Question

Kelly Fernandez and Michael Webster have decided to create a business. They have financing available and have a well-developed business plan. However, they have not yet decided which type of legal business structure would be best for them.

Required

Write a report for these two individuals outlining the types of situations in which the CORPORATE form of legal structure would be the best choice.

Answer 1

The type of business entity you choose will depend on three primary factors: liability, taxation and record-keeping. Here's a quick look at the differences between the most common forms of business entities:

• A sole proprietorship is the most common form of business organization. It's easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.
  
• A partnership involves two or more people who agree to share in the profits or losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses are "passed through" to partners to report on their individual income tax returns. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.
  
• A corporation is a legal entity that is created to conduct business. The corporation becomes an entity-separate from those who founded it-that handles the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. The key benefit of corporate status is the avoidance of personal liability. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that's required. While double taxation is sometimes mentioned as a drawback to incorporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income or losses to be passed through on individual tax returns, similar to a partnership.
  
• A hybrid form of partnership, the limited liability company (LLC) , is gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this business format are that profits and losses can be passed through to owners without taxation of the business itself while owners are shielded from personal liability.

Selecting a Business Entity

When making a decision about the type of business to form, there are several criteria you need to evaluate. 2 individuals focused on the following areas when they chose the business format for their company:

1. Legal liability. To what extent does the owner need to be insulated from legal liability? This was a consideration for EnviroTech, says Kalish. He and Berthold had a hefty investment in equipment, and the contracts they work on are substantial. They didn't want to take on personal liability for potential losses associated with the business. "You need to consider whether your business lends itself to potential liability and, if so, if you can personally afford the risk of that liability," Kalish says. "If you can't, a sole proprietorship or partnership may not be the best way to go."

Carol Baker is the owner of The Company Corporation, a firm based in Wilmington, Delaware, that offers incorporation services. She points to the protection of personal assets as "the number-one reason our clients incorporate. In case of a lawsuit or judgment against your business, no one can seize your personal assets. It's the only rock-solid protection for personal assets that you can get in business."

2. Tax implications. Based on the individual situation and goals of the business owner, what are the opportunities to minimize taxation?

Baker points out that there are many more tax options available to corporations than to proprietorships or partnerships. As mentioned before, double taxation, a common disadvantage often associated with incorporation, can be avoided with S corporation status. An S corporation, according to Baker, is available to companies with less than 70 shareholder returns; business losses can help reduce personal tax liability, particularly in the early years of a company's existence.

3. Cost of formation and ongoing administration. Tax advantages, however, may not offer enough benefits to offset other costs of conducting business as a corporation.

Kalish refers to the high cost of record-keeping and paperwork, as well as the costs associated with incorporation, as one reason that business owners may decide to choose another option--such as a sole proprietorship or partnership. Taking care of administrative requirements often eats up the owner's time and therefore creates costs for the business.

It's the record-keeping requirements and the costs associated with them that led Kalish to identify the sole proprietorship as a very popular form of business entity. It's the type of entity in place at his other business, Nationwide Telemarketing.

"I would always take sole proprietorship as a first option," he says. "If you're the sole proprietor and you own 100 percent of the business, and you're not in a business where a good umbrella insurance policy couldn't take care of potential liability problems, I would recommend a sole proprietorship. There's no real reason to encumber yourself with all the reporting requirements of a corporation unless you're benefiting from tax implications or protection from liability."

4. Flexibility. Your goal is to maximize the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners. Individual needs are a critical consideration. No two business situations will be the same, particularly when multiple owners are involved. No two people will have the same goals, concerns or personal financial situations.

5. Future needs. When you're first starting out in business, it's not uncommon to be "caught up in the moment." You're consumed with getting the business off the ground and usually aren't thinking of what the business might look like five or ten-let alone three-years down the road. What will happen to the business after you die? What if, after a few years, you decide to sell your part of a business partnership?

Keep in mind that the business structure you start out with may not meet your needs in years to come. Many sole proprietorships evolve into some other form of business-like a partnership or corporation-as the company grows and the needs of the owners change.

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