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Sole Proprietorship or Corporation?April 1, 2008 By: Bill Lynot Home-Based Travel Agent
The Wrong Choice Can Be a Costly Mistake
Nearly Three-Fourths Of The Millions of small businesses in the United States are sole proprietorships, according to the U.S. Department of Commerce. Obviously, that makes the "mom and pop" form of business a popular choice for entrepreneurs, but is it the best choice for you and your home-based travel agency?
That's an important question—one that you should consider carefully, whether you're just getting started or you've been thinking of changing your present form of business.
Genevia Gee Fulbright, CPA, of Durham, NC, says there are several circumstances under which a sole proprietor may want to consider incorporation. "If the business has shown consistent growth, the owner wants the company to become more formal, or there is some thought about the possibility of adding a partner or additional shareholders, changing from a sole proprietorship to a corporate entity structure should be considered," says Fulbright, who is the senior small business advisor for the National Association of Black Accountants.
There are three classifications of basic business entities from which to choose: Sole proprietorship, partnership and corporation. Each has its own distinct set of advantages and disadvantages. Even if you feel comfortable with your current business entity, you should be familiar with the legal, financial and practical consequences of each choice.
The simplest and least expensive way to launch a new business is, of course, as a sole proprietor—little or no legal expenses, no complex tax structure, no one else to interfere with management decisions.
As a sole proprietor, your agency profits flow directly through your personal tax return (using a separate tax form called Schedule C). You get to keep or reinvest all of the after-tax income produced by the business. If it ever becomes necessary, a sole proprietorship is the easiest of all business structures to dissolve.
With so many advantages, it might seem that a sole proprietorship is the only way to go for a home-based business. But hold on, there are other things to consider.
As a sole proprietor, you have unlimited personal liability for all debts against the business. Both your business and personal assets are at risk in the event of legal trouble.
Other disadvantages include possible difficulty in raising funds from outside sources if you want to expand. Also, it may be harder for you to attract high-caliber employees if you decide to expand.
As far as taxes and most legal considerations are concerned, a partnership is treated essentially the same as a sole proprietorship. Each partner is jointly and separately liable for the financial obligations incurred in the name of the business, and each is taxed on their share of the profits generated by the business. However, partnerships do inject some challenging personal issues.
The choice of a business partner is fraught with potential danger. Some experts suggest that good friends or relatives rarely work out as business partners because of the inevitable disagreements over business issues. Of great importance in partnerships is a clear understanding of such issues as:
- 1. Who does what? The job of each partner should be clearly defined and scrupulously honored. And don't forget those little undesirable tasks. They can cause more misunderstandings than the big, important jobs.
- 2. On what basis will the partners share in the profits of the business? Will it be 50-50? Under what circumstances and in what amounts will this be subject to change? How will the major financial decisions be handled? Such issues are extremely important and should never be left "to be decided later."
- 3. What happens if one partner dies? You just may find yourself in business with your partner's widow or widower, which is something you may not want. "To help avoid this, there are two things you should do," says Fulbright. "First, consider purchasing key-person life insurance. Then, with the help of your attorney, draw up a written agreement clearly establishing procedures for buying out a partner's interest in the event of death or any other unforeseen circumstance."
When you form a corporation for your business, you create a separate legal entity with the same legal rights and responsibilities as those conferred upon us humans. Because of that, some feel that incorporation is the answer to the entrepreneur's dream, and in some ways, that's true. The corporate form of business will limit your personal financial liability, be more stable in the event of your death and will make it easier for you to raise money for expansion and growth.
In theory, the corporation will do all of these things for you. In the light of harsh reality, however, you should investigate carefully before you leap.
One of the problems is the sometimes unrecognized differences between large, public corporations and the closely-held corporations typical in small businesses. If you try to swing a loan in the name of your small corporation, you are likely to find that the lender will require you to sign personally. In other words, you will be just as responsible for the loan as you would be in a sole proprietorship. Further, if you find yourself on the wrong end of a lawsuit, you may find yourself as well as the corporation named as a defendant. So much for the protection of personal assets.
What about selling stock to raise capital? Certainly, that's one of the primary advantages of a corporation; but, again, the small corporation will find a large gap between theory and practice. Finding people willing to invest in a corporation controlled by one or two people might prove as difficult as Diogenes' search for an honest man.
Will a corporation stand a better chance of survival than a sole proprietorship or partnership in the case of the death of a principal? Usually, but not always. Many small businesses survive as a direct result of the talents of the founder and prime mover and shaker. In such a case, if he or she dies, the business may well follow along shortly, regardless of the legal form bestowed upon it.
Finally, anyone considering incorporation should be aware that doing business in that form will introduce complications that can be a nuisance to someone used to the simple life. Corporations have to follow some rigid rules, file separate tax returns, maintain specific records and, at least in theory, hold directors' meetings.
In order to make life a little easier for the small entrepreneur, a special form of corporation known as Subchapter S was created. It allows small business owners to enjoy the advantages of incorporation without such penalties as double taxation.
"Another form of corporation, The Limited Liability Corporation, can be advantageous to small business owners under some circumstances," says Fulbright. "Typically, the costs and flexibility of the LLC business structure are helpful for smaller enterprises because:
- 1. There are fewer requirements and restrictions placed on the business owners in how they pull money out of the business and how much they pull out as compensation (taxing authorities do not place the "reasonable" salary standard on LLC business-owner compensation).
- 2. The LLC company does not pay entity-level taxes on profits (the owners pay taxes on their allocated share of profits, and losses can offset the owners' other income to the extent of active participation).
- 3. The LLC provides greater protection from creditors and general lawsuits if run properly, compared to a general partnership and other entities.
- 4. The LLC is a great way to hold real estate because it allows for easier distribution of assets without having to consider dividends or other forms of compensation to the business owners (i.e., C-Corps. and S-Corps. have to consider salary levels, distribution methods, etc.)."
If you are a sole proprietor considering incorporation, you may have considered using one of those companies that allow you to incorporate over the Internet, thereby taking advantage of some states' liberal laws regarding incorporating. That is an easy and inexpensive way to incorporate your business; however, you also should be aware of some pitfalls.
"If a business owner wants to incorporate in a state other than the one in which the business operates, he/she must understand that in most circumstances the state where the company resides will require the filing of an annual tax return. Also, an 'authority to do business' form must be filed in the resident state," says Fulbright. "That means two state returns would be required instead of one."
Also, you should be aware that some states have passed laws intended to make it more difficult to file incorporation papers in a state other than the one in which the business resides. For example, California charges $800 a year for a license for a foreign corporation or LLC to operate in the state.
"That's why I recommend that clients who are using the Internet to research information on incorporation consult with legal counsel familiar with the state laws in which the business will operate," says Fulbright.
Does all of this sound complicated? Well, it is. That's why no single business structure can be considered the best choice for every home-based business owner.
As with most other business decisions, a sound knowledge of the alternatives provides the best foundation for the right choice. Before making any decision involving your business structure, you should consult with your own accountant and attorney.