Categorized | Business Structure

Startup 1.2 – Business Structure (Sole, General, Corp, LLC, DBA)

Shoestring Venture: The Startup Bible (1st Edition)Who owns the business? You, the sole proprietor, are the owner.What people mean by the term, “ business structure,” is really the legal status of the company. There’s nothing dauntingly mysterious about business structures; they essentially differ from one another based on the answers to three simple questions:

  1. Who owns the business?
  2. Who is responsible for the debts and damages the business may incur?
  3. Who pays the taxes?

The “who” for each of these questions is not always the same person.

The type of business structure you choose has many ramifications. Your business’s structure determines how much tax you pay, how much paperwork you’ll need to do, how many lawyers get a crack at your wallet, how easy it is to find investors and loans, and whether you’re going to lose your house if you get in trouble.

Based on the answers to these three questions, businesses are broken down into Sole Proprietorships, General Partnerships, Limited Liability Companies, and Corporations.

Sole Proprietorship: To be a sole proprietor, you only need to choose a name for your business and get a business license, if your state requires one.

  • Who owns the business? You, the sole proprietor, are the owner.
  • Who is responsible for all debts and damages? You, the sole proprietor, are personally responsible for all debts and damages incurred by the company.
  • Who pays the taxes? From the standpoint of the law, you— walking, talking, breathing, take-out-the-paper-and-the-trash you—are the company. That means that you pay the taxes, too. You report your business’ earnings as income on your personal income tax returns whether you remove funds from your business or not. You also deduct business expenses and losses on those same tax returns.

From a financial perspective, since you’re the sole owner, investors are not likely to help you finance the endeavor. Therefore, you have to find the capital to run your company either from your own funds or by borrowing the money. If you borrow, you’re personally responsible for the debt. It’s just like any other personal loan, such as a mortgage, car loan, or student loan, that you may have. As a result, a sole proprietorship is magnificently easy and inexpensive to form and operate. In fact, in some states, such as California, you don’t even need a business license. Call yourself a business and shazam! You’re a business.

General Partnership: A general partnership is just like a sole proprietorship, only there’s more than one owner.

  • Who owns the business? You and a friend, you and a spouse, you and your family, or any combination of you and one or more other people own the business.
  • Who is responsible for debts and damages? Like a sole proprietorship, one or all of you are personally responsible for all the debts and damages the company incurs (if only one partner is financially responsible for all the company’s debts and damages, it’s called a “limited liability partnership”).
  • Who pays the taxes? From a legal perspective, you all, that is, all the partners in the business, are the business. All the owners report the business’s profit and loss on personal income tax forms based on the percentage of the company they “own.”

In a general partnership, the partners are liable for the actions of other partners. When one partner signs a legal document such as a lease or loan for the business, that action legally binds the other parties. Again, most general partnerships do not attract outside equity investors; they are largely funded from the financial resources of the partners or through borrowing.

Alternatively, some general partnerships combine passive investors with operational managers as partners (a passive investor injects capital into a business without participating in day-to-day management). One or more partners may merely be investors while other partners actually run the business.

Corporation: Corporations are essentially stand-alone legal entities separate and distinct from the owners.

  • Who owns the business? Unlike a sole proprietorship or general partnership, a corporation may have an unlimited number of owners. And because a corporation is a legally separate entity from its owners, the owners can easily buy and sell their ownership, called shares, in the company.
  • Who is responsible for debts and damages? In a corporation, the owners of the corporation are not personally responsible for any debts, liabilities, or damages the corporation may incur. So if a corporation owes money or is sued, nobody can go after the owners. They can only go after the assets of the company.
  • Who pays the taxes? In terms of taxes, corporations are taxed as entities separate from their owners. The corporation files its own income taxes and deducts its expenses from those income taxes. If it distributes earnings to the owners, the owners have to pay personal income tax on those distributed earnings.

Since liability is limited to the corporation itself, not the owners, corporations easily attract equity investors; corporations, then, are typically investor- and debt-financed. Finally, a corporation is a perpetual entity—it never dies until it goes out of business. If all the owners die, the corporation lives on.

Because they are stand-alone legal entities, corporations are much more difficult and expensive to form and are governed by separate laws and rules. A corporation can be publicly traded or privately owned; it can have millions of “owners” or just one (that’s right, just one person can own 100% of a corporation). A corporation’s only distinguishing feature is that it is a legal entity separate from its owners.

