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| DECIDING ON A LEGAL STRUCTURE |
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THE FIRST FORMAL DECISION to be made in starting a business is to select the legal structure
for the company. This decision will depend on the number of people who will control the company, how
decisions are to be made, and other considerations such as liability and tax issues. The information here
may help you make the decision, but it is important to consult with someone with experience who can
answer your questions. Seek counsel from an accountant or attorney to determine the form of business
organization that best suits your business.
A look at Legal Organizations
Advantages and Disadvantages of Forming a Corporation
Advantages and Disadvantages of An S Corporation
Limited Liability Company (LLC)
The Pros and Cons of Partnerships
General vs. Limited Partnerships
Joint Venture
Advantages and Disadvantages of Sole Proprietorships
| A LOOK AT LEGAL ORGANIZATIONS |
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In some cases, the business you do may be regulated and some business types may not be acceptable.
For example, the Alcoholic Beverage Control Commission will not issue a license to sell alcoholic
beverages to a sole proprietorship or a member-managed limited liability company. To save time, money
and frustration, take the time to find out everything you can about the requirements for your new
business before you file the organization papers.
It is important to consider each form of business organization carefully to evaluate the most appropriate
structure for your business. While it is possible for a business to start out under one organizational form and
change to another later, proper planning can prevent difficulties caused by an unsuitable legal structure.
The success of your new business depends on planning. The following is information from Dun &
Bradstreet’s All Business website, www.allbusiness.com in the Structuring Your Business link.
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ADVANTAGES AND DISADVANTAGES
OF FORMING A CORPORATION |
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A corporation is defined as a legal entity or structure created under the authority of a state’s laws,
consisting of a person or group of persons who become shareholders. The entity’s existence is
considered separate and distinct from that of its members. Like a real person, a corporation can enter
into contracts, sue and be sued, pay taxes separately from its owners, and do the other things necessary
to conduct business.
Incorporation can be a complicated process. You may choose to hire an attorney to guide you through
the process.
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May be for-profit or nonprofit. |
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Must have at least two officers, elected at annual meeting. |
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Corporation operated under charter and by-laws; law governs voting requirements for amendments and changes & record-keeping. |
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May create and issue stock. |
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Law provides personal liability protection for directors and officers acting in good faith. |
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Annual report, attorney-in-fact fee and corporation license tax required. |
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File Articles of Incorporation for Corporations, S- and C-type. |
Regardless of the tack you take, take into consideration the advantages and disadvantages listed below
before you embark on incorporating your company.
Advantages
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Limited liability. One of the key reasons for forming a corporation is the limited liability
protection provided to its owners. Because a corporation is considered a separate legal
entity, the shareholders have limited liability for the corporation’s debts. The personal assets
of shareholders are not at risk for satisfying corporate debts or liabilities. |
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Corporate tax treatment. Since a corporation is a separate legal entity, it pays taxes
separate and apart from its owners (at least in the typical C corporation). Owners of a
corporation only pay taxes on corporate profits paid to them in the form of salaries,
bonuses, and dividends. The corporation pays taxes, at the corporate rate, on any profits. |
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Attractive investment. The built-in stock structure of a corporation makes it attractive to
investors. |
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Capital incentive. The stock structure also allows corporations to attract key and talented
employees by offering them an ownership interest in the form of stock options or stock. |
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Owner/employee. A business owner who works in his or her own business may become
an employee and thus be eligible for reimbursement or deduction of many types of
expenses, including health and life insurance. |
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Operational structure. Corporations have a set management structure. The owners of a
corporation are shareholders, who elect a Board of Directors, which then elects the officers.
