LEGAL STRUCTURE OF THE BUSINESSES IN THE UNITED STATES

By Prof. Dr. Geo. S. Mentz, JD, MBA, CWM, CMA

LEGAL STRUCTURE OF THE BUSINESS

There are a variety of ways to legally organize a small business. This should be one of your earliest business decisions and is certainly one of the most important. Most often the legal structure chosen for a business is determined by legal, financial and tax considerations. As a result, this decision may be reached after meeting with accountants, attorneys, banks or other business consultants.

The three principal business structures are: sole proprietor-  ship, partnership, and the corporation. There are some variations  to these structures which will also be discussed. Each of the legal  structures has its inherent advantages and disadvantages. Your  choice should be made based upon the most advantageous structure  for your present business circumstances. Keep in mind, however,  that just as a business must change to meet the needs of the market- place, the legal structure of a business may need to change as the enterprise expands or evolves. A business structure may need to change to meet the needs of the owner(s) or the objectives of the company.

SOLE PROPRIETORSHIP

Sole proprietorship is a business which is owned and operated by one person. The owner of a sole proprietorship only needs to obtain the appropriate licenses for the business to begin operations. However, the sole proprietor should obtain a certificate of assumed name from the local government office where the business is established. The sole proprietorship is the simplest business organization and, therefore, the most widely used legal structure for small businesses.

The sole proprietorship controls all business assets aside from claims made by creditors. The owner receives all business profits and reports them as personal income for tax purposes.  The owner is liable for all losses and must pay all business debts. Therefore, an owner undertakes the risks of the business to the extent of all of his/her assets, whether used in the business or used personally. Business and personal insurance is a good idea along with meeting any city, state, or federal regulatory laws.

ADVANTAGES

- EASY TO SET UP THE BUSINESS

This business structure is very informal with few legal or governmental restrictions.

- ALL PROFITS RETAINED BY OWNER

The sole proprietor does not have to share profits with others.

- OWNER CONTROLS DECISION MAKING

Owner does not have to consult other partners or co-owners in making business decisions. As a result, this business structure provides the most flexibility to react quickly to changing market demands.

- LOW START-UP COSTS

Sole proprietorship requires lower initial capital than other business structures.

- TAX ADVANTAGES

Owner reports income and expenses on personal income tax return and pays taxes on net income (gross total minus expenses). Taxes are computed at owner's personal tax rate which may be less than combined corporate taxes.

- EASIER TO TERMINATE BUSINESS

Because of its informal nature, the sole proprietorship may cease quickly, although liabilities will be the owner's responsibility

DISADVANTAGES

- UNLIMITED LIABILITY

The sole proprietor is responsible for all business debts. These may exceed the owner's assets, including a house and car. Proper insurance coverage can reduce liability from physical loss or personal injury.

- DIFFICULTY IN RAISING CAPITAL

Business loans may be the most difficult way to obtain cash to run a business. Other types of business structures often raise capital by other means and are able to obtain long-term financing more readily.

- INEXPERIENCE OF SINGLE OWNER

- BUSINESS CONTINUITY LIMITED

The business has no existence apart from the owner.  The business may be weakened or terminated upon illness or death of the proprietor.

PARTNERSHIP

A partnership exists when two or more people join together to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

Although a partnership agreement is not a legal requirement, written articles of partnership are customarily prepared by an attorney. A partnership agreement or modification of the agreement may be oral or written. The agreement should define

the contributions (financial, material, or management) of the partners to the business as well as a partner's role in, and relation to, the business. Specifically, the agreement will also define a partner's share of the profit and loss. The partnership should obtain a certificate of assumed name from the local authorities where the business is established. Some US states DO allow for a Registered Limited Liability Partnership. So, check with your Regional authorities or Secretary of States office.

Small businesses may find it advantageous to use a special form of partnership namely limited partnership. This business structure includes at least one general partner and one or more limited partner(s). The limited partner risks only his or her invested capital. The general partner is personally liable for losses and is actively involved in the management of the business. Limited partners are not liable for losses above the amount invested as long as they do not take an active role in the management of the business. This allows a person to invest in a limited partnership without risking personal assets.

ADVANTAGES

- EASY TO SET UP BUSINESS

Although it may have a more formal structure (partnership agreement) than a sole proprietorship, a partnership still has few legal restrictions when compared to a corporation.

- LARGER POOL OF EXPERTISE

Available business talent is increased proportionately to the number of partners. "Two heads are better than one."

- MORE SOURCES OF VENTURE CAPITAL

Partners bring additional assets with them, as well as  provide a broader management base making it easier to secure needed operating capital.

