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ASK A LAWYER
[Excerpted from material from the U.S. Small Business Administration]
In starting a small business, one of the first questions you
should ask is what form of legal entity you should use or "How
should I organize my business?" Also, as your business grows and
changes, you should from time to time ask yourself whether the
entity you have chosen remains the best form of organization for
The entities most commonly used by small businesses in the United
States are (1) the sole proprietorship, (2) partnerships and
(3) stock corporations. [Note: Limited Liability Companies are
increasing in popularity but are not discussed in this file. See other
'Lectric Law Library files for info on this form of entity. - staff]
In discussing these entities, this file answers the following questions:
- Getting started--How is each type of legal organization set up?
- Control--Who owns and who controls the business?
- Liability--Who is responsible if the business fails or has losses?
- Continuity and transferability--How long does each type of
organization last, and how does the owner sell the business?
- Taxes*--How are the profits and losses of the business taxed?
Also included is a summary of the pros and cons of the different
legal entities and a table (Table 1) comparing a number of factors
to consider when you select one of them for your business.
*This file discusses basic federal income tax principles as they
existed in 1991. Tax laws are frequently changed. For a detailed
examination of federal taxes as they apply to small businesses
consult the following Internal Revenue Service publications: Tax
Guide for Small business, Pub.No. 334; Tax Information on Partnerships,
Pub.No. 541; Tax Information on Corporations, Pub.No. 542 and Tax
Information on S Corporations, Pub.No. 589.
Table 1 -- Comparison of Legal Entities
Proprietorship Partnership Corp. S. Corp.
Difficulty and cost Low to
to form Low Moderate High High
Difficulty and cost
to maintain Low Low High High
Risk of owner
liability High High Low Low
Difficulty of tax
preparation Low Moderate High High
ing in new owners Low Moderate High Low
Cost of terminating
business Low High High High
A majority of the small businesses in the United States are
operated as sole proprietorships. This type of business
organization is the simplest and is the form usually chosen by
the one-person business, in which the owner and worker are the
same person (although sole proprietorships can have employees).
Its primary advantage is its ease of formation; its most
important disadvantages are (1) it can have only one owner and
(2) the owner is individually responsible for all losses of the
Selecting a Name and Beginning
You can start a sole proprietorship simply by beginning to
conduct your business. You should open a separate bank account to
keep track of your business's finances and keep records of all of
the expenses and revenues connected with running the business.
A sole proprietorship is usually operated under the name of the
individual owner, although other names can be used. If the name
selected is not yours, you may be required to file a "fictitious
name" certificate in the town, city or county in which your
business is located. Care should be taken in selecting a name to
ensure it is not the same or similar to the name of another
business. Also, note that many states prohibit using the words
"incorporated," 'Inc.," "Corporation," "Company" or "Co." unless
your business is a corporation.
Obtaining Permits and Licenses
Many states and localities require businesses to obtain business
licenses or permits, no matter what type of entity is involved.
Examples of the licenses often required are business licenses,
zoning occupancy permits and tax registrations. You should call
local government offices for information and application forms.
Who Owns the Business?
If you create a sole proprietorship, all the assets of the
business are owned directly by you. A sole proprietorship may be
owned by only one individual--ownership by more than one person
creates a partnership.
Who Controls the Business?
Generally, the owner of the sole proprietorship controls the
business. If you are the owner of a sole proprietorship, you may
hire employees to help you manage the business, but you will have
legal responsibility for the decisions made by your employees and
ultimate control over the business.
In a sole proprietorship, the business and the owner are one and
the same. There is no separate legal entity and thus no separate
legal "person." This means that as a sole proprietor you will have
unlimited personal responsibility for your business's
liabilities. For example, if your business cannot pay for its
supplies, the suppliers can sue you individually. The business
creditors can go against both the business's assets and your
personal assets, including your bank account, car or house.
(However, in some states, you may be able to protect your
personal assets from business risks by owning them jointly with
your spouse or by transferring them to your spouse or children.
There may be tax and other reasons why this is not a good idea;
seek the advice of a lawyer first.) The reverse is also true;
i.e., your personal creditors can make claims against your
Insurance may be purchased to cover many of the risks of running
a sole proprietorship. Some businesses are not very risky, so the
personal liability may not be a great concern. However, you
should understand that if you choose to operate your business as
a sole proprietorship and lose money (which insurance will not
cover), you will be personally liable for the loss.
CONTINUITY AND TRANSFERABILITY
How Long Does a Sole Proprietorship Last?
A sole proprietorship can exist as long as its owner is alive and
desires to continue the business. When the owner dies, the sole
proprietorship no longer exists. The assets and liabilities of
the business become part of the owner's estate.
Can You Sell Your Business?
A sole proprietor can freely transfer a business by selling all
or a portion of the assets of the business.