Other than the election of directors, shareholders do not participate in the operations of the
corporation. The Board of Directors is responsible for managing and exercising the rights
and responsibilities of the corporation. The Board sets corporate policy and the strategy for
the corporation, and elects officers — usually a CEO, vice president, treasurer, and secretary
— to follow the policies set by the Board, and manage the corporation on a day-to-day
basis. In a small corporation, the lines between the shareholders, Board of Directors, and
officers tends to blur because the same people may be serving in all capacities. |
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Perpetual existence. A corporation continues to exist until the shareholders decide to
dissolve it or merge with another business. |
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Freely transferable shares. Shares of corporations are freely transferable, because as
a separate entity, the existence of a corporation is not dependent upon who the owners
or investors are at any one time. A corporation continues to exist as a separate entity, and
is not terminated or dissolved even when shareholders die or sell their shares. Shares of
corporations are freely transferable unless shareholders have “buy-sell” agreements limiting
when and to whom shares may be sold or transferred. Also, securities laws may restrict the
transferability of shares. |
Disadvantages
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Fees. It costs money to incorporate. There are four types of fees: a fee to file the Articles
of Incorporation with the Secretary of State, a first-year franchise tax prepayment, fees
for various governmental filings, and attorneys’ fees. But every year, tens of thousands of
businesses choose to incorporate online without the use of an attorney. |
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Formalities. The proper corporate formalities of organizing and running a corporation
must be followed, to receive the benefits of being a corporation. |
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Paperwork. Paperwork is a huge component of the corporate formalities that must be
followed. Reports and tax returns must be compiled and filed in a timely fashion; business
bank accounts and records must be maintained and kept separate from personal accounts
and assets; records must be kept of corporate actions, including meetings of shareholders
and Board of Directors; and licenses must be maintained. |
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Disclosure of names of corporate officers and directors. Most states do not require that
names of shareholders be a matter of public record; however, many states require that
the names and addresses of corporate officers and directors be listed on one or more
documents filed with the Secretary of State. |
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Dissolution. Since corporations have a perpetual existence, states provide a mechanism
for dissolving a corporation and liquidating its assets. Dissolution does not happen
automatically. A corporation can be dissolved voluntarily or involuntarily. A corporation’s
officers and directors are charged with responsibility for dissolving the corporation,
including gathering corporate assets, paying creditors and outstanding claims, and
distributing the remaining assets to shareholders. |
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Tax consequences. C corporations have potential double-tax consequences — once
when the company makes its profit, and a second time when dividends are paid to
shareholders. S corporations can mitigate this tax issue. |
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ADVANTAGES AND DISADVANTAGES
OF AN S CORPORATION |
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There are two types of corporations: Regular and Subchapter S corporations. The profits of a regular
corporation are taxed twice, at the corporate as well as the individual level, only if dividends are paid. A
regular tax return must be filed each year to pay tax on the corporation’s income. Any profits left after
taxes may be given to stockholders, who must then pay tax on the amounts they receive.
The S corporation is treated as a partnership for tax purposes and like a corporation it enjoys limited
liability. But like a partnership, it is not subject to corporate federal income tax. Although a tax return is
filed, the income and expenses of the S corporation are divided among its stockholders who report the
profits on their individual returns. Thus, it is taxed only once.
Because the S corporation avoids double taxation while providing stockholders the protection of a
regular corporation, this form of organization is popular among small businesses. However, Subchapter
S status may create certain disadvantages that should be considered.
Specifically, an S corporation may have no more than 100 shareholders and may issue only one class of
stock, thus limiting its ability both to raise capital and to attract certain investors. Meanwhile, stock in an
S corporation cannot be sold to another corporation or partnership. Only individuals, estates and some
trusts may own shares. Further, all shareholders must be United States residents and must consent to
the S corporation election.
Finally, shareholders that own more than two percent of the corporation’s stock are not eligible for tax
sheltered fringe benefits allowed to regular corporations. This includes accident and health plans, group
term life insurance, and employer-provided meals and lodging.
Advantages of an S Corporation
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Corporate losses can be passed through to the shareholders, and as the owner (and
shareholder), you may be able to take the loss against income that appears on your
personal return. |
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You can have the protection of limited personal liability without having to pay
corporate taxes. |
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You can minimize self-employment tax and FICA tax. Your profits, as a shareholder, are not
taxed in this manner. |
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It’s easier to raise capital as a corporation than as a sole proprietorship or partnership. |
Disadvantages of an S Corporation
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Numerous regulations and requirements must be upheld by an S Corporation, including a
limit on the number of shareholders (see list below). |
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Like a C Corporation, it can be costly to set up and follow corporate formalities. |
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Close scrutiny by the IRS of shareholder-employees, who must receive reasonable
compensation (subject to employment taxes) before any nonwage distributions may be
made to that shareholder-employee. |
Other regulations imposed on S Corporations
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All shareholders must be U.S. citizens. |
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All shareholders must vote in favor of the S Corporation. |
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Benefits such as health or accident insurance for employee shareholders (with at least a 2
percent partnership) may not be deducted by the corporation. |
A corporation that plans to pass through dividends regularly to shareholders may want to elect S
Corporation tax status. Also, a business owner who may want to take business losses on his or her own
personal tax return, possibly to offset income earned by his or her spouse, may opt for this type of
corporation. If you do set up an S Corporation and later decide that there’s a better alternative for your
business, you can vote to drop S Corporation status.
Like other corporations, the S Corporation can limit the personal liability of the owners. Creditors can
go after the assets of the corporation and not the owners, if there are outstanding debts. It is important,
however, that the owner keeps his or her personal financial records and those of the S Corporation
completely separate, to avoid legal entanglements.
