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Choosing a Form for Your Business

Business enterprises can be set up in a variety of different forms including:
Sole proprietorships ' partnerships ' corporations
Each form of business entity has unique advantages and disadvantages. One of the most significant considerations in choosing a form of business entity is how the business entity is taxed.

Businesses can generally change their legal structure after they are formed. However, changing the form of the business entity sometimes causes tax liabilities to the business or its owners that could have been avoided by initially choosing the best business form. Therefore, when establishing a business, deciding on the form of business entity is one of the most important decisions a business owner can make.

    The choice of a business should be made in consultation with an attorney, accountant, or other competent business adviser. These professionals can also, within their respective professional areas, provide important services in:

Negotiating agreements among participants in a business venture, preparing a business plan, advising on the requirements of various statutes.

Obtaining competent advice and services early in the process of embarking on a business venture can significantly contribute to the long-term success and profitability of the venture.

Sole Proprietorships

The sole proprietorship is the simplest and most common form of business entity. A sole proprietorship is a business that is conducted by a single individual owner (the "sole proprietor"). Sole proprietors can conduct business under their own name by simply doing business, for example, as "Jane Jones." A sole proprietor can also do business under a trade name (sometimes called a "fictitious name") as "Jane's Jet Skis" or "Supreme Skis." If a sole proprietor operates under a trade name or fictitious name, the sole proprietor is usually required to file a form (a "trade name certificate") in the city, county, or state where the business is located. A sole proprietorship may have employees and is permitted to carry on most businesses.


A sole proprietorship is simple to start and avoids the operating expenses required for other legal entities such as corporations. For example, additional operating expenses for other forms of business may include incorporation expenses, franchise taxes, annual report fees, and additional professional fees. This is because the complex statutes governing partnerships, corporations and other kinds of business entities usually do not apply to or include sole proprietorships. Sole proprietors make their own decisions and avoid the conflicts that may occur among partners of a partnership or shareholders of a corporation.


Because a sole proprietorship is simply a single individual carrying on a business, the individual owner is personally liable for all the debts and other obligations of the business. It is usually difficult to obtain outside financing for a sole proprietorship. In making a decision to extend credit, a bank or other finance source will look at the net worth and individual credit history of the sole proprietor. Raising capital to start or expand the business is limited, as a practical matter, to what is called "debt financing" (that is, loans). This is because a sole proprietorship has only one owner and, as a result, cannot sell "equity interests" (stock or partnership interests) as is typically done by corporations and other forms of business. A sole proprietorship is a greater financial risk for the business owner. The sole proprietor is personally liable for all obligations of the business, including debts incurred in the operation of the business. The liabilities of a sole proprietor include liability for the negligent or willful acts of employees and agents. Thus, if an employee were to negligently injure a third person in the course of the employee's duties, the sole proprietor may, along with the employee, be personally liable for damages. If the sole proprietor had no insurance or insufficient insurance to cover the damages, the sole proprietor's other assets (home, car, or stock portfolio) could be seized to pay the damages. If the business is unsuccessful and is terminated, the sole proprietor will be personally liable for payment of all business debts such as bank loans and unpaid bills to vendors and service providers (accountants, consultants and attorneys). If the assets of the sole proprietor are insufficient to satisfy the outstanding business debts, the sole proprietor may be forced to declare personal bankruptcy.

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Legally, a sole proprietorship is totally identified with the sole proprietor. Therefore, on the death of the owner, the business enterprise terminates, leaving only the assets of the business such as equipment, accounts receivable, and real property. Because the assets used in the business are not separated from the other assets of the sole proprietor, it may be difficult to sell the business as a whole after the death of the sole proprietor. If there are disputes among the heirs, selling the business assets can be particularly troublesome.

    Tax treatment of Sole Proprietorships

A sole proprietorship doesn't have any existence separate and apart from the individual sole proprietor. As a result, any income that is earned from the business is considered the income of the individual owner. The sole proprietorship itself is not separately taxed on its income; rather, the sole proprietor reports business income and expenses on their own tax return and pays tax accordingly. This means that the net income from the business is taxed only once. In contrast, the income from a corporation is taxed twice: once when the corporation is taxed, and again when the income is distributed to shareholders in the form of dividends. See Corporations.

General Partnerships and Joint Ventures

A general partnership is a business enterprise entered into by two or more persons who do not form a corporation or any other type of business entity to operate the business. If two or more individuals start a business together with the understanding that each will share in the profits of the enterprise, they are considered a general partnership even if they didn't specifically intend to start a general partnership. For example, if two sisters start a mail order business over the kitchen table and agree to share the profits, they are usually be considered a general partnership if they don't form some other kind of business entity such as a corporation. Both very large and very small businesses can operate as general partnerships.

