Make
Your
Business Legal
Dun & Bradstreet estimates that
there are over eleven million businesses in the United States.
The overwhelming majority of these companies are small, privately
held concerns.
Before charging off to join the
ranks of this army of small enterprises you will need to give
some serious thought to the legal structure that is most suitable
for your particular business. Consideration should be given
not only to your current circumstances but also to your future
plans and objectives as you determine the legal structure
under which you will operate.
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Numerous factors will influence
your ultimate decision, including:
- Cost and complexity of the
various alternatives
- Control issues
- Legal reporting requirements
- Tax considerations
- Flexibility
- Liability concerns
Let's examine some of the alternatives
and discuss the advantages and disadvantages of each of these.
There are significant differences between alternative business
structures, particularly with respect to taxation and liability.
As always, it is advisable to obtain legal and tax advice
before proceeding.
Legal Business Entities
Sole Proprietorship
By far the most common and simple
of the business structures is the sole proprietorship. A sole
proprietorship is the de facto structure of choice for many
would-be entrepreneurs who are eager to "hang out their shingle"
and get on with business without the burden and expense of
filing for corporate status.
From a legal as well as a tax perspective,
no distinction is made between the owner of the business and
the business itself. In short, they are one and the same.
This is a concept which has important implications. In essence,
as the owner of a sole proprietorship you personally assume
all the liabilities and responsibilities of the business.
Advantages:
- Start-up costs are low.
- Registration is simple and
quick.
- Taxation occurs at your personal
tax rate, which may be lower than the corporate rate.
- It may be possible to shield
non-related personal income from taxes through the deduction
of legitimate business expenses.
- You are in total control of
your business.
- The business can be discontinued
at will.
Disadvantages:
- As the owner of a sole proprietorship,
you are personally liable for any and all liabilities which
are incurred by the business.
- Because you are the sole shareholder,
access to capital may be limited.
- In order to allow the entry
of other stockholders or partners, the legal structure of
the business must be changed.
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Partnership
A partnership is essentially a pooling
of resources of two or more individuals or businesses to form
a new legal business entity. The partners become co-owners
of the jointly formed enterprise.
A partnership agreement is necessary
to spell out the details of the partnership arrangement, including
ownership interests, capital requirements, profit distributions
and general responsibilities of each of the partners. This
document is critical to the smooth operation of the partnership
as well as the protection of the involved parties. If possible
it should be drafted under the guidance of a qualified attorney.
General vs. Limited Partnerships:
There is an important distinction
between general and limited partnerships which should not
be overlooked. An active partner in a business is normally
considered to be a general partner. Each partnership must
have at least one general partner. The general partners manage
and operate the business. They also assume complete and unlimited
personal liability for all debts of the partnership.
Limited partners, by contrast are
really just passive investors. They are inactive in the management
and operation of the partnership and their liability for the
debts of the partnership is limited to the amount of their
investment. If the partnership fails, they stand to lose their
entire investment. Other personal assets (like their homes)
however, are generally protected from creditors of the partnership.
The same cannot be said of the general partners.
Advantages:
- Allows for a pooling of capital
and resources.
- Distributes liability and exposure
over more individuals or business entities.
- Allows for a variety of perspectives
that may facilitate prudent decision-making.
- Partnerships are not taxable
entities. All profits pass through to the partners and are
taxed at their respective tax rates.
- Losses incurred by the partnership
may be allocated to each of the partners according to their
share of ownership in the business and used to offset other
ordinary income.
Disadvantages:
- The general partners in a business
assume unlimited personal liability for all debts incurred
by the partnership.
- Certain tax forms and profit
distribution schedules must be filed each year with the
IRS.
- Overall control of the business
is distributed among the various partners according to their
level of ownership. If you have a minority position in the
firm, you may find that the strategic direction of the business
is not always consistent with your expectations.
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Corporation
After the sole proprietorship, the
corporation is the most common business entity. The corporation
is a versatile business structure with special characteristics
that make it appealing to owners and investors.
To begin with, the corporation is
considered to be a separate legal entity with an indefinite
life span. As a separate entity it is liable for its own debts.
Owners or stockholders are liable for the debts of the corporation
only to the extent of their investment in the firm. An additional
advantage of the corporation is its facility for raising capital
through the sale of stock to numerous potential investors.
Because the corporation is a more
formal organization than the sole proprietorship, it has special
reporting requirements and is more complex and expensive to
establish. It is also subject to a potentially expensive double
taxation. This occurs because the dividends, which are paid
out to shareholders from corporate profits, are not tax deductible
to the corporation. In other words, they are recognized and
taxed as income to the corporation and then paid out to shareholders
in after-tax dollars. Once these dividends are distributed,
they become subject to a second round of taxes as they are
recognized as income by each individual shareholder.
Advantages:
- Owners and investors have limited
liability for the debts of the corporation.
- Corporations can have numerous
stockholders providing important access to capital.
- Corporations can endure indefinitely.
- Ownership is easily transferred
through the sale of stock.
Disadvantages:
- Corporations are relatively
costly and time consuming to establish.
- Corporations have special ongoing
reporting requirements.
- Double taxation of income may
occur in a corporation.
Subchapter S Corporation
The Subchapter S Corporation or
S Corporation, as it is commonly called, is a relatively new
alternative to the traditional corporation. Designed for small
businesses, it allows business owners to enjoy limited liability
benefits while avoiding the onerous double taxation of corporate
earnings.
The S Corporation is essentially
identical to a normal corporation with several significant
exceptions:
- The S Corporation is considered
a pass-through entity for tax purposes. That is, profits
are not taxed to the corporation but are passed directly
to the shareholders. They are taxed only once.
- The S Corporation can have
only a limited number of stockholders (currently 75 - up
from 35 under a previous law). This precludes large and
very widely held public corporations from taking advantage
of subchapter S status.