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| LIMITED LIABILITY COMPANY (LLC) |
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A Limited Liability Company (LLC) is a form of business organization that incorporates components
of both a partnership and a corporation. Specifically, this organizational structure is treated like a
corporation for state law purposes and thus offers limited liability to its owners. Yet, the limited liability
company is treated by the Internal Revenue Service and by the West Virginia Department of Tax and
Revenue as a sole proprietor if you have one member or a partnership or corporation for multiple
members for income tax purposes.
Advantages of a Limited Liability Company
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More flexible than a limited partnership or S-Corporation with similar tax advantages. |
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Limited liability to the members. |
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Income is taxable only once at the member’s tax rate. |
Disadvantages of a Limited Liability Company
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Restrictions to transferability. |
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Life of the LLC varies from state to state. |
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Does not have stock therefore not transferable. |
Limited Liability Company (LLC)
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For-profit only. |
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May be fixed term or perpetual. |
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May be single-member or multiple-member company; members may have authority
defined in operating agreement. |
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May be member-managed or manager-managed. |
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Members have equal ownership unless otherwise defined by agreement. |
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Company operated under articles of organization. Additional provisions may be provided
by operating agreement, or if none is written, then by the provisions of law. |
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Law provides personal liability protection for members and managers acting in good faith. |
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May be taxed as partnership under federal law, depending on structure. |
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Annual report and attorney-in-fact fee required. |
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File Articles of Organization for Limited Liability Companies. |
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| THE PROS AND CONS OF PARTNERSHIPS |
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General partnerships have many benefits, but perhaps the most compelling is the ease with which
they can be set up and maintained. You do not have to register with the state and pay fees, as you do to
establish a corporation or limited liability company (LLC). And because a general partnership is normally
a “pass through” tax entity -- meaning the partners, and not the partnership, are taxed -- filing income
tax returns is relatively easy. Unlike a regular corporation, there is no need to file separate tax returns
for the corporate entity and its owners. However, although West Virginia law does not require a written
partnership agreement, many organizations and government agencies such as the Small Business
Administration will require the partners to have a written agreement before guaranteeing a loan. If there
is no partnership agreement, the partnership is subject to the terms of the Uniform Partnership Act.
Another advantage of general partnerships is the flexibility they offer. In partnership agreements, the
partners are free to set their responsibilities and benefits as they see fit or as the needs of the business
dictate. The structure of the organization and the distribution of profits and losses are much more
flexible in a general partnership than they are in a corporation. Because of this, an individual partner
can be rewarded with higher profits for taking on more financial risk. Typically, corporations distribute
dividends evenly according to the percentages of stock held by each stockholder.
Partnerships are also considered a discrete asset and as such (as opposed to a sole proprietorship)
can be transferred to other people, heirs, or estates. Transference is usually limited by the terms of the
partnership agreement.
But partnerships can also be risky. The business-related acts of one partner can legally bind all other
partners. So it’s essential that you enter into partnerships only with people you trust. It is equally
essential that, no matter how much you trust your partners, you execute a written partnership
agreement establishing each partner’s share of profits or losses, day-to-day duties, and what happens if
one partner dies or retires.
Another disadvantage of doing business as a general partnership is that all partners are potentially
personally liable for all business debts and lawsuits. At a minimum, each partner is financially
responsible for his or her share of the business debt. But in many cases, it is the partner with the greatest
assets who loses the most if the business fails. Of course, a good insurance policy can help reduce
lawsuit worries, and many small, savvy businesses don’t have debt problems.
General partnerships are also limited in their ability to raise money. Other than debt financing,
partnerships are often unable to get large chunks of cash. Although a partnerships can raise capital by
selling equity interests, that’s very difficult to do on a large scale because of potential personal liability
and the limited resale market for partnership equity.
Bottom line: Avoid general partnerships and consider forming an LLC or an S corporation for start-up
businesses.
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For-profit only. |
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Must have two or more partners; partners have equal authority unless otherwise defined in
partnership agreement. |
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Partners have equal ownership unless otherwise defined by agreement. |
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Company operated under partnership agreement. |
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No personal liability protection provided by law. |
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Taxed as partnership, with profits assigned according to partnership interest. |
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A general partnership is not required to file with the Secretary of State. However, the law
provides the option of filing. |
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| GENERAL VS. LIMITED PARTNERSHIPS |
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There are two types of partnerships: general partnerships and limited partnerships (LPs). In a general
partnership, each partner can incur obligations on behalf of the partnership, and each assumes
unlimited liability for the partnership’s debts. For example, if the partnership owns a truck, and the truck
strikes and injures a pedestrian, each partner is personally liable for any damages or judgments.