A subchapter “S” corporation is slightly different (the description above applies to subchapter “C” corporations). A subchapter S corporation’s earnings are not federally taxed, only the company’s capital gains and passive income. Individual owners pay personal income taxes on distributed earnings, just like for a “C” corporation. So an “S” corporation avoids the “double taxation” of earnings that most corporations suffer ( taxed once for the corporation and taxed a second time when distributed to the owners).

But there’s a catch: an “S” corporation can have a maximum of only seventy-five owners and every owner must be an American citizen. Both “C” corporations and LLC’s, which we discuss below, can have as many owners as there are people on the planet. In addition, other corporations, whether “S” or “C”, cannot own an “S” corporation. All this means is that it will be difficult to find investors or sell your company if you structure your business as an “S” corporation. However, just like a “C” corporation, ownership can be traded without consulting other owners. So you can always easily sell part or all of your stake in the business, provided the number of owners never exceeds the magic seventy-five.

Limited Liability Company (LLC): A “ Limited Liability Company” is a new legal business structure that looks a lot like an “S” corporation. Unlike a corporation, investors don’t own shares, but rather an equity interest in the company. Again, the company does not pay taxes on its earnings; rather, the individual owners pay personal income taxes on distributed earnings they receive. Capital gains, which are taxed twice for a corporation—once for the corporation and once for the shareholders—are only taxed on the shareholders. And, just like a corporation, the owners are not personally responsible for debts or damages incurred by the company. While it is more difficult to find investors for an LLC than a corporation, an LLC permits easier access to investors than a sole proprietorship or a limited partnership. Unlike a corporation, however, selling all or part of one’s interest may involve obtaining permission from the other owners.

So, in many ways, an LLC is the best of both worlds: you get the limited liability of a corporation without the double taxation and all the paperwork, regulations, and legal expenses. The downside is that laws governing LLCs are very volatile and in constant flux. If you have any intention of running your business across state lines, you have to make yourself familiar with all the relevant laws or you might be stuck with a less profitable business structure.

Doing Business As (DBA): Finally, you’ll probably have to deal with “DBA” registrations along with all the other alphabet soup of business structure stuff. A DBA is actually not a legal business structure; instead it is simply a state business registration that allows a business to use a name that does not include the name or names of its owners. Let’s say your name is Bill Smith and you run a company called “Bill Smith Cooking School.”

You don’t need a DBA registration. There’s your name, Bill Smith, right in the business name. If on the other hand, you call your business “Bon Appetit,” then you are Bill Smith doing business as “Bon Appetit.” You are required to file a DBA application. If you remember our three questions about business legal structure (who owns the business, who is responsible for the debts and damages, and who pays the taxes), then a DBA is a business name that doesn’t answer these questions. With a business name like “Bon Appetit” or “Synergistics,” consumers and other businesses have no idea who owns the business and who’s responsible for it. So to protect consumers and other businesses, the state requires a filing that associates the fictitious name (“Bon Appetit”) with the people who are responsible for the business, its debts, and its taxes (“Bill Smith”).

WATCH THE LAWS!

Keep in mind that your business structure is entirely a legal entity, and laws change all the time. You may choose a profitable and effective business structure this year, but as the laws change over time and across states, you may need to consider a different business structure.

1.2.1 FindLaw for Small Business—Incorporation and Legal Structures : http://www.findlaw.com

FindLaw for Small Business is one of the most thorough and easily navigable sites concerning laws and regulations governing small businesses. Like SCORE and Entrepreneur Magazine Online (referenced below), FindLaw should become one of your top bookmarks in your browser; there you’ll find a well-organized and complete set of articles covering every legal issue you will encounter as an entrepreneur, as well as an exhaustive set of links to other Internet resources and a search engine for local small business lawyers. If FindLaw were a book, you’d probably pay eighty dollars or more for it. And it would be worth more.

FindLaw’s discussion of legal structures is the most thorough and easy-to-read explanation of the various business structures, their legal and tax implications, and how you should choose a legal structure that meets your long-term business and personal goals. All their materials on each type of business structure include immensely useful Internet resources, such as sample operating agreements, forms, filing fees, state guides, tax information, and tax forms.

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