A sole proprietor is taxed on all income from the business at
applicable individual tax rates. The business income, and
allowable business expenses, are reflected on the individual tax
return. No separate federal income tax return is required of the
sole proprietor. However, a proprietor must pay self-employment
tax on the business income.
Pros and Cons
* Is inexpensive to start.
* Is simple to run.
* Has no double taxation on profits (see section on corporations).
* Owner has unlimited personal liability for business liabilities.
* Business has unlimited liability for owner's personal liabilities.
* Ownership is limited to one person.
There are two types of partnerships: general partnerships and
limited partnerships. A general partnership is created when two
or more individuals agree to create a business and to jointly own
the assets, profits and losses. A limited partnership may be
created only by following certain steps set out in each
particular state's statutes. The primary advantage of
partnerships is that they can have more than one owner; the most
important disadvantage is that the general partners are
personally responsible for the losses and other obligations of
Start by Agreeing
You can start a general partnership by agreeing with one or more
individuals to jointly own and share the profits of a business.
There is no limit on the number or type of partners (i.e.,
individuals, other partnerships or corporations) you may have in
A general partnership is deceptively easy to start because it can
be formed by an oral agreement. However, it is advisable to have
a written agreement signed by all partners addressing major
issues relating to the business, including
* How much time and/or money the partners will contribute to the
* How business decisions will be made.
* How profits and losses will be shared.
* What will happen to the business and to a partner's share of the
business if that partner dies, becomes disabled or stops
working/contributing to the business.
* How long the partnership will exist.
* When the partnership will make distributions (i.e., payments of
income earned based upon partnership share) to its partners.
A limited partnership consists of one or more general partners
(i.e., those who are generally liable for the business) and one
or more limited partners (i.e., those who have limited
liability). If the statutory requirements are not followed, a
limited partnership will be treated as a general partnership;
therefore, it is important that you consult with an attorney in
creating a limited partnership.
Selecting a Name/Filing Certificates
As with the sole proprietorship, partnerships often use the name
of the partners as the name of the business. If all the partners'
names are not used, or if none of the partners' names are used,
you may have to file a "fictitious name" certificate. A number of
states require partnerships to file partnership certificates
either with the local government or in the office of the
secretary of state or its equivalent. Check with your local
government office to determine whether your state has such
The partnership should keep separate bank accounts and financial
records for the business so the partners know whether there are
profits and losses, and how much of either they receive.
Who Owns the Business?
The partnership agreement should state what percentage of the
business and profits each partner will own. In the absence of an
agreement, each partner will own an equal portion of the business
and profits (as well as the liabilities) of the business.
Who Controls the Business?
The partnership agreement should specify who will control and
manage the business of the partnership. In the absence of an
agreement, all general partners have equal control and equal
management rights over the business. This means that all of the
partners must consent and agree to partnership decisions. It is
important to note, however, that any partner can bind the
partnership and the individual partners to contracts or legal
obligations, even without the approval of the other partners.
In a limited partnership, the management and control of the
business is handled by the general partners. State law restricts
the types of control and management the limited partners can
undertake without jeopardizing the limited partnership's
A general partnership has characteristics of both a separate
legal entity and a group of individuals. For example, it can own
property and conduct business as a separate legal entity.
However, the general partners are "jointly and severally" liable
for the partnership; i.e., all of the partners are liable
together and each general partner is individually liable for all
of the obligations of the partnership. This means that a creditor
of the partnership could require you individually to pay all the
money the creditor is owed. Your partners would then reimburse
you for their share of the debt or loss. Before you decide to
join a general partnership, determine whether your partners can
financially afford to share the losses of the partnership. If you
are the only partner with any assets or money, the creditors of
the partnership can require you to pay them, and you will be
unable to get reimbursement from your partners.
Limited partners do not have personal liability for the business
of the partnership. Limited partners are at risk only to the
extent of their previously agreed-upon contributions to the
CONTINUITY AND TRANSFERABILITY
How Long Does a Partnership Last?
A partnership exists as long as the partners agree it will and as
long as all of the general partners remain in the partnership. If
a general partner dies or leaves the partnership, the partnership
dissolves and the assets of the partnership must be sold or
distributed to pay first the creditors of the partnership and
then the partners. The partnership agreement may provide for the
continuation of the business by the remaining partners, in which
case it may not have to be sold upon the withdrawal of a general
partner. When a general partner leaves a partnership, he or she
is entitled to an accounting that will determine his or her share
of the assets and profits of the partnership. The agreement
should also cover how a partner will be paid for his or her share
of the partnership when he or she leaves or dies.
Can a Partner Sell His or Her Share of the Partnership?