This unlimited liability risk makes limited partnerships an attractive alternative to general
partnerships. In an LP, there is usually just one general partner (although there can be more). The other
partners are called “limited partners.” The general partner has full management responsibility runs
the day-to-day operations of the business. A limited partner cannot incur obligations on behalf of the
partnership and does not participate in the firm’s daily operations or management. In fact, a limited
partner’s role usually involves nothing more than making an initial capital investment in exchange for a
share of the firm’s profits.
While the general partner wields most of the power, they also bear the lion’s share of the liability.
A limited partner’s liability, on the other hand, cannot exceed their financial contribution to the
partnership. So, if a truck owned by a limited partnership accidentally injures someone, the damaged
party could go after the general partner’s personal assets but could only go after a limited partner’s
actual investment in the partnership.
As a result, a limited partnership offers two key advantages: It gives the general partner the freedom
to run the business without interference, and it protects the limited partners if something goes wrong.
Limited partners may choose to get more involved in a partnership’s daily operations, but they do so at
their own risk. In the eyes of the law, their involvement may make them a general partner and strip them
of their limited liability.
Partnership
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For-profit only. |
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Must have at least one general partner and one limited partner; partners have equal
authority unless otherwise defined in partnership agreement. |
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Partners have equal ownership unless otherwise defined by agreement. |
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Company operated under partnership agreement. |
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No personal liability protection provided by law. |
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Taxed as partnership, with profits assigned according to partnership interest. |
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Annual report and attorney-in-fact fee required. |
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File Statement of Registration for Limited Partnerships and Limited Liability Partnerships. |
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Joint venture is a partnership of one or more sole proprietorships, partnerships, or corporations for the
purpose of pursuing a specific business activity or transaction. The main advantage of a joint venture is
that existing businesses can join together without having to form a new entity and without having any
continuing obligations to each other beyond the joint venture agreement. The primary disadvantage is
that parties of the joint venture are liable for the actions of each partner.
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ADVANTAGES AND DISADVANTAGES
OF SOLE PROPRIETORSHIPS |
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The most common and simplest form of business is a sole proprietorship. Many small businesses
operating in the United States are sole proprietorships. An individual proprietor owns and manages the
business and is responsible for all business transactions. The owner is also personally responsible for all
debts and liabilities incurred by the business. A sole proprietor can own the business for any duration of
time and sell it when he or she sees fit. As owner, a sole proprietor can even pass a business down to his
or her heirs.
In this type of business, the owner pays taxes on income from the business as part of his or her personal
income tax payments.
Sole proprietors need to comply with licensing requirements of West Virginia, as well as local regulations
and zoning ordinances. The paperwork and formalities, however, are substantially less than those
of corporations, allowing sole proprietors to open a business quickly and with relative ease — from
a bureaucratic standpoint. It can also be less costly to start a business as a sole proprietor, which is
attractive to many new business owners who often find it difficult to attract investors.
Advantages of a Sole Proprietorship
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A sole proprietor has complete control and decision-making power over the business. |
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Sale or transfer can take place at the discretion of the sole proprietor. |
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No corporate tax payments. |
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Minimal legal costs to forming a sole proprietorship. |
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Few formal business requirements. |
Disadvantages of a Sole Proprietorship
The sole proprietor of the business can be held personally liable for the debts and obligations of the
business. Additionally, this risk extends to any liabilities incurred as a result of acts committed by
employees of the company.
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All responsibilities and business decisions fall on the shoulders of the sole proprietor. |
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Investors won’t usually invest in sole proprietorships. |
NOTE: If the business is conducted under a fictitious name, it’s up to the sole proprietor to file all
applicable forms under the fictitious name or under doing business as (DBA). This, however, does not
mean that the business is a separate entity from a legal standpoint. The sole proprietor remains liable
even if he or she is doing business under a fictitious name.
Most sole proprietors rely on loans and personal assets to initially finance their business. Some will elect
to incorporate once the business has started to grow, while other business owners maintain their sole
proprietorship for many years
Sole Proprietorship
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For-profit only. |
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May only have one owner. |
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Company operated under business franchise registration requirements. |
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No personal liability protection provided by law. |
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Profits taxed as individual income. |
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A sole proprietorship is not required to file with the Secretary of State. |
Remember, this is general information. It is important to consult with someone with experience who can
answer your questions. For more detailed information, visit the West Virginia Secretary of State’s Web
site, www.sos.wv.gov.
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