Legal Structure of Your Business - How to Select
By Jocelyn West Brittin,
McGuire, Woods, Battle & Boothe,
McLean, Virginia, U.S.A.
U.S. Small Business Administration
See also: PDF-version
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TABLE OF CONTENTS
Continuity and Transferability
Pros and Cons
Continuity and Transferability
Pros and Cons
Continuity and Transferability
Pros and Cons
APPENDIX: INFORMATION RESOURCES
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 your business.The entities most commonly used by small businesses
in the United States are (1) the sole proprietorship, (2) partnerships
and (3) stock corporations. In discussing these entities, this
publication answers the following questions:
! Getting started -- How is each type of legal organization
! 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
! Taxes1 -- 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.
1 - This publication discusses basic federal income
tax principles as they exist 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
|Difficulty and cost to form
||Low to Moderate
|Difficulty and cost to maintain
|Risk of owner liability
|Difficulty of tax preparation
|Flexibility of ownership; bringing in new owners
|Cost of terminating business
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 business.
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
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
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 business's assets.
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 explanation under
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 the business.
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 your business.
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
! 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 requirements.
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 existence.
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 partnership.
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
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 income.
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
! Partnership is legally responsible for the business
acts of each partner.
! General partnership interest may not be sold or
transferred without consent of all partners.
! Partnership dissolves upon death of a general
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
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 professional corporation.
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
! 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 officer.
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 shareholders.
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
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
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
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 he 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
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 your business.
APPENDIX: INFORMATION RESOURCES
U.S. Small Business Administration (SBA)
The SBA offers an extensive selection of information on most
business management topics, from how to start a business to exporting
SBA has offices throughout the country. Consult the U.S. Government
section in your telephone directory for the office nearest you.
SBA offers a number of programs and services, including training
and educational programs, counseling services, financial programs
and contract assistance. Ask about
- SCORE: Counselors to America’s Small Business, a national
organization sponsored by SBA of over 11,000 volunteer business
executives who provide free counseling, workshops and seminars
to prospective and existing small business people. Free online
counseling and training at www.score.org.
- Small Business Development Centers (SBDCs), sponsored
by the SBA in partnership with state governments, the educational
community and the private sector. They provide assistance, counseling
and training to prospective and existing business people.
- Women’s Business Centers (WBCs), sponsored by the
SBA in partnership with local non-government organizations across
the nation. Centers are geared specifically to provide training
for women in finance, management, marketing, procurement and
For more information about SBA business development programs
and services call the SBA Small Business Answer Desk at 1-800-U-ASK-SBA
(827-5722) or visit our website, www.sba.gov.
Other U.S. Government Resources
Many publications on business management and other related topics
are available from the Government Printing Office (GPO). GPO bookstores
are located in 24 major cities and are listed in the Yellow Pages
under the bookstore heading. Find a “Catalog of Government Publications
Many federal agencies offer Websites and publications of interest
to small businesses. There is a nominal fee for some, but most are
free. Below is a selected list of government agencies that provide
publications and other services targeted to small businesses. To
get their publications, contact the regional offices listed in the
telephone directory or write to the addresses below:
Federal Citizen Information Center (FCIC)
The CIO offers a consumer information catalog of federal publications.
Consumer Product Safety Commission (CPSC)
Washington, DC 20207
The CPSC offers guidelines for product safety requirements.
U.S. Department of Agriculture (USDA)
12th Street and Independence Avenue, SW
Washington, DC 20250
The USDA offers publications on selling to the USDA. Publications
and programs on entrepreneurship are also available through county
extension offices nationwide.
U.S. Department of Commerce (DOC)
Office of Business Liaison
14th Street and Constitution Avenue, NW
Washington, DC 20230
DOC's Business Liaison Center provides listings of business
opportunities available in the federal government. This service
also will refer businesses to different programs and services
in the DOC and other federal agencies.
U.S. Department of Health and Human Services (HHS)
Substance Abuse and Mental Health Services Administration
1 Choke Cherry Road
Rockville, MD 20857
Helpline: 1-800-workplace. Provides information on Employee
Assistance Programs Drug, Alcohol and other Substance Abuse.
U.S. Department of Labor (DOL)
Employment Standards Administration
200 Constitution Avenue, NW
Washington, DC 20210
The DOL offers publications on compliance with labor laws.
U.S. Department of Treasury
Internal Revenue Service (IRS)
1500 Pennsylvania Avenue NW
Washington DC 20230
The IRS offers information on tax requirements for small businesses.
U.S. Environmental Protection Agency (EPA)
Small Business Ombudsman
1200 Pennsylvania Avenue NW
Washington, DC 20480
The EPA offers more than 100 publications designed to help small
businesses understand how they can comply with EPA regulations.
U.S. Food and Drug Administration (FDA)
5600 Fishers Lane
Rockville MD 20857-0001
The FDA offers information on packaging and labeling requirements
for food and food-related products.
For More Information
A librarian can help you locate the specific information you
need in reference books. Most libraries have a variety of directories,
indexes and encyclopedias that cover many business topics. They
also have other resources, such as
- Trade association information
Ask the librarian to show you a directory of trade associations.
Associations provide a valuable network of resources to their
members through publications and services such as newsletters,
conferences and seminars.
Many guidebooks, textbooks and manuals on small business are
published annually. To find the names of books not in your local
library check Books In Print, a directory of books currently
available from publishers.
- Magazine and newspaper articles
Business and professional magazines provide information that
is more current than that found in books and textbooks. There
are a number of indexes to help you find specific articles in
- Internet Search Engines
In addition to books and magazines, many libraries offer free
workshops, free access to computers and the Internet, lend skill-building
tapes and have catalogues and brochures describing continuing
Published - July 2011