The Legal Form of Business

Pondering the legal structure of your business may seem like a job for the attorneys, but it can have a profound impact on your personal liabilities, the way your company is managed, how profits are taxed and ongoing costs of maintaining the legal status of your business. Due to these far-reaching implications, business owners should have a basic understanding of their options, and the advantages and disadvantages of each.

According to Florida Gulf Coast University's Small Business Development Center, a resource center for entrepreneurs, there are four major factors to consider when choosing a legal form of a business. These include the amount of liability, the management structure, taxes and maintenance costs.

** Liability pertains to financial exposure. In some forms of business the owner's or partners' personal assets are treated as company assets. In other forms, personal liability is limited.

** Management structure is determined by many factors: the number of individuals owning the company, who makes decisions for the company and what decisions they are authorized to make.

** Tax codes classify businesses and their owners very differently depending upon the legal form of the business. These differences provide major financial motivation in determining which legal form of business is best for a company.

** Costs of maintenance vary with each legal form of business.

What's Available

The three most common legal forms of business are the sole proprietorship, the partnership and the corporation.

When a single individual owns and operates a business, he or she is likely to be a sole proprietorship. This is a common way to structure a new enterprise. This type of structure is easy to start, and all profits belong to the owner. As sole proprietor, you are not considered to be an employee of the company, so unemployment taxes are avoided. On the other hand, the owner's personal assets are entirely exposed. In other words, if the business owes a debt that it cannot repay, the debt could be satisfied with the owner's personal assets. The good news comes at tax time, when the owner's profits are taxed just once, at the individual rate.

When more than one person joins together to do business, they may choose to structure the company as a partnership. A partnership agreement defines how each partner is involved, such as how much each partner will invest and how profits or losses will be divided. In general, as with the sole proprietorship, partners are not considered employees of the company. "There are different kinds of partnerships," explains Stephen Dalton, an instructor at FGCU and a partner at the Pavese Garner law firm. "The oldest, most traditional form that most people think of is that of a general partnership." In a general partnership, the personal assets of all partners are exposed and all partners may make decisions regarding the business with equal authority.

Limited partnership and limited liability partnership are two additional forms of the partnership. According to Dalton, they include some of the protections of corporations. Some partners may have limited personal liability, while others may be fully liable. Partners may have limited responsibilities that are outlined in the partnership agreement. In this case, not all partners may be authorized to make decisions on all matters.

Partnerships are basically ownership teams. A team that functions well can achieve a synergy, becoming wildly successful. But where there are various personalities, there also lies the possibility of disagreement and conflict in the partnership structure.

Incorporation

Of course, many businesses choose to incorporate. The federal government views a corporation as an entity that is separate from its owners. The owners of the business are shareholders in the corporation, which is a legal entity. The biggest advantage is that each owner's liability is limited to his or her investment as a shareholder in the corporation. "The usual reason to choose the corporate form is to avoid personal liability," states Dalton. "Especially for contractual agreements."

A corporation may be classified as a "C" corporation or an "S" corporation. The classifications determine the way the company handles taxes.

The Internal Revenue Service sees a "C" corporation as a taxpaying entity. The company's profits are taxed at the corporate level. Profits may then be shown as dividends earned by the shareholders. Here's where dual taxation comes into play. The IRS sees those dividends as income for the owners, and taxes the owners as individuals for the profit. In essence, the profits are taxed twice: once at the corporate level, and once at the individual level.

The financial drawback is the obvious reason that many incorporated businesses choose to be classified as "S" corporations.

Sub Chapter S is part of the Internal Revenue code. Provided a business meets certain requirements -- for instance, it is incorporated in the United States, the shareholders are non-aliens, the shareholders are individuals, all stock is equal and there are less than 75 shareholders, -- it may be eligible to be classified in this manner.

"Many small businesses choose to be 'S' corporations," Dalton says, "It protects them from dual taxation. In addition, assets of the individuals are protected should the corporation be unsuccessful." In an "S" corporation, profits pass through as income or loss to the individual shareholders.

There is much more organization, paperwork and record keeping associated with a corporation than with other forms of business. Annual report filings are also required. In addition, the section of the tax code that applies to this form of business is rather complex. Expect to pay more for professional tax advice and preparation.

How does a business owner know which legal form is the best option? The choice is not trivial. An owner should consult with both his or her accountant and attorney about which choice is optimal. Dalton advises, "There is constantly a broader array of choices available to business owners. That makes this a much more complicated choice."

And, based on the consequences, it's a very important choice, too.

For several years, Cynthia Jackson was a director at NCR Corporation and AT&T Corporation. She is currently a freelance writer and co-owner of the Southwest Florida franchise for UCC Total Home, a nationwide buyers' cooperative.