- LOW START-UP COSTS

Partnership requires lower initial capital than corporations.

- PARTNERS CONTROL DECISION MAKING

Although less flexible than sole proprietorship, decisions are made by fewer people than a corporation.

- TAX ADVANTAGES

Like sole proprietorship, the owners (partners) pay personal income tax on the net income of the business.

DISADVANTAGES

- UNLIMITED LIABILITY OF AT LEAST ONE PARTNER

Like the sole proprietorship, the partners (owners) are personally liable for the debts of the business, unless otherwise stipulated in the partnership agreement.

- BUSINESS CONTINUITY LIMITED

A partnership automatically terminates with the death,  incapacity or withdrawal of a partner. The business may continue to operate if a right of survivorship is stipulated in the partnership agreement and a new partnership is formed. Partnership (life) insurance can facilitate necessary buyouts in the event of a partnership dissolution.

- DIFFICULTY IN RAISING CAPITAL

Although partners may provide greater sources of assets than a sole proprietorship (single owner), long-term financing may be difficult.

- DIVIDED AUTHORITY

Decision making is divided between partners. Conflicts may arise when differences in business objectives occur.

- DIFFICULTY IN FINDING SUITABLE PARTNERS

Highly motivated, cooperative business partners are often hard to find.

LIMITED LIABILITY PARTNERSHIP

The limited liability partnership (LLP) is a form of general  partnership typically available only to professionals, including accountants, doctors and lawyers. This form may be used because  some states prohibit these professionals from forming corporations  or limited liability companies because of state laws or professional ethics rulings.

In some jurisdictions, there are no restrictions on who may form a LLP. General partnerships and limited partnerships may register a limited liability partnerships with the their Secretary of State's office or other designated business registration office. Registration generally must be renewed annually.

LLP's provide many of the advantages of general partnership but  limits each partners liability for negligence or malpractice (profes-sionals) to themselves or employees under their direct supervision. However, in most state including Michigan, partners are liable for most debts and obligations incurred by all members of the partnership.

Before establishing a LLP (with the local officials) and Registering a LLP with the Secretary of State or Corporation Division, owners should be aware of any occupational restrictions or the extent of personal responsibility for debts and obligations incurred by the partnership.

ADVANTAGES

- EASY TO SET UP BUSINESS

Fewer legal restrictions than a corporation.

- LOWER START-UP COSTS

- PARTNERS NOT PERSONALLY LIABLE FOR NEGLIGENCE/MALPRACTICE OF ASSOCIATES

- TAX ADVANTAGES

Partners report business profits/losses on their personal income tax returns, typically at lower rates than a corporation.* States differ on this.

DISADVANTAGES

- FINANCIAL LIABILITY

Partners are personally liable for contractual and debts or obligations incurred by the partnership, unlike limited  liability companies (LLC) and professional service limited  liability companies (PLLC).

- LIMITED AVAILABILITY

Although not true of Michigan, the LLP is not available in  some states and sometimes is limited to specific professional  groups (attorneys, accountants and doctors).

Partners in a LLP should be sure to carry sufficient personal liability/malpractice insurance.

CORPORATION

The corporation is the most complex business structure. A corporation is an association of individuals with a separate legal existence. The corporation is recognized by law as being a distinct legal entity apart from the individuals who own it.

The corporation is usually formed by the authority of the state government where the business is located. Businesses in Most states must file incorporation papers with the Secretary of States office or Business Registration office of your Jurisdiction. If the corporation is located and operates in only one region/state, it is known as a domestic corporation. When it does business in a state(s) other than where it is based, it is known as a foreign corporation. A corporation from another country is known as an alien corporation when it does business in the United States.

Corporations are usually formed by the transfer of money, property, or both by prospective shareholders in exchange for stock in the corporation. An attorney is usually hired to file all papers necessary to incorporate in a state. A search must also be done to be sure that the name of the corporation is not already being used in the state. The USPTO Trademark office is a good start but also check for local or state trademarks. Finally, the state will approve incorporation by issuing a charter for the corporation which out- lines the powers and requirements of the business. Laws regulating corporations vary considerably between states. Foreign corporations are also subject to Federal regulations regarding  interstate commerce.

Unlike a partnership whose operation is set forth in a private contract (partnership agreement), the corporation's financial and management structure must conform to state and, in some cases, federal regulations which are set forth in the document ("charter," "certificate," or "articles") of incorporation. Also, unlike sole proprietorship and partnership whose owners are taxed individually on the net income of the business, a corporation is treated as a taxable entity separate from the owners, thereby, incurring corporate income taxes while stockholders, are taxed on dividends received. This is known as double taxation.