The partnership agreement should state whether a partner can sell
his or her partnership share. In many states, the sale or
transference of a partnership share cannot take place without the
consent of all the other partners. Even if a partner does
transfer a share of the partnership, he or she will remain
personally liable for the business losses incurred prior to the
sale of that interest.
The partnership itself is not responsible for paying taxes on the
income generated by the business. A partnership tax return is
filed, but for informational purposes only. Instead, each partner
individually pays taxes on his or her share of the business
income. The profits and losses "flow down" from the partnership to
the individual partners. (Recent changes in the tax law may
restrict the use of partnership losses to offset income of the
partner generated by activities outside of the partnership.
Consult a tax advisor about these matters.) In certain cases, a
partner may be required to pay tax on income from the
partnership, even without having received any of the income.
Partners must also pay self-employment tax on their partnership
Pros and Cons
* Is a very flexible form of business.
* Permits ownership by more than one individual.
* Avoids double taxation.
* Has few legal formalities for its maintenance.
* Partners have unlimited personal liability for business losses.
* Partnership is legally responsible for the business acts of each
* General partnership interest may not be sold or transferred
without consent of all partners.
* Partnership dissolves upon death of a general partner.
The stock corporation is more complex than the sole
proprietorship or the partnership, but it has certain advantages
that may make it worth considering as a business form.
A corporation is considered a separate legal entity; because of
this, the owners of the corporation (known as its shareholders or
stockholders) are not personally responsible for the losses of
the business. Although a corporation usually has more than one
owner, it is possible for only one individual to create and own
100 percent of a corporation.
A stock corporation may elect Subchapter S status for tax
purposes. Once such an election is made, the corporation is
referred to as a Subchapter S corporation. This election is
discussed in the section on taxes.
Most states also recognize non-stock corporations, which are
commonly used for nonprofit organizations, community
associations, etc. There are no owners in a non-stock
corporation, although there may be members. Because this form of
corporation is rarely used by small businesses, it will not be
further discussed in this booklet.
The Corporate Formalities
If you decide to do business as a corporate entity, you will have
to comply with the formal requirements of state law to create the
corporation. Note that members of certain professions, such as
doctors or lawyers, may be required to do business as a
The individual(s) who will own the business (i.e., the
shareholders or stockholders) must agree on the following to
create a corporation:
* The name of the business.
* The total number of shares of stock the corporation can sell or
issue (known as "authorized shares").
* The number of shares of stock each of the owners will buy.
* The amount of money or other property each owner will contribute
to buy his or her shares of stock.
* The business in which the corporation will engage.
* Who will manage the corporation (i.e., who will be the directors
and officers of the corporation).
Once the shareholders agree on these issues, they must prepare
and file articles of incorporation or a certificate of
incorporation with the corporate office of the state in which
they want to incorporate. (A corporation may be formed in its
home state or in any other state.)
Fees Paid to the State
You cannot form a corporation without filing with the appropriate
state office. Most states charge an initial fee for filing the
corporate documents and an annual fee for allowing the
corporation to continue. These fees are sometimes based upon the
number of shares of stock authorized and the par value of the
stock. Because each state has its own rules and schedule of fees,
call your state's corporate commission or secretary of state to
determine what fees will apply to your business.
The corporation will also need bylaws, i.e., a set of rules of
procedure by which the corporation is run. These include rules
regarding stockholder meetings, director meetings, the number of
officers in the corporation and the responsibilities of each
The corporation is a legal entity separate from its owners;
therefore, it will need a separate bank account and separate
records. The money and property that the shareholders pay to buy
their stock, and the assets and money that are earned by the
corporation, are owned by the corporation and not by the
A Word About the Corporation's Name
When you send your corporate documents to the state, you must
include the name of the corporation. If the name you have
selected is already used by another company, your documents will
be rejected. In many states, you can telephone the corporation
commission and they will tell you whether the name you have
selected is available as a corporate name. You also should take
care to avoid using a name that is similar to that of an existing
company or product.
The Owners Have Ultimate Control
The shareholders of the corporation elect, at least once a year,
a group of individuals to act as the board of directors. Usually,
the directors must be elected by enough of the owners to
represent a simple majority of the outstanding shares, although a
higher vote requirement can be required. Thus, those who hold a
majority of the shares have ultimate control over the
corporation. Terms of directors often are for more than one year
and are staggered to provide continuity. Shareholders can elect
themselves to be on the board of directors.
Certain major decisions must be approved by the shareholders,
such as amendments to the articles of incorporation, merger with
another company and dissolving the corporation. In some states,
certain of these decisions require more than a majority of the
shareholders to agree; be sure to consult an attorney about your
state's voting requirements.
In some states, small businesses are permitted to incorporate
without a board of directors or with other differences. Seek
professional advice regarding what types of options may be
permitted in your state.