A joint venture is very similar to a general partnership except that it is usually formed either for a specific, limited purpose or for a limited period of time. For example, technology companies often form joint ventures to fund research and development of a particular item useful for their respective businesses (such as a specialized computer chip) when development might be too expensive for either company to fund alone.

Like the sole proprietorship, in most states, general partnerships are not required to file any certificates or other organizational documents with local, county, or state authorities; but they usually must file a "trade name certificate." Statutes in the state where the partnership is formed typically govern the rights and duties of the partners. These rights and duties may also be governed by a partnership agreement if the partners choose to have one prepared.


The arrangement of duties and benefits are flexible. Members of the partnership can structure the partnership according to their agreement. In comparison, in a corporation, allocation of profit and loss is proportional to the percentage of stock held by each stockholder. See Corporations. For example, in a corporation, the general rule is that if each stockholder owns 50% of the stock, each is entitled to 50% of the dividends. In a partnership, distributions of profits, losses and capital gains need not be directly proportional to the percentage interests held by the partners. Because of this flexibility, individual partners can be rewarded for taking special economic risks or for services provided to the partnership. One partner may agree to contribute most of the equipment used to start the business enterprise and to run it on a daily basis. In return, the partners may agree that this partner gets, say, 90% of the profits of the business. Under certain circumstances, however, the Internal Revenue Service will disregard disproportionate allocations. A partnership interest may be transferable because, unlike a sole proprietorship, a partner's interest in the partnership is a discrete asset. The partner can transfer the partnership interest to another person or to the partner's heirs or estate, when he dies or becomes disabled. Customarily, however, transfers of the partnership interest are ordinarily restricted under the terms of the partnership agreement. These "buy-sell" provisions usually give the partnership and the existing partners a "right of first refusal" when a partner wants to transfer his interest in the partnership, even if the transfer is to a member of the partner's immediate family. One important purpose of these provisions is to prevent existing partners from having individuals (either known or unknown to them) become their partners. Transfers are also restricted to prevent unfavorable tax consequences that may occur if more than a certain percentage of partnership interests is sold within a certain period. General partnerships are more attractive to lenders because the lender will look to the aggregate net worth of all the partners in making a decision to extend credit.


Each partner in a partnership has liability for the obligations of the partnership. Each partner is, at a minimum, liable for at least his "pro rata share." Under some circumstances each partner may be liable for the entire amount of all partnership debts and other obligations. Therefore, if the partnership becomes bankrupt or insolvent, one partner with greater assets may be required to satisfy the liabilities of the other partners even if they exceed what would ordinarily be considered that partner's pro rata share of those liabilities. Under the partnership statutes of most states, partnerships usually terminate upon the death or withdrawal of any partner unless the partners agree to continue the partnership. The partners may include a continuation provision in the partnership agreement or, in the event of a death or withdrawal, the remaining partners may agree to continue the partnership. Usually, the agreement to continue must be made within a specified period of time. However, if there is only one partner left, the partnership will be dissolved unless an additional partner (or partners) is admitted to the partnership within a specified period. Unlike the sole proprietor, general partners do not have the right to act alone in making partnership decisions. However, partnership agreements often give designated partners the authority to make specific kinds of agreements. General partnerships are limited in their ability to obtain financing that is other than "debt financing." Unlike sole proprietorships, partnerships can raise capital by selling equity interests in the partnership. As a practical matter, however, the sale of such interests on a large scale is very difficult because of the prospect of potential personal liability and the usually limited market for resale of the interest.

    Tax Treatment of General Partnerships

One of the advantages of a general partnership is that, like a sole proprietorship, the business is not taxed. Rather, income, losses, and gains are passed through to the general partners in accordance with the allocations provided in the partnership agreement. If there is no partnership agreement, income, losses, and gains will be allocated in proportion to the partnership interests of each partner. A particular advantage to this form of business is that the partners can agree among themselves as to how income, losses, and gains are divided among the partners. The partners then report the amount allocated on their own income tax returns and pay tax accordingly. However, there are some limits on the ability of partners to provide for disproportionate allocations.

Limited Partnerships

A limited partnership is a partnership in which the duties and obligations of the partners are divided between "general partners," and "limited partners." Usually, the formation and operation of limited partnerships are regulated under state statutes, defining the obligations and duties of these classes of partners and imposing other obligations. For example, limited partnership statutes usually require that a certificate of limited partnership containing specified information be filed in designated government offices and be kept current.

A "general partner" is a partner who is responsible for managing the partnership and its operations. Like the partners in a general partnership, general partners in a limited partnership are personally liable for all of the partnership's debts and other obligations. A "limited partner" is one who is prohibited from taking part in the partnership's management and day-to-day operations. Unlike the "general partner" the limited partner is usually not personally liable for the partnership's debts and other obligations. Thus, the only risks taken by limited partners are the money or other assets that they have invested in the partnership and any loans made to the partnership.