- There are restrictions on stock
ownership and subsidiary ownership designed to maintain
the integrity and intent of this popular alternative - although
these have been relaxed significantly in recent years.
- There are restrictions pertaining
to the conversion of a normal corporation to an S Corporation
and vice versa. Generally a period of time is required before
a company is able to change its election.
Limited Liability Company
The limited liability company (LLC)
is a relatively new alternative that is now being offered
in many states. The LLC operates very much like a partnership
but offers investors the additional benefit of limited liability
for company debts.
Like the partnership, the LLC passes
profits and losses directly on to investors according to their
level of ownership in the firm.
Advantages:
- LLC's can offer multiple classes
of stock
- LLC's can have an unlimited
number of shareholders
- Equity ownership can be held
by corporations and partnerships as well as individuals
- Owners assume no personal liability
for debts of the LLC
- Profits and losses can be passed
directly to owners
Disadvantages:
- Certain restrictions apply
to the transfer of equity ownership
- States differ with respect
to taxation of LLC's
- LLC's have no continuity of
life. If an owner dies or leaves, the LLC is dissolved.
Complying with Legal and Regulatory Requirements
In addition to defining the legal
structure of your new business, you must ensure that you are
complying with all local, regional and national regulations
relating to the establishment and operation of your business.
Business Licenses
It is important that you properly
license and register your business with the appropriate local,
county and state authorities. While this is generally neither
expensive nor time-consuming it is a critical step in properly
establishing your business.
Licensing requirements will vary
by city and state. A good place to start would be to contact
your local licensing authority and inquire about the requirements
for starting a new business. Look in the city or county government
pages of your local telephone directory for a listing entitled
Business Licenses, Business Taxes or City Clerk.
Zoning Restrictions
Local zoning requirements are designed
to safeguard the community from the hazards and nuisance of
heavy traffic flows, parking problems, unsightly premises,
noisy operations, and other potential problems arising from
your business activities.
If you decide to lease commercial
office space, the building owner or manager will be able to
inform you of any specific restrictions relating to the site.
If you choose to operate from your home you will need to call
the planning or zoning office in your town or city to inquire
about possible restrictions. If you intend to operate a service
business you will generally not experience problems but it
is always a good idea to receive the blessing of the city
before beginning your operations.
Employer Identification Number
The employee identification number
(EID) is an extremely important but often overlooked requirement
for running a business. The EID works very much like a social
security number. It is the means whereby the federal government
monitors and verifies employee related tax payments from business
organizations. Employer identification numbers are required
by law for all businesses that employ one or more individuals.
There are quarterly payroll tax payment and reporting requirements
that carry stiff penalties if ignored. You would be well advised
to make this a matter of considerable priority both at the
outset of your business and on an ongoing basis thereafter.
Neglecting payroll tax payments
is a very serious matter. Falling behind on payroll taxes
has caused more than one business failure. In the long run
it is far more expensive to ignore or postpone payroll tax
payments than virtually any other payment obligation I can
think of.
An application for an EID is available
from the IRS.
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Developing a Credit Rating
If you are interested in building
a credit rating, it is advisable to register with Dun & Bradstreet,
or other national business credit reporting agencies. Dun
& Bradstreet will assign your business a DUNS number - a business
identification number. Your DUNS number will become a permanent
part of your business identity and will be widely used by
government and industry to identify your organization.
There is no cost to register with
D&B and it is strictly voluntary. However, you should be aware
that a DUNS number will eventually be assigned automatically
and a credit file compiled on your business. You should also
be aware that the Federal Government requires that all of
their contractors have a DUNS number.
It is often in your best interest
to cooperate with credit agencies to ensure that your credit
report contains as much positive information as you are able
to legitimately provide.
Trademarks
Trademarking allows a business to
register a name or symbol for its sole use in identifying
its specific products or services. Most recognizable brand
names are trademarked. Trademarks can become very valuable
over time. For example, if I could go out and develop a new
soft drink and label it Coca-Cola, I might stand to make a
lot of money. The Coca-Cola trademark is extraordinarily valuable.
Unfortunately for me, it is already registered to the Coca-Cola
Company. This prevents me from using it.
Trademarks can be obtained for business
names, logos, product names and even key phrases used to market
or identify a business, product or service. A trademark provides
for the exclusive use of the trademarked identifier for a
period of ten years. Trademarks are generally renewable for
subsequent ten-year periods until the trademark is allowed
to lapse without being renewed. At that point it is up for
grabs. A smart company will never allow a valuable trademark
to lapse.
For a fee you can have a trademark
attorney conduct a national search to ensure that your preferred
name has not already been trademarked by another firm. If
it is available, the attorney will have it registered - for
an additional fee. There is also a fee assessed by the U.S.
Department of Commerce to register the name. Total fees for
attorney services and registration fees can quickly approach
$1,000 or more.
A growing number of on-line services
are available to assist you in conducting trademark searches
and name registrations. Trademark Express can be contacted
at 1-800-340-2010 or visited at www.tmexpress.com
on the Internet.
Of course, many people opt to save
money by conducting their own searches and registration on
the U.S. Department of Commerce website. The U.S. Department
of Commerce maintains an interactive public domain database
which is updated every few months. Most searches can be completed
in a matter of seconds.
Current as well as pending trademark
information is available through this on-line database. Trademark
requests can also be processed on-line for the normal filing
fee. The U.S. Department of Commerce Patent and Trademark
Office web page can be found at www.uspto.gov
on the Internet.
The Patent and Trademark office
can also be contacted at 1-800-786-9199. Trademark applications
and information can also be requested in writing from the
U.S. Department of Commerce, Patent and Trademark Office,
Washington, DC 20231.
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