The Board of Directors Makes Major Decisions
The board of directors is responsible for the major decisions of
the corporation. It must meet at least once a year. Each director
on the board is given one vote; usually the vote of a majority of
the directors is sufficient to approve a decision of the board.
Directors may be paid for their services, although payment is not
required. The board of directors elects the officers of the
corporation. The officers usually consist of a president, vice
president, secretary and treasurer. In many states, one person
may hold any or all of these offices.
Day-to-Day Decisions Are Made by the Officers
Officers of the corporation are responsible for running the
day-to-day business of the corporation. Although they often are
employees of the corporation and receive a salary, they can be
nonemployees and/or serve without pay. The shareholders can be
elected as officers.
How Do the Owners Get Paid?
If you own stock in a small business corporation and also work as
an employee in that corporation, there are two ways you may be
paid: (1) as an employee, you should receive wages or a salary
for the work you perform and (2) if the corporation's business
makes enough money, you may be paid a dividend or distribution on
the stock you own. (A dividend must be paid equally to all shares
of common stock and is usually expressed as an amount per share,
such as "$5 per share.") The board of directors decides whether
dividends shall be paid. If dividends are not allowed in any
given period, a shareholder has no right to any of the money the
corporation's business has made (except as an employee receiving
a salary or wages). This is because the corporation is a separate
legal entity, and the money it makes belongs to the corporation.
The most important reason for you to consider incorporating your
business is because a corporation is its own legal "person,"
separate from its owners. This means, among other things, that
creditors of the corporation may look only to the corporation and
the business assets for payment. The individual shareholders are
not personally liable for the losses of the business if the
corporation is properly established and properly operated. The
shareholders' only risk is their investment in the corporation.
There are certain cases in which shareholders do incur some
liability for the corporation. For example, if the shareholders
do not observe the statutory requirements for running the
corporation or do not keep the corporation's money, accounts and
assets separate from their personal accounts, then they may also
be found to be personally liable for the business's losses. Also,
if the shareholders "guarantee" the obligations of the corporation
in order to borrow money or to rent space, for example, then they
are legally responsible for the obligations guaranteed. Finally,
if shareholders make loans to the corporation and the business
fails, their loans may be paid off only after the other loans of
the corporation are paid.
Continuity and Transferability
The corporation, as a separate legal person, does not cease to
exist if one or more of its owners dies. Its corporate existence
lasts as long as its shareholders decide it should; a
corporation's "life' is usually perpetual.
Ownership of a corporation can be transferred by sale of all or a
portion of the stock. Additional owners can be added either by
selling stock directly from the corporation or by having the
current owners sell some of their stock. (Before selling shares
of stock to outsiders, check to see whether federal or state
securities laws permit the sale.)
Small businesses that are corporations are often owned by a small
group of shareholders who all work in the business. Often these
shareholders formally agree to certain restrictions on the sale
of their shares, so they can control who owns the corporation.
The corporation must file its own income tax returns and pay
taxes on its profits. The corporation must report all income it
has received from its business and may deduct certain expenses it
has paid in conducting its business.
Dividends paid to shareholders by the corporation are taxed to
each shareholder individually. This is why there is said to be a
"double tax" on corporations. The corporation must pay taxes on
its profits, and the shareholders must pay taxes on the dividends
paid to them from the profits.
Subchapter S Corporations
You may elect Subchapter S status for your small business
corporation if it meets the following requirements: (1) the
corporation has no more than 35 shareholders; (2) the corporation
has only one class of stock; (3) all of the shareholders are U.S.
residents, either citizens or resident aliens; (4) all of the
shareholders are individuals (i.e., no corporations or other
entities own the stock) and (5) the corporation operates on a
calendar year financial basis.
To elect Subchapter S status for your business, you will need to
complete Federal Form 2553 and, in some states, file a separate
state election form.
Generally, a Subchapter S corporation does not pay taxes on the
income generated by the business. Instead, the income or losses
are passed through to the individual shareholders and reported on
their tax returns. The income or losses are divided among the
shareholders based upon the percentage of stock of the
corporation that they own.
You may be required to pay tax on the income of a Subchapter S
corporation even if you have not been paid any money (i.e.,
dividends or distributions) from the corporation.
Pros and Cons
* Provides limited liability to owners.
* Is easy to transfer ownership.
* Is easy to add additional owners/investors.
* Is more costly to set up and maintain.
* Requires separate tax returns.
* Is subject to double taxation.
The decision of what entity to select for your business may be
very complicated. This booklet provides fundamental information
regarding each type of entity, but your state's laws may be
different, or there may be additional factors for you to consider
that are more complicated than those discussed in this booklet.
Consult an attorney before deciding which structure is best for
For more info about SBA business development programs and services
call the SBA Small Business Answer Desk at 1-800-827-5722.
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