ADVANTAGES

- LIMITED LIABILITY

Stockholders are only liable for losses up to the amount of their investment.

- EASE IN RAISING CAPITAL

Operating capital can be acquired by the issuance of stocks or long-term bonds. Long-term financing is easier to obtain using corporate assets, the personal assets of stockholders and personal guarantees of major stockholders.

- OWNERSHIP IS TRANSFERABLE

Ownership is easily transferred through the sale of stock certificates. This also eases a change of ownership with minimum disruption to the corporation and little financial loss to a dissatisfied owner.

- CORPORATION IS A LEGAL ENTITY APART FROM THE OWNERS

- BUSINESS EXISTENCE CONTINUES

Unlike sole proprietorship or partnership, a corporation  continues to operate even with the removal, illness or death of a corporate officer or stockholder.

- CORPORATION MAY DRAW ON THE EXPERTISE OF OTHER PEOPLE

Stockholders elect a board of directors which hold centralized power to set management policy, elect corporate officers, and hire management specialists  to assist in operating the business. Stockholders indirectly participate in managing the company by voting for the board of directors. The board of directors, corporate officers, and hired managers combine their expertise to efficiently run the business.

DISADVANTAGES

- CLOSELY REGULATED

A corporation must operate within its state charter, however, some states have very broad charters.

- EXTENSIVE RECORDKEEPING

By governmental regulation, numerous local, state and federal reports must be submitted.

- EXPENSIVE TO ORGANIZE

The corporation is the most expensive legal structure to organize. Most states set forth in corporate charters a specific amount of commencing business capital needed. Also, there is a state incorporation fee. If an attorney prepares the documents of incorporation these fees may easily exceed the state incorporation fee.

- DOUBLE TAXATION

A corporation is taxed on its net income, meanwhile, stockholders are taxed as individuals on corporate dividends they receive. As a result, some corporate earnings are "double taxed."

S CORPORATION

Most corporations are organized as "C" corporations as described in the preceding section. Another option, however, is the "S" corporation. Named for Subchapter S of the Internal Revenue Code, S corporations allow small business owners (shareholders) to directly divide corporate income according to their ownership interest (number of shares of stock owned) and pay taxes on these dividends on their individual income tax returns. Further, S corporations allow shareholders to use business losses of the corporation to offset income on their income tax returns. In not paying corporate taxes, the double taxation feature of the "C" corporation is avoided.

These advantages do come at the expense of several restrictions which are placed upon S corporations. In order to qualify as an S corporation, a small business must meet the following requirements:

- The S corporation must be a domestic corporation. It  must be a corporation that is either organized in the United States or organized under federal or state law. Certain types of organizations are ineligible to be S corporations. They include financial institutions, insurance companies, or a domestic international sales corporation (DISC).

- It must have only one class of stock.

- It must have shareholders who are citizens or residents of the United States. Nonresident aliens cannot be shareholders.

- It must have no more than 75 shareholders (husband and wife count as one stockholder).

- It must have as shareholders only individuals, estates (including estates of individuals in bankruptcy) and certain types of  trusts. Partnerships and corporations cannot be shareholders in an S corporation.

ADVANTAGES

- AVOIDS DOUBLE TAXATION

- BUSINESS LOSSES CAN BE OFFSET AGAINST INCOME BY OWNERS

Initially, a small business often incurs beginning losses. The S corporation allows the owners (stockholders) to declare losses against their income on their individual tax returns. In a traditional corporation, losses are reported on corporate tax returns.

DISADVANTAGES

- SEVERAL RESTRICTIONS PLACED ON S CORPORATIONS

- S CORPORATIONS MUST OPERATE ON CALENDAR YEAR FOR TAX

REPORTING (WITH CERTAIN EXCEPTIONS)

- FRINGE BENEFITS SUCH AS LIFE AND HEALTH INSURANCE PROVIDED

TO STOCKHOLDERS ARE TREATED AS TAXABLE INCOME

PROFESSIONAL CORPORATION

Professionals in certain occupations that wish to incorporate  their practice may form a "professional corporation." In many states,  this is their only option. In others, they have the option to form  C or S corporations, in addition to professional corporations. Professionals wanting to incorporate should check with their state's corporate filing office (typically with the Secretary of State or Corporation Division) to find which professions must create professional corporations.

The occupations that typically must use professional incorporation, include the following:

Accountants Architects Attorneys Engineers Health Care Professionals, including audiologists, dentists, nurses, opticians, optometrists, pharmacists, physical therapists, physicians and speech pathologists Psychologists Social Workers,Veterinarians

The professional corporation must be formed in order to deliver  professional service. All owners in the corporation must be  licensed to practice that professional occupation.

