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What is a sole proprietorship and how does it operate?

A sole proprietorship is not a separate legal entity from its owner and there are no formal requirements to form a sole proprietorship other than obtaining a business license. By definition, a sole proprietorship is limited to a business owned by one person. A sole proprietorship does not file its own income tax returns or pays tax on its net profits. Instead, the owner includes the net income or losses from the sole proprietorship on his or her personal tax returns. The owner's liability for the actions of the sole proprietorship are not limited to his or her investment in the business. The rules for operating a sole proprietorship and/or what happens if the owner dies or becomes disabled are not set forth in any organizational documents. The daily activities of a corporation are run by the owner.

What is a corporation and how does it operate?

A corporation is a separate legal entity from its shareholders and it is formed by filing Articles of Incorporation with the appropriate state agency. You can have a single shareholder corporation. A corporation files its own income tax returns and pays tax on its net profits. In most instances, a shareholder's liability for the actions of the corporation and/or other shareholders is limited to the shareholder's investment in the corporation. The rules for operating a corporation are controlled by its Articles and By-Laws. If there are no By-Laws, there are some statutory provisions which dictate how the corporation is run in certain situations. The daily activities of a corporation are run by its officers and the longer-term major decisions are made by its directors and shareholders. In most smaller corporations, the officers, directors and shareholders are the same people. If there is more than one shareholder, the corporation usually also has a Shareholders Agreement which deals primarily with what happens to a shareholder's stock if he or she dies, becomes disabled or wants to sell his or her stock in the corporation.

What is a general partnership and how does it operate?

A general partnership is a separate legal entity from its partners and it is formed by an agreement (oral or written) of its partners. By definition, there must be two or more persons in order to create a partnership. A partnership files its own informational income tax returns but it does not pay tax on its net profits. Instead, each partner reports on his or her individual income tax returns their proportionate share of the partnership's net profit or loss. In most instances, a partner is liable for all actions of the partnership and/or the other partners. This means that a partner's liability is not limited to his or her investment in the partnership. The rules for operating a general partnership are controlled by its Partnership Agreement or if no formal partnership agreement exists (oral or written), there are a set of statutory provisions which dictate in certain situations how the general partnership will be operated. All of the partners in a general partnership have the right to participate in the management of the general partnership's activities. The Partnership Agreement usually also deals with what happens to a partner's interest in the general partnership if he or she dies, becomes disable or wants to sell his or her interest in the general partnership.

What is a limited liability company ("LLC") and how does it operate?

An LLC is a separate legal entity from its members and it is formed by filing Articles of Organization with the appropriate state agency. You can have a single person LLC. An LLC files its own informational income tax returns but it does not pay tax on its net profits. Instead, each member reports on his or her individual income tax returns their proportionate share of the LLC's net profit or loss. In most instances, a member's liability for the actions of the LLC's and/or other members is limited to the member's investment in the LLC. The rules for operating an LLC are controlled by its Articles and Operating Agreement. An LLC can be either managed by a manager(s) or by its members. In a manager managed LLC, one or more but less than all of the members are responsible for managing the daily activities of the LLC (similar to the officers of a corporation). In a member managed LLC, all of the members participate in managing the daily activities of the LLC (similar to the general partners in a general partnership). If there is no Operating Agreement, there are statutory provisions which dictate how the LLC will be operated in certain situations. The Operating Agreement usually also deals with what happens to a member's interest in the LLC if he or she dies, becomes disabled or wants to sell his or her interest in the LLC.

What are the advantages and disadvantages of using a sole proprietorship, a corporation, a general partnership and a limited liability company to operate my business?

The primary advantage of a sole proprietorship is that it is simple and inexpensive to start and operate. The disadvantages are the owner's exposure to liability from his or her business and the automatic termination of the business in the event the owner dies. If the business is making a lot of money, there may also be some tax disadvantages of using a sole proprietorship.

The main advantage of a corporation is the protection it gives the owner from the liabilities of the business. If the owner has substantial assets outside of his or her business, in most instances, those other assets cannot be reached by the creditors of his or her corporate business. Also, there are a number of tax deductions which are available to corporations which may reduce the overall tax burden of the business. Also, since the death of a shareholder does not automatically terminate the business, it is easier to deal with the continuation and sale of the business. The chief disadvantages of using a corporation are the costs of setting up and operating the corporation and its more formal structure (more paperwork). Also, if the business is very profitable and there is a need or desire to distribute the earnings of the corporation to the shareholders, there can be a double tax on such earnings (at the corporate level and then at the personal level).

The key advantages of using a general partnership to operate your business are the simplicity of its formation and the pass-through taxation on its net profits. Since the partnership does not pay tax on its net profits, if such net profits are distributed to the partners there will only be one tax on such net profits (at the individual level). Also, in the early stages of many businesses, the business incur losses. Again because of this pass-through taxation, those losses will be passed through to the partners who in most instances can use those losses to offset income from other sources. The partnership agreement can also provide for the orderly transition of the business in the event of the death, disability or desire to sell of any of the partners. The major disadvantage of a general partnership is the partner's exposure to liability from the activities of the business as well as the activities of the other partners.

The principal advantages of an LLC are limitation of the liability of its members to their investment in the LLC and the pass-through taxation of its net profits or losses. It is a hybrid of the best aspects of a corporation and a general partnership. An LLC also costs less to create and is less formal in its operation. The Operating Agreement can provide for orderly transition of the business in event there is a change in the ownership of the LLC. The only real disadvantage of an LLC is that in some instances the tax benefits of using a corporation could be greater than using an LLC. Finally, LLCs have only been around for a relatively short time (as compared to corporations and partnerships) and there are still a number of unanswered legal questions.

Why do you need a Shareholders Agreement and what are the key provisions that it should contain?

A Shareholders Agreement is needed to establish simple and clear procedures for the buying and selling of the stock in a corporation (usually in small closely held corporations) of a withdrawing shareholder. A shareholder may either want to (or need to) withdraw from the corporation for a number of reasons including needing funds; death; disability (mental or physical); termination of employment; bankruptcy; and/or retirement. If there is no agreement dealing with these issues there are some statutory provisions which mandate what should be done in some instances but these mandates may not be what the shareholders would want and may not cover all situations. The most important provision in the Shareholders Agreement is the one establishing the price of the stock to be bought and sold. Valuing a closely held business is very difficult and there are a number of different methods that can be used to establish such value (i.e. capitalized earnings formula, book value, appraisal, agreed upon price, arbitration procedure, etc.). The Shareholders Agreement should also deal with: the types of transfers of shares which are permitted or restricted; mandatory and optional repurchase of shares by the company and/or other shareholders in certain cases; the obligations of the buyers of the stock; and payment terms and security for deferred payments.