Business Law

Legal Form for Your Business

When you start a business, you must decide on a legal structure for it. Usually, you’ll choose either a sole proprietorship, partnership, limited liability company (LLC), or corporation. No single choice fits everyone.

For many small businesses, the best initial choice is either a sole proprietorship or, if more than one owner is involved, a partnership. Either one of these structures makes especially good sense in a business where personal liability is not a big worry (for example, a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money). Sole proprietorships and partnerships are relatively straightforward and inexpensive to establish and maintain.

Forming an LLC or a corporation is more complicated and costly, but it’s worth it for some small businesses. The main feature of LLCs and corporations that makes them attractive to small businesses is the limit it provides on the owners’ personal liability for business debts and court judgments against the business. Another factor might be income taxes; you can set up an LLC or a corporation in a way that lets you enjoy more favorable tax rates. In certain circumstances, your business may be able to stash away earnings at a relatively low tax rate. Also, an LLC or corporation may be able to provide a range of fringe benefits to employees (including owners) and deduct the cost as a business expense.

Given the choice between creating an LLC or a corporation, many small business owners will be better off going the LLC route. For one thing, if your business will have several owners, the LLC can be more flexible than a corporation in the way you parcel out profits and management duties. Also, setting up and maintaining an LLC can be a bit less complicated and expensive than a corporation.

But there may be times a corporation will be more beneficial. For example, because a corporation (unlike other types of business entities) issues stock certificates to its owners, a corporation can be an ideal vehicle if you want to bring in outside investors or reward loyal employees with stock options.

Keep in mind that your initial choice of a business form doesn’t have to be permanent. You can start out as a sole proprietorship or partnership and, if your business grows or the risks of personal liability increase, you can convert your business to an LLC or a corporation.

 

Type of Entity Main Advantages Main Drawbacks
Sole Proprietorships ·      Simple and inexpensive to create and operate

·      Owner reports profit or loss on his/her personal tax return

·      Owner is personally liable for business debts
General Partnership ·      Simple and inexpensive to create and operate

·      Owners (partners) report their share of profit or loss on their personal tax return

·      Owners (partners) personally liable for business debts
Limited Partnership ·      Limited partners have limited personal liability for business debts as long as they don’t participate in management

·      General partners can raise cash without involving outside investors in management of business

·      General partners personally liable for business debts

·      More expensive to create than general partnership

·      Suitable mainly for companies that invest in real estate

C Corporation ·      Owners have limited personal liability for business debts

·      Fringe benefits can be deducted as business expense

·      Corporate profit can be split among owners and corporation, resulting in lower overall tax rate

·      More expensive to create than partnership or sole proprietorship

·      Paperwork can seem burdensome to some owners

·      Separate taxable entity

S Corporation ·      Owners have limited personal liability for business debts

·      Owners report their share of corporate profit or loss on their personal tax returns

·      Owners can use corporate loss to offset income from other sources

·      More expensive to create than partnership or sole proprietorship

·      More paperwork than for a limited liability company, which offers similar advantages

·      Income must be allocated to owners according to their ownership interests

·      Fringe benefits limited for owners who own more than 2% of shares

Professional Corporation ·      Owners have no personal liability for malpractice of other owners ·      More expensive to create than partnership or sole proprietorship

·      Paperwork can seem burdensome to some owners

·      All owners must belong to the same profession

Nonprofit Corporation ·      Corporation may not have to pay income taxes

·      Contributions to some charitable corporations are tax-deductible

·      Fringe benefits can be deducted as business expense

·      Full tax advantages available only to groups organized for the following purposes: charitable, scientific, educational, literary, religious, testing for public safety, fostering national or international sports competition, and preventing cruelty to children or animals

·      Property transferred to corporation stays there; if corporation ends, property must go to another nonprofit

Limited Liability Company ·      Owners have limited personal liability for business debts even if they participate in management

·      Profit and loss can be allocated differently than ownership interests

·      IRS rules allows LLCs to choose between being taxed as partnership or corporation

·      More expensive to create than partnership or sole proprietorship

·      A member’s entire share of LLC profits may be subject to self-employment tax

Professional Limited Liability Company ·      Same advantages as a regular limited liability company

·      Gives state-licensed professionals a way to enjoy those advantages

·      Same as for a regular limited liability company

·      Members must all belong to the same profession

Limited Liability Partnership ·      Mostly of interest to partners in old-line professions such as law, medicine, and accounting

·      Owners (partners) aren’t personally liable for the malpractice of other partners