A limited partner participating in management of the limited partnership may become personally liable, however, for partnership debts and obligations. Limited partners are, nonetheless, typically given certain voting rights with respect to major partnership decisions such as:

    the sale of all (or substantially all) of the partnership's assets and the admission, removal, or retention of a partner

A person can be both a general and limited partner of a limited partnership.

The death or resignation of a limited partner does not cause the dissolution of a limited partnership. However, limited partnership statutes typically provide that if a general partner dies or resigns, the limited partnership will be dissolved unless certain conditions are met. For example, usually there must be at least one remaining general partner, and the certificate of limited partnership that has been filed with government authorities must authorize the remaining general partner(s) to continue the business. The limited partnership may also be continued if all the remaining general partners and a specified percentage of the limited partners agree in writing to continue the business within a certain time period.

The advantage of limited partnerships is that limited partners are not personally responsible for the partnership's debts and other obligations. As a result, it is far easier to market limited liability partnership interests as an investment, particularly with respect to discrete projects such as real estate development.

    Tax Treatment of Limited Partnerships

Partners of a limited partnership are generally taxed in the same way as the partners of a general partnership. They are also given the same flexibility to allocate profits, losses, and gains regardless of the percentage of equity interest in the partnership.


A corporation is a legal entity wholly separate and apart from its owners (the shareholders or "stockholders"). Corporations are formed by filing a "certificate of incorporation" or "articles of incorporation" with the Secretary of State. The certificate or articles of incorporation contains information specified by the state corporation statute. The document may also include:

    provisions regarding corporate management, provisions indemnifying the corporation's directors and officers, and limiting their personal liability to the corporation and its shareholders

Once the certificate or articles are filed, the information is part of the public record and can be obtained by anyone for a small search fee.

The rights and obligations of the corporate shareholders are set forth in great detail in state corporation statutes. These lengthy and complex statutes set out basic rules such as:

    how a corporation must be formed, officers that it must have, annual reports that must be filed, and/or the types of shares which can be issued by the corporation

Some of these rules must be followed exactly while others, at the option of the shareholders, may be varied in the certificate or articles of incorporation, or in the bylaws of the corporation.

Bylaws are a separate set of rules governing how a corporation is run. Bylaws are adopted by the shareholders who formed the corporation. They can later be changed by a vote of the shareholders or the directors, depending upon the particular state corporation law and the provisions of the certificate of incorporation.

Corporations are governed at three levels:
1.Shareholders elect directors. Shareholders do not, other than through the election of directors, typically exercise any control over the overall plans, goals, or day-to-day operations of the corporation. However, corporate statutes give shareholders rights to approve or dissent from major corporate actions not in the normal course of its business, such as mergers and sales of all (or substantially all) of a corporation's assets. 2.Directors are responsible for the management and exercise the rights and power of the corporation. More specifically, directors, either acting as a board or through one or more committees of the board, set corporate policy, establish short and long term plans and strategies, and determine the overall direction of the corporation's business. 3.Directors elect officers such as president, vice president, treasurer and secretary to carry out the policies of the board and to run the corporation on a day-to-day basis. Corporations enjoy many advantages as a business form. Perhaps the most important advantage is that a corporation's stockholders, directors, and officers are not liable for the debts or other obligations of the corporation. Usually they are liable only for any debts or other obligations which they have personally guaranteed or result from their own negligence or misconduct.

Because it is a separate entity, a corporation is not terminated or dissolved upon the death or departure of a shareholder. As a result, the shares of corporations are usually freely transferable. If the corporation's shares are "publicly-traded," the shares can be purchased on a national stock exchange such as the New York Stock Exchange, NASDAQ National Market System, or the American Stock Exchange.

Smaller corporations are often "closely-held;" that is, the shares are owned by a small group of shareholders. It is common for the shareholders of smaller corporations to have "buy-sell" agreements limiting when shares may be sold and to whom they may be sold.

    Tax Treatment of Corporations

The federal tax treatment of corporations is governed by the Internal Revenue Code. Attorneys, accountants, and other professionals usually refer to the types of corporations and their tax treatment according to the provision of the tax code that applies to that type of corporation. For tax purposes, there are two main types of corporations:

    "C" corporations "S" corporations

A corporation taxed at the entity level is known as a "C" corporation. Income that has been taxed at the entity level will again be taxed if, and when, it is distributed as dividends to shareholders. This double taxation is, perhaps, the single greatest disadvantage to operating a business as a corporation. However, "S" corporations may avoid much of this double taxation.

