One of the first and most important decisions a new business owner must make is to decide the form of legal structure to use in forming the business. There are three main types of legal form in which to translate business; sole proprietorship, partnership and corporate. Each type has advantages and disadvantages, which should be discussed thoroughly with legal counsel before making a final decision.
As a sole proprietorship, the owner is the business, and the business is the owner. If a judgment is rendered against the business, all the assets of the business owner are available to satisfy the judgment; there is no insulation from liability. From a legal perspective, this may be one of the biggest drawbacks of a sole proprietorship.
Also income and losses pass directly to the business owner. The maximum tax rate for the business is, therefore, the maximum personal tax rate for the owner, currently 31 percent.
To create a sole proprietorship generally no special steps are required. If a name other than the owner’s name is used, a fictitious name certificate or a trade name certificate may need to be filed with the county. This is an inexpensive procedure and one that can be performed easily without the services of an attorney. Similarly, the transfer of the business is easily performed although that process may require the services of counsel, unless the business owner is familiar with the state requirements of notice to creditors and others.
The second type of business structure is a partnership. Two or more persons enter into a contract to share in the profits and the losses of the business, as well as to address the division of ownership and management responsibilities. Legal liability falls equally upon the partners, unless a limited partnership has been formed; a limited partnership restricts full liability to the general partner. Limited partners are only liable for the amount of their investment. Partners remain liable, however, for taxes as in a sole proprietorship, so the maximum tax rate for a partnership currently is 31 percent. Creation of a partnership doesn’t require legal counsel, although legal assistance is recommended in order to ensure that the rights and responsibilities between partners are properly addressed. It is recommended that all partners retain separate counsel so that their individual interests are protected.
A third type of business structure is a corporation. Although it is legal and possible to create a corporation without the services of an attorney, that is not usually done and is not recommended. There are a number of choices to make that will affect the operation and taxation of the corporation. It is recommended that both an attorney familiar with corporate law and an accountant be consulted before the final decision is made to transact business in the corporate status.
The most common decision for a corporate owner to make at creation of the corporation is whether to elect to be treated as a subchapter C corporation. S corporations are taxed by the federal government in a manner similar to sole proprietorships. Income and losses are passed to the owner(s), and income can therefore be taxed at the 31 percent rate. C corporations are taxed at the corporate rate, which is currently 34 percent. While the difference between 31 and 34 percent appears minimal, the final tax impact can be substantial. C corporation profits, after being taxed at 34 percent, may be distributed to the individual owner(s) and taxed again at the individual rate of 31 percent. Therefore, C corporation profits may eventually be taxed at a total rate of 65 percent. The decision to choose an S corporation is obviously of great importance, as is the proper action to insure the S election is done correctly. However, there are times when a new corporation may wish to retain C status rather than pass profits on to an owner as in an S corporation. This can occur, for example, when a new corporation wishes to retain profits for re-investment in the company. The possibilities are many and varied, and the advice of an accountant is necessary. Currently, New Jersey does not recognize an S corporation with the result that all corporations, C or S, are taxed the same in this state.
Corporate status conveys an important protection not available in either of the two other structures. Corporations are legal entities and therefore are legally liable for their own debts. The inability of the corporation to pay its debts does not normally confer liability upon the corporate owner. Thus, the corporation can conduct business without risking the personal assets of the owner.
In order to assure the continued protection that corporate status confers, it is necessary for the owner(s) to maintain certain formalities in the day-to-day operations of the business. It is recommended that business owners consult legal counsel to be certain they perform the necessary actions to assure legal formalities are met. Failing to do so can make the owner liable for corporate debts.