Business entity form – the pros and cons
Choosing the business entity form is one of the most important series of decisions a business owner will make. Here are some of the pros and cons of the various options available to a business owner.
A sole proprietorship is a business entity form where an individual (or a married couple) elect to operate solely on their own. He/she may decide upon a name for the business, but in reality the business is her or him.
- No additional income tax filings – A sole proprietorship’s profits and losses are shown on the owner’s (or married couple’s) individual tax return. They are reported on an attachment to the return called,
“Schedule C”. Consequently, a sole proprietorship is not required to file separate income tax returns. However, this does not mean it has no tax filing obligations. If the business has sales which are taxable, it will need to obtain a sales tax number, collect the applicable tax at point of sale and withhold and pay the applicable sales and use taxes as required under state law. Also, if the sole proprietorship has employees, the owner is required to withhold and pay over to both the federal government and the state the applicable employee taxes and
withholdings. Finally, a sole proprietor will be taxed by his/her municipality upon the value of the tangible personal property employed by the business.
- Complete Management control – The owner of a sole proprietorship only has to report to himself/or herself. There is no ownership outside of him/her (or the married couple); so there is no need for a structured management scheme.
- Inexpensive to create – There are practically no filing requirements. No formal agreements are needed. There are no organizational transfers. While the owner may want to take steps to protect the business’s trade name and trade mark, this may not even be required. So, it qualifies as the most inexpensive form of business to create.
- Individual liability – A sole proprietor is individually liable for all acts of the business. So, he/she is obligated personally to pay all debts. In a retail business, he/she is responsible to the buyer for the quality of items sold. If there is an accident, the owner is responsible. This applies to offsite accidents caused by an employee where the employee is acting within the scope of his/her employment. So, if an owner asks his/her employee to drive across town to pick up a part and gets into an accident, the owner can be sued. In such a case, the burden of proof is on the owner to prove the employee was acting outside the scope of his/her employment. Yes, insurance can be purchased to cover some, if not all, of the liability risks; but in a sole proprietorship, the ultimate liability falls on the owner. We hope to review these issues in depth in future articles.
- No survival mechanism – The sole proprietorship is the owner. Should the owner die, the business dies with the owner. While the law allows a person to step in to manage the business (the personal representative), this is only for a short time (generally, 90 days!). The same is true, perhaps to a lesser extent, if the owner becomes ill or disabled. Without an organizational structure, the sole proprietorship is at risk.
- No multiple taxpayers – Yes, we know, up above we wrote that a single income tax return was a plus. It is, but it is a two edged sword. The negative side is there is only one spot to put income and expense items. Often, in the business context, it helps to have multiple taxpayers which we go into in future articles.
A partnership is a business entity form which is created when two individuals (or existing entities) agree to enter into a business relationship with the goal of creating a profit. The agreement need to be in writing, although we would recommend it be. The business does not need to actually earn a profit. All that is needed is the common goal.
- No tax on entity – A partnership under the income tax laws of Maine and the federal government is not considered a tax paying entity. While there is no tax at the partnership level, the profits, losses and credits of the business are taxed to the individual members. A tax return is required, but it is basically and income statement with a form, Schedule K, which allocates items among the partners. This schedule is included in the taxpayers’ tax return.
- Flexible organizational form – As stated above, a partnership does not require anything to be in writing. There is no required form or mandated identity to positions in the organization. Further, there are no special filing requirements which need be made with the government with the exception of tax filings. This allows the partners to establish their organization by agreement. To reduce future misunderstandings, we recommend that our clients put their agreement in writing. The writing also can serve as a set of instructions going forward which, among other things, can be helpful to the tax return preparer in making tax allocation decisions.
- Inexpensive to maintain – A partnership does not require yearly filings; so it is fairly inexpensive to maintain.
- Individual liability – Each partner is liable for the acts individually and collectively with the other partner or partners, legally stated: every partner is jointly and severally liable to the public for the acts of the partnership. What this means is just like a sole proprietorship, each owner can be sued individually even if he/she had no involvement in the act that caused the liability or damage. While your partnership agreement can be useful to the partners to allocate risk within the partnership and among themselves, such an agreement has no direct impact on those who are outside the partnership.
- Limited life – A partnership is an agreement, when individuals are involved, that lasts only as long as the individual partners are alive. Death ends the partnership just like it does the sole proprietorship. After death, the Personal Representative can operate as a partner for only a short period; so any partnership agreement should have death provisions which can be funded at the death of a partner.
- Complex tax return – While the partnership pays no tax, it still is required to file income tax returns with the federal government and the state of Maine (as well as any other state which imposes an income tax on business operations). These returns are basically income statements but they can be costly to prepare, especially if the partners have allocated certain rights among themselves.
- Expensive to establish – A partnership is basically a series of compromises between the partners on issues of organizational structure, distribution of profits and losses and allocation of tax benefits and burdens. These compromises require time to work through and a writing to memorialize the understandings. While often this can be done with a single attorney representing the partnership entity, each partner has a separate interest which may require him/her to employ separate attorneys. We can help the new business owner to budget out the costs, but these documents are an expense of any start up partnership. A benefit of this form is these writings do not need to be updated unless there is an event causing the revision and there is no filing requirement with the state.