·      Owners report their share of profit or loss on their personal tax returns

·      Unlike a limited liability company or a professional limited liability company, owners (partners) remain personally liable for many types of obligations owed to business creditors, lenders, and landlords

·      Often limited to a short list of professions

 

Prepare for Ownership Changes with a Buyout Agreement

If you are in business with others, there’s a good chance that there will be ownership changes as the years go by. That’s true whether you organize your business as a partnership, a limited liability company (LLC), or a corporation. Ownership changes may be the last thing you want to think about when the business is brand new. However, the fact is that many things can happen down the road—or maybe a few steps away—to affect the ownership of your business. For example, you or a co-worker may:

  • decide to move out of state to pursue a new line of work
  • become physically or mentally challenged—or even die
  • seek to buy out a co-owner’s interest in the business
  • want to sell to an outsider

What happens then? Will the transition proceed smoothly and fairly, or will there be discord and, possibly, lawsuits? The answer may depend on how well you have planned for the future. Without careful planning, the business itself may be in jeopardy. In an extreme case, all the time and money that you and the other owners have put into the venture may evaporate as the business falls apart.

Certainly, during the sunny, optimistic days when you’re putting the business together, it’s hard to focus on disruptive changes that you may face in the future. It’s equally difficult to do so when the business is humming merrily along. But planning ahead can save all involved from a ton of grief.

Most businesses with two or more owners should put together a buyout agreement; traditionally these are known as “buy-sell” agreements. This principle applies regardless of the legal format you’ve chosen for your business. Partners in a partnership, shareholders in a corporation, and members of an LLC will all benefit from well-drafted buyout provisions.

A buyout agreement is a binding contract among owners of your business that controls the buying and selling of ownership interests in that business, much like a “premarital” agreement for business owners. When a co-owner is thinking about selling or giving away his or her interest, a good buyout agreement steps in to give the continuing owners some control over the transaction. Often the agreement will regulate who can buy the departing owner’s interest and at what price, or sometimes whether the co-owner can sell at all.

Importantly, a buyout agreement helps ensure that you and your co-owners aren’t forced to work with strangers or other people you won’t get along with. It provides an exit strategy. It can help ensure that if a co-owner leaves the business, that person will receive a reasonable sum in exchange for his or her ownership interest, or if a co-owner dies, the heirs will be paid fairly.

Typically, a buyout agreement also gives the business and its continuing owners a chance to buy out an owner who’s stopped working for the business or has died. This eliminates the possibility that active owners will be forced to share profits with an inactive owner or an unsuitable new owner. Some buyout agreements also say that if an owner dies, the surviving owner can force the deceased owner’s estate representative or inheritors to sell back the deceased owner’s interest to the company or its surviving owners. Similar provisions may apply when an owner decides to retire after a certain time or becomes challenged and can’t actively participate in the business.

 

Trademark and Service Marks

A trademark or service mark normally consists of a word or words (or other significant) that identify a product or service as different from all others. Buick automobiles, Saab automobiles, Blue Shield health plan, and Kaiser health plan are all examples of trademarks.

For most small businesses, a trademark or service mark will consist of words or a logo. Occasionally, a business can obtain trademark or service mark protection for a product shape, color, or scent that’s linked exclusively to the source company in consumers’ minds. For example, the distinctive “curved and ribbed shape” of the old Coca-Cola bottle is a federally registered trademark. But such protection is not easy to come by.

Trademark law is the primary tool that businesses use to protect the symbols and words that identify the origin of services and products. The basic rule is that the first user of a distinctive (that is creative or unusual) name or symbol gets the exclusive right to use it on relevant goods or services. The twin goals of trademark law are to

  • prevent businesses from getting a free ride off the creativity of others in naming and distinguishing services and products, and
  • prevent customers from being confused by names that are misleadingly similar.

If you’re the first user of the mark on certain goods or services, you can register the name or symbol with the Unites States Patent and Trademark Office (USPTO). Registration enhances your rights, particularly your ability to go after infringers because it places competitors on nationwide notice of your ownership of the mark. And even if don’t get around to registering your rights as soon as you begin using the trademark, you’ll probably be able to stop later users of a similar mark, provided that you used it first within a specific region.

Trademark laws are powerful, but not all-encompassing. They don’t automatically protect a business name (the name of your company). There are various rules as to what qualifies as a trademark and not all terms or logos meet the test. Essentially, to be considered a mark, a business name must create an association between consumers and your product or service.