Professional corporations provide protection for owners from the malpractice liability of associates in the group. This does not protect a professional from his/her own malpractice liability, however. Personal liability protection may be provided by adequate  malpractice insurance coverage.

Professional corporations were once a more popular business  structure than they are today. Prior to 1986, professional corporations could shelter more income from taxes than sole proprietorships or partnerships. Today, the IRS classifies most professional corporations as "personal service corporations," thereby, subject to the flat 35% corporate income tax rate.

ADVANTAGES

- OWNERS PROTECTED FROM THE NEGLIGENCE OF ASSOCIATES

DISADVANTAGES

- OWNERSHIP RESTRICTED TO LICENSED PRACTITIONERS OF A SPECIFIC OCCUPATION

- HIGHER START-UP COSTS AND MORE PAPERWORK THAN A SOLE PROPRIETORSHIP OR PARTNERSHIP

LIMITED LIABILITY COMPANY

A limited liability company (LLC) is a business structure that  combines the advantages of partnerships and corporations. The  owners of a LLC are referred to as members. Members of a LLC have  the liability protection afforded corporate shareholders but are taxed like a partnership, thereby avoiding "double taxation."  Gains and losses that flow through the company are reported on members' personal tax returns and the LLC entity itself is not taxed on its income.

Depending on how the Operating Agreement is written, members  may play an active role in managing the LLC and therefore more  resemble a partnership; or they may hire managers to actively run  daily operations and in that case the members resemble shareholders  of a corporation. It is vital that the Operating Agreement clearly  define the members' roll in managing the LLC, otherwise, by default  management is vested equally among all members. Likewise, the Operating Agreement should specify the time, place and manner in which meetings are conducted and decisions made; voting rights; the transfer of membership interest; selection and termination of management; and the distribution of profits, losses and cash flow. Most states (except Texas and New York) specify that a LLC have at least two members. Unlike a S corporation, there is no limit on the number or types of members in a LLC. Further, there is no citizenship restriction on LLC members as there is with S corporation shareholders.

The LLC begins it existence when Articles of Organization are filed with the Secretary of State or Corporation entity in the state that the business operates. Articles of Organization usually contain the following information:

The name of the LLC. This must include a statement of  "Limited Liability Company" or initials LLC as part of  the company name. Some states allow "LC"

Location (county) where the business is located.Date of dissolution (in addition to specific events of  termination - see below).

Purpose for which the company was organized.Name of a Registered Agent. This must be a resident of  the state, a state corporation, or a foreign corporation with a certificate of authority to transact business in the state.

Statement of termination. The four most common methods include:

* By unanimous consent of all members of the company.

* Time specified in the operating agreement or the Articles of Organization.

* The occurrence of events specified in the Articles of Organization.

* The death, resignation, expulsion, bankruptcy or other withdrawal of a member within a certain number of years (typically 30 years).

As indicated above, a LLC exists for a specific amount of time.

A corporation typically exists perpetually.

A variation of the LLC is the Professional Service Limited  Liability Company (PSLLC). Depending upon the state, professionals  may be restricted from forming LLCs. In other states, professionals  such as attorneys, physicians, architects, or dentists may form  PSLLCs, according to their state's regulations.

The filing process to form a LLC is complex in some states and needs to be done with complete attention to detail. Knowledge of both  Federal regulations, particularly the IRS Tax Codes and state  regulations governing the LLC formation are essential so that the LLC  qualifies for taxation as a partnership rather than a corporation.  For this reason, and for the protection of its members, an attorney  specializing in corporate law should prepare the paperwork and advise  the members in matters relating to the formation of LLC.  Keep in mind that single member LLCs (with one owner) are very easy to set up, file, and run. Taxes are filed directly on the individuals federal tax forms for the LLC as a flow through tax without double taxation which exists in C-Corporations.

ADVANTAGES

- MEMBERS HAVE SAME PROTECTION FROM PERSONAL LIABLITY AS OFFICERS AND SHAREHOLDERS IN A CORPORATION

- MEMBERS ARE TAXED LIKE PARTNERSHIPS

Income and losses flow through the LLC and members  report them on their personal income tax returns and thereby typically are taxed at a lower rate.

- LLC ENTITY ITSELF DOES NOT PAY INCOME TAX/AVOIDS "DOUBLE TAXATION"

- LOWER START UP COSTS THAN A CORPORATION

- GREATER FLEXIBILITY IN MANAGEMENT THAN A CORPORATION

Management responsibility can be designated to specific  members or to a professional management team.

