In good form: choosing the legal structure that's right for your business - Legal Aid: Leading Edge

Entrepreneur, Sept, 1996 by Steven C. Bahls, Jean Easter Bahls

YOU CAN'T SEE the frame of a house, but it's there, keeping everything together. An observer may not be able to tell much about the frame, but a well-constructed one can make a big difference in a windstorm.

The same goes for business structure. People dealing with your business may not notice whether it's a sole proprietorship, a partnership, a corporation or a limited liability company. The form you choose, though, can make a big difference when it's time to pay taxes, respond to a lawsuit or split up the business.

Which form is best? That depends on how many people own the business, how they want to operate it and their goals. Here's an overview of the four basic structures and some of their pros and cons.

1. Sole proprietorship: One person owns and operates this business. Chances are the shoe repair shop on the corner and the hot dog stand in the mall are sole proprietorships. It's the default position for a business with one owner if no papers have been filed to incorporate it or form a limited liability company.

The chief advantage is simplicity. As a sole proprietor, you receive all the business's profits to use as you choose for employees, supplies and overhead. But losses are yours, too.

For tax purposes, you should keep business income and records separate from your personal finances, but the business isn't a legal entity separate from its owner. This means when you die, so does your business (unless your heirs choose to continue it). It also means that if someone sues your business, all your assets are on the line. If you stick with this form, make sure you have enough liability insurance to protect your house and your bank account.

2. Partnership: If more than one person owns the business and you haven't filed papers to incorporate or form a limited liability company, the law will most likely consider it a partnership. This form gives each partner a say in the business's management and a stake in both profits and losses. Each partner is also fully responsible for the business's debts. So if your partner makes a bad business deal, it's your problem, too.

Partnership is a flexible form. Partners need not share the business equally; depending on the assets and time each one contributes to the business, they might split the ownership and authority in some other proportion. That should be made clear, though, in a partnership agreement signed by both (or all) partners. Likewise, partners may agree among themselves about their rights and duties. There's no need to follow the formalities required of corporations, such as electing directors and officers.

Still, a major disagreement in a partnership could spell trouble. Disputes between partners are as common as spats between spouses. An unhappy partner can ask a court to dissolve the partnership, sell the assets and divide the proceeds. If you choose a partnership, prevent problems by drawing up an agreement specifying the rights of each partner, how disputes will be settled and how to transfer the business if one partner quits. Agree in writing whether the surviving partner is obligated to buy the other's interest, how the purchase price will be determined and when it must be paid.

3. Corporation: The chief advantage of incorporating is that the owners aren't personally responsible for the business's debts. That includes loans and credit, though in practice, most banks and many suppliers require business owners to sign a personal guarantee. It also includes most business-related court judgments, unless you personally commit a fraud or purposely injure someone.

A corporation is a self-contained legal entity owned by shareholders. Shares of stock may be bought and sold much more easily than partnership interest, so a corporation is convenient for passing the business on to the next generation. Incorporation also makes it more likely that the business will survive the death of the founder.

Corporations must observe certain formalities, including electing officers and directors, holding annual meetings, keeping separate records, and filing separate tax returns. If you disregard these formalities, courts may decide the corporation is a sham and hold you responsible for its debts.

Generally, corporations pay higher taxes than individuals do. Business income distributed as dividends is taxed twice: first on the corporate return, then on the owner's. However, you may elect to operate as an S corporation. You gain the advantages of the standard (or C) corporation, but all income passes through to your tax return and is taxed only once.

4. Limited liability company: A relatively new option, limited liability companies are now available in most states. They combine the simplicity and flexibility of partnerships with the protection from personal liability that a corporation affords. Better yet, LLCs are not subject to double taxation like C corporations; with a properly formed LLC, all income passes through to the owners.

But like partnerships, LLCs do not have perpetual life. Some state statutes stipulate that the company must dissolve after 30 or 40 years. Technically, the company dissolves when a member dies, quits or retires. Careful drafting of charter documents, though, can allow the business to continue as a new LLC.