Legal Forms of Operating Your Business
There are three legal forms under which you may conduct business: the proprietorship, the partnership, and the corporation. The form you choose has a great impact on your personal liability, your remuneration, and the tax laws governing yourself and your business. Many entrepreneurs rush this decision with only the present in mind. Unexpected developments or decisions in the future, however, can turn any legal form chosen into a costly mistake. Therefore, it is important to consider both short and long-term objectives before making a decision.
A proprietorship occurs when you are the sole owner of an unincorporated business. Legally, you and your business are viewed as one and the same; consequently, you are responsible for all debts and liabilities incurred by the business and vice-versa. You should note that your own personal assets may settle any debts which cannot be settled by business assets. On the other hand, all assets and income of the business are attributable to you.
Because there is no legal distinction between yourself and your business, all income or loss from operations (not to be confused with cash draws and contributions) are reported on your own personal tax return. Cash draws and contributions reflect advances to and from the proprietorship, and do not affect the amount reported on your tax return. Because the income from your business is taxed personally, it is subject to personal rates of taxation.
A partnership occurs when two or more individuals pool their efforts and assets and operate as a jointly owned unincorporated business. The partners need not be equal partners; they may own whatever percentage reflects their investment and contribution to the business. Any income or losses of the partnership are then allocated in proportion to this percentage.
In general, a partnership has more legal risk than a proprietorship because a partner may also be liable for another partners' actions. In other words, as a partner, you may be called upon to satisfy in full all liabilities of the partnership. You will, however, have the right to recover from the other partners their proportionate share of the liabilities. Furthermore, when an individual contributes assets to a partnership, he or she retains no claim on specific items, but merely acquires an equity interest in all assets of the partnership. Hence, it is extremely important to have a partnership agreement drawn up to establish the income allocation, rights, and restrictions of all parties involved.
There are two basic types of partnerships. In a general partnership, all partners are jointly and severally liable for each otherís actions.
In a limited partnership, partners may join on a limited basis and are personally liable only up to the amount of their investment. The limited partner is typically a "silent" one who provides only capital and does not take an active part in the business. By law, there must be at least one "general" partner with unlimited liability in the partnership.
As was the case for a proprietorship, each partner must report his or her share of the partnership income or loss on their own personal tax return and any partnership income is subject to personal rates of taxation.
In the corporate form, your business is viewed as a legal entity separate from yourself and has the legal power to do anything which a natural person may do. In fact, it has a perpetual life! Under the incorporated scenario, you are considered a "shareholder" of the corporation through your ownership of its shares. The corporation alone is responsible for its actions and you are personally protected in most situations (see below) since the amount of your liability is limited to your investment in shares.
Because the corporation is viewed as a separate legal entity, it must file its own income tax return and is subject to tax rates different from those of individuals.
Being both an employee and shareholder of the corporation, your remuneration may be a combination of salaries and dividends. At the calendar year end (December 31st), you are still required to file a personal tax return. However, no corporate income over and above the salaries paid to you need be reported on your tax return. Any additional benefits or income from your incorporated business, such as dividends, interest on loans, and other taxable benefits must be reported on your personal tax return as well.
Under any legal form chosen, but especially under an incorporated legal form, it is important that you identify yourself appropriately to the public. That is, if you are operating as an incorporated business, you may not describe yourself as a proprietorship or partnership, and vice-versa. Any incorrect communications (ex. - correspondence, advertising, contracts) may lead to a loss of protection from liabilities.
Furthermore, if a shareholder has not provided any personal guarantees covering the companyís debts, then no creditor can touch the personal assets of the shareholder.
The choice of which legal entity to operate under is not one you should be taking lightly. There are more detailed differences, reasons, advantages, and disadvantages for your choice of an entity. To analyze your decision in more depth, please contact us for more information.
The information presented in this document is of a general nature only and should not be relied upon to replace professional advice. Before acting on this information, talk with a professional adivisor as laws and regulations are constantly changing. Readers accept full responsibility; no document found here is a substitute for a consultation.