A corporation is a business entity form which is created by statute at the state, not the federal, level. By filing the appropriate form, Articles of Incorporation, correctly with the state (in Maine, with the Secretary of State’s Office) a business entity is deemed to exist which is treated as having a separate identity from the individuals who created it. In essence, a corporation once filed with the state is treated as a person. A corporation’s membership can be small. It needs only have one shareholder
- Limited Liability – A corporation provides its owners (shareholders) with protection from liability which does not exist under any of the above entity forms. In most cases, the shareholders are not directly responsible for acts done by the corporation. So, unlike a partnership, if an employee is driving the company truck on company business and gets into an accident, the corporation can be sued, but not the owners. The same concept applies to business contractual liability. So, you may ask, why the term “limited liability”? The answer is, while the owner will be free from liability for acts he/she is not associated with, he/she remains for those things he/she participates in. So, in the accident example, if the owner was in the passenger seat an ordered the driver to run a stop sign which caused the accident, he/she would be liable. Turning to the business contract, if the owner neglects to show his/her corporate authority in signing a contract or goes further and personally guarantees performance of a contract, he/she may be found responsible. The concept of limited liability protections deserves an in depth review which we hope to do in future articles. Of course, if you have a question before the articles come out, we invite you to give us a call.
- Unlimited life – Since a corporation is a creature of statute and not a human, it does not have a temporal existence. Theoretically, it can live forever. This can be very important in estate planning for the owners because the business will survive them. The going concern value of the business may be passed on to survivors. Frequently when we are faced with estates in which the personal representative is pressured to liquidate, we suggest the use of a corporate form (or the limited liability form discussed below) to allow the business to continue to operate.
- Established structure – A corporation has a statutory structure. The corporation is managed by its owners either directly or through a board of directors. They are required to work under a set of bylaws. The corporation must have at least three officers: a president, a treasurer and a secretary/clerk. These individuals are identified to the state on a yearly basis. The actions of these individuals when properly authorized are the actions of the corporation. It is wise to have the board or shareholders have written authorizations in place. We hope to review these issues in future articles, but if you have a question please give us a call.
- Tax election – Most corporations in Maine qualify to report their taxes as either a regular corporation, a “C” corporation, or as a small business corporation, an “S” corporation. A “C” Corporation reports and pays all income at the corporate level; while an “S” corporation uses a pass through approach, similar but not identical to a partnership. There are rules for electing and qualifying for S corporation status which we hope to review in a future article.
Double taxation – A “C” corporation is subject to tax at the corporate level. When the profits are distributed to the shareholders as dividends, they are taxed again at the individual shareholder level. Now, the impact of this double taxation is reduced a bit if a corporation elects “S” corporation status because most corporate attributes are passed through to the shareholders like a partnership. The concept is that small businesses should incur income tax only at the shareholder level, but there remain situations where even after an “S” corporation election is made double taxation is imposed.
Regulatory Compliance – A corporation, being a creature of statute, must comply with the statutes. In Maine that means the shareholders need meet at least yearly and the corporation must file a report annually with the Secretary of State’s Office.
Inflexible structure – That “established structure” discussed above which to many is a benefit of the corporate form can also be a burden. Many business arrangements just do not fit easily into the ridged corporate structure. Many service businesses, such as accounting firms, accounting firms and real estate offices, work on a more collegial basis. While these types of businesses can function within the corporate structure, it is often like putting a square peg through a round hole.
Cost of organization and operation – A corporation begins with a meeting of incorporators who approve the filing of Articles of Incorporation. When the Articles come back, they meet again to adopt bylaws and issue shares. Then, the new shareholders meet to elect a board of directors (if management by a board of directors is elected) and to elect the initial slate of officers. This should all be documented in writing in a book, the corporate minute book. Then, at least annually, the directors and/or shareholders need to meet to satisfy the law. Again, this should be recorded in the minute book. Finally, as the corporation moves through a year, situations may arise which require a vote. For example, the corporation may purchase vehicles on an installment loan or through a lease. The authority for the action is the vote which will be recorded in the minute book. All of this causes the corporation to incur legal costs. Again, please ask us for a budget plan, we can work with our clients to spread out the cost in appropriate circumstances.
Limited Liability Companies.
A limited liability, like a corporation, is a business structure which is established by a filing with the state (in Maine, the Secretary of State’s Office). A limited liability company works through the agreement of its members; so its filing is a relatively simple document called Articles of Organization, but its operations are controlled by the members’ agreement, called the Operating Agreement. The Operating Agreement is very similar to a partnership agreement. Unlike corporate bylaws, it can be tailored to the entities needs. But, like a corporation, a sole person can be its only owner (member).
- Limited liability – The owners of a limited liability company (LLC), the members, have the same protections from liability as do shareholders of a corporation.
- Pass through of tax liability – There is no taxation at the LLC level. Like a partnership, the income, losses and tax attributes pass directly to the members. Unlike an S corporation where there is taxation if the entity dissolves, there is no tax on dissolutions. Further, the members generally are free to take their property out of the entity without adverse tax consequences. So, the tax costs of incorporation are avoided while the liability protection remains.
- Organizational life not measured in human life – Since an LLC’s existence is based upon filings with the state, its life is not necessarily controlled by the term of life of its owner or owners (although they can make such an agreement among themselves). The entity lasts as long as it is registered with the state.
- Flexible organizational structure – An LLC must elect to be managed by the owners (members) or by a board (managers), but the members are free to set up the organizational structure to address their needs.
- Regulatory Compliance – Like a corporation, an LLC needs to file a report annually with the Secretary of State’s Office.
- Cost of organization and operation – Because the entity needs to have evidence of existence, the owners will find, like the corporation, they will need to maintain a minute book to maintain its decisions in writing. This work is generally done by the attorney. This work, along with the organizational writings and tax filings, cause this to be a fairly costly entity. As with the creation of the other entity forms, please ask us for a budget plan, we can work with our clients to spread out the cost in appropriate circumstances.
There are multiple options for the person who wishes to operate a business in Maine. There are pros and cons to each business entity form. We do hope this article is of help to those of you who are thinking of starting or buying a new business. Please give us a call, if you need to discuss a situation in detail.