Despite double taxation, corporations do enjoy some tax-related advantages as compared to other business forms. Because of disparities in the top federal tax rates applicable to individuals (39.6% as of 1998) and corporations (35% as of 1998), corporations may enjoy a tax advantage in those circumstances where capital must be retained to fund purchases of equipment, machinery, or other assets on a regular basis. For example, if a capital-intensive business was conducted as a partnership, the partners would be individually taxed (possibly at the 39.6% top rate) on these earnings, even if they had to leave all or part of these earnings in the company to fund the acquisition of machinery and equipment. However, a corporation is not required to distribute earnings to its shareholders and may use them for corporate purposes. The corporation's top tax rate on these earnings would be 35%. Corporations that are not performing certain professional services are entitled to rates as low as 15% if their income is below a certain threshold.

There are, however, limitations to the amount of earnings a corporation may accumulate before it must distribute them to shareholders or face an additional tax on these accumulated earnings.

    "S" Corporations

Certain small companies with no more than 100 shareholders and meeting certain requirements (only one class of common stock, only certain types of shareholders) can be taxed as an "S" corporation. An S corporation is also limited in the shares it may own in another S corporation unless the other corporation meets the requirements of a qualified subchapter S subsidiary(QSSS).

If a corporation elects to be taxed as an S corporation and qualifies, it will be taxed at the federal level very similarly to partnerships and limited liability companies. That is, the income, losses, and gains will be passed through directly to the shareholders and there will be no tax "at the entity level." Notwithstanding an S election, certain transactions by S corporations that were previously C corporations may result in an entity level tax. This includes:

    a tax on appreciation that occurred prior to the election to be taxed as an S corporation a tax on passive investment income - a tax on LIFO recapture

Some states do not recognize "S" corporations for tax purposes and tax them as they would a "C" corporation; that is, at the entity level. Some states recognizing "S" corporations tax them, but at a reduced rate.

    Professional Corporations

Professional corporations are corporations formed by doctors, lawyers, accountants, engineers, architects, and other professionals to do business in their respective professions. Under most state laws, only licensed professionals can be shareholders and directors of professional corporations. The same rule usually applies to partnerships, limited liability companies, and other entities formed by professionals to practice their professions. In most states, a professional will not be liable for the negligence or misconduct of other professionals working for the corporation, except those directly supervised by such professional. Of course, professionals will be liable for their own negligence or misconduct.

A professional corporation can be either a "C" corporation or an "S" corporation under the federal Internal Revenue Code.

Limited Liability Companies

Set Up Corporation New Jersey LawyerA limited liability company, or "LLC," is an unincorporated business entity that is similar to both corporations and partnerships.

Like a corporation, the formation of an LLC shields its members from personal liability for the debts and obligations of the company.

Like a partnership, an LLC is typically formed by the filing of a "certificate of formation" or similar certificate with the Secretary of State. Also like a partnership, the members of LLCs typically enter into an operating agreement that establishes how the LLC is governed. Many of the provisions of an LLC operating agreement are similar to those contained in partnership agreements. For example, the operating agreement usually contains a "buy-sell" agreement governing how and to whom shares in the LLC may be transferred.

LLCs may have an unlimited number of owners and there are no restrictions on the type of persons who may be owners. Some states require that an LLC have at least two owners. Additionally, an LLC may have more than one class of equity interest, as well as wholly owned subsidiaries whose assets, liabilities, and operating results will be treated independently from those of its LLC parent.

One advantage of an LLC over a corporation is that there is more flexibility in management. For example, an LLC may be managed in the following ways:

    solely by its members, by its members and a management committee serving in a function similar to the board of directors of a corporation, by its members, a management committee, and its officers

Further, an LLC, unlike an S corporation, may provide for allocations of profits, losses, and distributions disproportionate to the percentage of equity interest held in the LLC.

Because an LLC combines the insulation from personal liability of a corporation with the tax advantages and managerial flexibility of a partnership, it will, in most cases, be the entity of choice for new businesses. Moreover, using the LLC form of conducting business will not be an impediment to raising capital in offerings of the company's securities because of the protection against liability afforded to equity holders and the ability to provide for free transferability of equity interests. Many states now permit professionals to operate their practices through LLCs, but in such instances a professional may have personal liability not only for their own negligence or misconduct, but also for the negligence or misconduct of other professionals under their direct supervision.

    Tax Treatment of Limited Liability Companies

Unless it elects to be taxed as a corporation, the tax treatment of an LLC is the same as that of a partnership or sole proprietorship. That is, the profits and losses are passed through to the members of the LLC and there is no tax "at the entity level."

Need assistance setting up your business? The Law Offices Of John Morelli are here to help.

While we hope that this short paper is of some information to you, it should be remembered that it is no substitution for competent legal and accounting advice. Your situation should be thoroughly discussed with an attorney before making the decision as to which business entity is best for you.

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