- LESS FORMAL THAN A CORPORATION

Once the LLC completes its operating agreement, formalities such as annual meetings of shareholders or issuing of stock are not dictated. However, it is wise to keep records  when major decisions are made or important meetings held.

- NO RESTRICTIONS ON THE NUMBER OR TYPE OF MEMBERS

Unlike S corporations that restrict the number of shareholders to 75 and the type to individuals, estates and trusts, LLCs have no limitations on the number of members and allow partnerships and corporations to be members.

* Note, the federal government of the USA allows for LLCs to operate without a TIN tax number and just your social security number if you are a "single owner" LLC without other members. i.e. you are the manager/owner.

DISADVANTAGES

- OWNERSHIP IS HARDER TO TRANSFER THAN WITH A CORPORATION

Transferring of stock in a corporation is very easy and may occur without the consent of other shareholders. Ownership interest in a LLC may not be transferred without the vote or the consent of a significant number of members depending on the terms of the operating agreement. When the LLC has a large number of members, transfer of ownership is often difficult.

- LACK OF UNIFORMITY IN FILING PROCEDURES

Filing to form a LLC is done at the state level. Both the requirements and the departments that govern the filing vary between states. Strict adherence to the state procedures and to IRS guidelines will ensure that the LLC is properly structured and will qualify for "flow through" tax status, rather than tax status as a corporation. Because of its complexity, filing should be done with legal assistance.

- DISSOLUTION OF THE BUSINESS

Corporations exist in perpetuity; LLCs have a finite existence that is limited by the following factors or events. The date for dissolution set forth in the Articles of Organization (often 30 years from formation); occurrence of events outlined in the Operating Agreement; or written consent of two-thirds (or other percentage specified in the Operating Agreement) of the members.

Additionally, state procedures usually trigger  dissolution when bankruptcy, death, expulsion, incapacity or withdrawal of any member occurs. When consent by the majority of members is given to continue the LLC and the date for dissolution has not been exceeded, most Operating Agreements allow the business to continue to operate.

COOPERATIVE or Co-Op

A cooperative is a business organized by people for their own use. Members own the cooperative but unlike private corporations, no dividends are paid to outside investors.

Members are a group of people interested in receiving goods or services at rates typically lower than available in the retail marketplace. Savings may be rebated to members-users (patrons) in proportion to their purchases or taken continually in the form of lower prices. Each member has one vote regardless of the volume of business or investment placed in the cooperative.

Co-ops are set up under the laws of the state in which they operate; they have all the necessary legal papers for incorporation; there is a board of directors or trustees; and there is management to run the business. The major difference is that this business is strongly consumer driven because it is consumer-owned.

Most consumer cooperatives are incorporated, except buying clubs. Incorporation offers few benefits when a small number of households are cooperating by purchasing as a group, distributing immediately, carrying little or no inventory, dealing in cash, and having few fixed assets.

Incorporation is advisable for more complex business organizations.

The often cited advantage of incorporation is the protection from unlimited liability. Members cannot be held liable for the organization's debts, except taxes. Incorporation also assures the public that the cooperative has met certain standards demanded by the state of incorporation.

ADVANTAGES

- DEMOCRATIC REPRESENTATION AMONG MEMBERSHIP (EACH MEMBER HAS ONE VOTE)

- LIMITED LIABILITY TO MEMBERS, IF INCORPORATED

- MOTIVATION FOR BUSINESS TO SUCCEED IS STRONG BECAUSE MEMBERS DIRECTLY BENEFIT IN THE FORM OF REBATES OR COST SAVINGS

DISADVANTAGES

- EXPENSES OF INCORPORATION

- CORPORATIONS ARE CLOSELY REGULATED

WHICH STRUCTURE IS RIGHT FOR MY BUSINESS?

In choosing the legal structure for your business, a number of considerations may affect your decision. The preceding definitions show the advantages and limitations of the most ommon legal structures.

The size of the business is perhaps the biggest factor in the selecting the legal structure. If "you" (personally) are the business, then sole proprietorship is most likely the legal structure of choice. If your business consists of two or more  persons, and you want your business to be relatively simple and  unregulated, then a partnership may be your choice.

Incorporation should be undertaken if the business has:  assets sufficient to warrant the costs of incorporation; stock-holders needing the provision of limited liability; and the ability to profitably withstand the added governmental regulation and related reporting requirements.

Such decisions should not be made without obtaining all needed information. You, your partners, or potential stockholders may or may not be able to provide this information.

The professional advice of an attorney and an accountant should be obtained before making any important business decision *