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New Business Kit; Chapter 1-Selecting Your Business Entity
Form of Business - A Major Decision
Sole Proprietorship Partnerships
Limited Liability Company
Agreement-If More Than One
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One of the first major decisions you will have to make as you start your new business is the form of legal entity it will take. To a large degree this decision may be dictated by the way you have organized your operations and whether you intend to work on your own or in conjunction with others.
The form of entity you choose can have a significant impact on the way you are protected under the law and the way you are affected by income tax rules and regulations. There are five basic forms of business organizations. Each has its own benefits and drawbacks and is treated differently for legal and tax purposes.
A sole proprietorship is typically a business owned and operated by one individual, or very often by a husband and wife. A sole proprietorship is not considered to be a legal entity under the law, but rather is an extension of the individual who owns it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The income or loss of a sole proprietorship is combined with the other earnings of an individual for income tax purposes.
A sole proprietorship is perhaps the easiest form of business to own and operate because it does not require any specific legal organization, except of course, the normal requirements such as licenses or permits. A sole proprietorship typically does not have any rules or operating regulations under which it must function. The business decisions are solely the result of the owner's abilities.
Partnerships can take two legal forms, general or limited. In a general partnership, two or more individuals join together to run the business enterprise. A partnership must usually file a fictitious business name statement to operate a business under the partnership name. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. The authority of the partners, and the way in which profits or losses are to be shared, can be modified by the partnership agreement. The responsibility for liabilities can also be modified by agreement among the partners, but partnership creditors typically have recourse to the personal assets of each of the partners for settlement of partnership debts.
A limited partnership is comprised of one or more general partners who are personally liable for partnership debts and one or more limited partners who contribute capital and share in the profits or losses of the business. The limited partners do not take a part in running the business and are not liable for the debts of the partnership.
The rights, responsibilities and obligations of both the limited and general partners are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership, whether limited or general.
A partnership is a legal entity recognized under the law and as such it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. When a partnership is small most creditors require a personal guarantee of the general partners for credit.
A partnership is also required to file an income tax return for federal purposes (Form 1065), and a partnership return for Pennsylvania. A partnership typically does not pay income tax; the information from the tax return is combined with the personal income of the partners to determine the overall tax liability.
A corporation is a separate legal entity which exists under the authority granted by state law. A corporation has substantially all of the legal rights of an individual and is responsible for its own debts. It must also file income tax returns and pay taxes on income it derives from its operations. Typically, the owners or shareholders of a corporation are protected from the liabilities of the business. However, when a corporation is small, creditors often require personal guarantees of the principal owners before extending credit. The legal protection afforded the owners of a corporation can far outweigh the additional expense of starting and administering a corporation.
A corporation must obtain permission from the Secretary of State to use or do business under a fictitious name. A corporation must also adopt and file articles of incorporation and by-laws which govern its rights and obligations to its shareholders, directors and officers.
Corporations must file annual income tax returns with the IRS (Form 1120) and the Pennsylvania Department of Revenue and possibly other states in which it does business. The elections made in a corporation's initial tax returns can have significant impact on how the business is taxed in the future.
Incorporating a business allows a number of other advantages such as the ease of bringing in additional capital through the sale of equity, or allowing an individual to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire or sell their interest.
Should you decide to incorporate your business venture, you should seek the advise of competent legal counsel and business oriented CPAs. Call Halcolm Bard Certified Public Accountant and Consultants at (814) 837-9150.
An S corporation is a corporation that has made an election to be taxed similar to a partnership. There is no entity level federal income tax paid; rather the profits and/or losses flow through to the shareholders and are included with their other income on their individual income tax return. A Pennsylvania "S" return must be filed and the Capital Stock/Franchise tax paid. There are limitations on who can become an "S" corporation.
It is the intent of the General Assembly that the legal existence of limited liability companies organized in Pennsylvania be recognized outside the boundaries of the Commonwealth and that, subject to any reasonable requirement of registration, a domestic limited liability company transacting business outside Pennsylvania be granted protection of full faith and credit under the Constitution of the United States. LLCs are deemed to be corporations. However, for personal income tax purposes and S corporation purposes, LLCs may elect "pass-through" treatment, in which cases each LLC member is subject to tax on its pro rata share of the net income or loss of the LLC for its taxable year. However, LLCs are subject to capital stock and franchise taxes, as well as local taxes and fees.
It there is more than one person involved in a business it is very important to have an agreement with all parties involved. The agreement should detail how profits and losses are split and how management decisions are made. More importantly the agreement would determine what happens upon death, disability or retirement of a partner/shareholder or what procedures have to be followed if one person wants to sell their interest. These things should to be decided at the beginning of the business.
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Chapter One -
Selecting a Legal Entity