A Step by Step Guide
This guide will help you decide on the best legal structure for your specific business,.
There are many reasons today for owner-managers of businesses to look at the legal structure of their firms. The changing tax laws and fluctuating availability of capital are just two situations which require alert mangers to review what legal structures best meet their needs.
Each form of business organization has its advantages and disadvantages. This Guide seeks to briefly identify them for the owner-manager who wants to know "what questions to ask" when seeking the proper professional advice.
Table of Contents
2. The Sole Proprietorship
3. The Partnership
4. The Corporation
The Sole Proprietorship
The sole proprietorship is usually defined as a business which is owned and operated by one person. To establish a sole proprietorship, you need only obtain whatever licenses you need and begin operations. Hence, it is the most widespread form of small business organization.
Advantages of the Sole Proprietorship
Ease of formation. There is less formality and fewer legal restrictions associated with establishing a sole proprietorship. It needs little or no government approval and is usually less expensive than a partnership or corporation.
Sole ownership of profits. The proprietor is not required to share profits with anyone.
Control and decision making vested in one owner. There are no co-owners or partners to consult. (Except possibly your spouse.)
Flexibility. Management is able to respond quickly to business needs in the form of day to day management decisions as governed by various laws and good sense.
Relative freedom from government control and special taxation.
Disadvantages of the Sole Proprietor
Unlimited liability. The individual proprietor is responsible for the full amount of business debts which may exceed the proprietor's total investment. This liability extends to all the proprietor's assets, such as house and car. Additional problems of liability, such as physical loss or personal injury, may be lessened by obtaining proper insurance coverage.
Unstable business life. The enterprise may be crippled or terminated upon illness or death of the owner.
Less available capital, ordinarily, than in other types of business organizations.
Relative difficulty in obtaining long-term financing.
Relatively limited viewpoint and experience. This is more often the case with one owner than with several.
Note: a small business owner might very well select the sole proprietorship to begin with. Later, if the owner succeeds and feels the need, he or she can form a partnership or corporation.
The Uniform Partnership Act, adopted by many states, defines a partnership as "an association of two or more persons to carry on as co-owners of a business for profit." Though not specifically required by the Act, written Articles of Partnership are customarily executed. These articles outline the contribution by the partners into the business (whether financial, material or managerial) and generally delineate the roles of the partners in the business relationship. The following are example articles typically contained in partnership agreement:
Name, Purpose, Domicile
Duration of Agreement
Character of Partners (general or limited, active or silent)
Contributions by Partners (at inception, at later date)
Business Expenses (how handled)
Authority (individual partner authority in conduct of business)
Books, Records, and Method of Accounting
Division of Profits and Losses
Draws or Salaries
Rights of Continuing Partner
Death of a Partner (dissolution and winding up)
Release of Debts
Sale of Partnership Interest
Additions, Alteration, or Modification of Partnership Agreement
Settlements of Disputes
Required and Prohibited Acts
Absence and Disability
Some of the characteristics that distinguish a partnership from other forms of business organization are the limited life of a partnership, unlimited liability of at least one partner, co-ownership of the assets, mutual agency, share of management, and share in partnership profits.
Kinds of Partners
Ostensible Partner. Active and known as a partner.
Active Partner. May or may not be ostensible as well.
Secret Partner. Active but not known or held out as a partner.
Dormant Partner. Inactive and not known or held out as a partner.
Silent Partner. Inactive (but may be known to be a partner).
Nominal Partner (Partner by Estoppel). Not a true partner in any sense, not being a party to the partnership agreement. However, a nominal partner holds him or herself out as a partner, or permits others to make such representation by the use of his/her name or otherwise. Therefore, a nominal partner is liable as if he or she were a partner to third persons who have given credit to the actual or supposed truth of such representation.
Subpartner. One who, not being a member of the partnership, contracts with one of the partners in reference to participation in the interest of such partner in the firm's business and profits.
Limited or Special Partner. Assuming compliance with the statutory formalities, the limited partner risks only his or her agreed investment in the business. As long as he or she does not participate in the management and control of the enterprise or is in the conduct of its business, the limited partner is generally not subject to the same liabilities as a general partner.
Advantages of the Partnership
Ease of formation. Legal informalities and expenses are few compared with the requirements for creation of a corporation.
Direct rewards. Partners are motivated to apply their abilities by direct sharing of the profits.
Growth and performance facilitated. In a partnership, it is often possible to obtain more capital and a better range of skills than in a sole proprietorship.
Flexibility. A partnership may be relatively more flexible in the decision making process than in a corporation. But, it may be less so than in a sole proprietorship.
Relative freedom from government control and special taxation.
Disadvantages of a Partnership
Unlimited liability of at least one partner. Insurance considerations such as those mentioned in the proprietorship section apply here also.
Unstable life. Elimination of any partner constitutes automatic dissolution of partnership. However, operation of the business can continue based on the right of survivorship and possible creation of a new partnership. Partnership insurance might be considered.
Relative difficulty in obtaining large sums of capital. This is particularly true of long term financing when compared to a corporation. However, by using individual partners' assets, opportunities are probably greater than in a proprietorship.
Firm bound by the acts of just one partner as agent.
Difficulty of disposing of partnership interest. The buying out of a partner may be difficult unless specifically arranged for in the written agreement.
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