole proprietorships or partnerships, it has an existence separate from its owners. It has all the legal rights of an individual in regards to conducting commercial activity — it can sue, be sued, own property, sell property, and sell the rights of ownership in the form of exchanging stock for money.
As a result, the corporation offers some unique advantages. These include (1) limited liability: owners are not personally responsible for the debts of the business, (2) the ability to raise capital by selling shares of stock, and (3) easy transfer of ownership from one individual to another. Plus, unlike the sole proprietorship and partnership, the corporation has “unlimited life” and thus the potential to outlive its original owners.
Corporation: Advantages and Disadvantages
|Stockholders have limited liability.||Corporations are taxed twice.|
|Corporations can raise the most investment capital.||Corporations must pay capital stock tax.|
|Corporations have unlimited life.||Starting a corporation is expensive.|
|Ownership is easily transferable.||Corporations are closely regulated by government agencies.|
|Corporations utilize specialists.|
The main disadvantage of the corporate form can be summed up in two words: taxation and complexity. In what amounts to double taxation, you must pay taxes on both the income the corporation earns and the income you earn as an individual. Along with this, corporations are required to pay an annual tax on all outstanding shares of stock. Given its complexity, a corporation is both more difficult and more expensive to start than are the sole proprietorship and the partnership. In order to form a corporation, you must be granted a charter by the state in which your home-based business is located. For a small business the cost of incorporating usually ranges from $500 to $1,500. This includes the costs for legal assistance in drawing up your charter, state incorporation fees, and the purchase of record books and stock certificates. And, since corporations are subject to closer regulation by the government, the owners must bear the ongoing cost of preparing and filing state and federal reports.
If you are interested in forming a corporation, but hesitate to do so because of the double taxation, there is a way to avoid it. You can do this by making your business an S corporation. The Internal Revenue Service permits this type of corporation to be taxed as a partnership rather than a corporation. However, in order to qualify for S status, your business must meet the specific requirements set forth by the IRS. These include limits on (1) the number and type of shareholders in the business, (2) the stock that is issued, (3) the corporation’s sources of revenues.
Recommended Books on Legal Structure
- Business Structures: Forming a Corporation, LLC, Partnership, or Sole Proprietorship (Entrepreneur Magazine’s Legal Guide)
- Inc Yourself, 10th Edition 10th edition by McQuown, Judith (2004) Paperback
- Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State
- How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners
- Sole Proprietorship: Small Business Start-up Kit
- Choosing the Right Legal Form of Business: The Complete Guide to Becoming a Sole Proprietor, Partnership,? LLC, or Corporation