Do Business Well

Here are two examples of what can happen. Let’s say that you currently own your own home, which is worth $150,000, and it has a mortgage of $70,000. You also have stocks and other holdings worth $25,000. You intend to open the business with your savings of $20,000. After six months in business, you decide to close down due to continuous losses. You are out of cash and owe suppliers $40,000. You signed a lease that has eighteen months to go at $500 per month. You also failed to pay employee tax deposits of $10,000.

Your vendors, the landlord, and the government will go after your home, stock, and anything else that isn’t nailed down to collect the $59,000 you owe. And they will have every legal right.

In case number two, you go into the business with every penny you can scrape together. You live in an apartment and drive an old, beat-up VW. Five years later you are very successful. You have net assets worth $500,000 in addition to the book value (assets minus liabilities) of the business. One of your customers has an accident using one of your products. The manufacturer is out of business. You are the retailer. The customer successfully sues your business for $2 million. Your insurance pays the first million. Your business is able to come up with another $250,000. Your customer may next go after every asset you own personally.

This liability exposure is true for sole proprietorships, partnerships, and the general partners in a limited partnership. Only through incorporation can you escape this potential disaster.

Regarding the tax flexibility issue, 100 percent of the income of the business is taxed at the rate applicable to the owner as an individual. Under tax law in 1991, there is a slight advantage over regular corporation taxation. Of course, the government is always changing the rules, so consult your attorney or CPA to determine the current situation.

Regardless of the small current advantage in actual tax percentages between sole proprietorship and corporations, the real problem for the sole proprietor is the lack of flexibility. The owner of a corporation will have an easier time writing off certain expenses that may be perceived as personal or partly personal in a corporate tax return than will his counterpart in a sole proprietorship. In the second instance the small business return is part of the owner’s tax return. With a corporation, it is an entirely different filing. We don’t mention these issues of scrutiny with any intention of suggesting illegal tax avoidance. The point is, in a sole proprietorship situation even appropriate write-offs will get a tougher look in the owner’s personal tax return.

A sole proprietor also has fewer options for pension, profit sharing, and employee benefit programs. Many of these have substantial tax advantages, but are only available to corporations.

Additionally, you may not be able to raise funds as easily with a sole proprietorship. Banks and other financial institutions who lend to companies prefer that the owner’s liability be limited to the net worth of the business, as in a corporation. Why? Because, unless the corporation is rock solid, the bank will also ask for a personal guarantee from the owners. Then it will be the only entity that can attempt to take your personal assets if your company fails. In the case of a sole proprietorship, all creditors would have access to the owner’s personal assets.

You are also limited in raising funds from others. The only method available is loans. Only through the other enterprise types can you raise money by offering ownership.

Partnerships. A partnership is identical in every aspect to a sole proprietorship except that everything is split among the partners. Thus, the personal liability will now extend to any partner. Creditors or individuals with judgments against the company can now attempt to get satisfaction by attaching any or all the partners‘ assets.

The partnership does file a separate tax return, which helps to make expenses easier to claim. However, the same tax-advantaged programs (pensions, profit sharing, and so forth) that are unavailable to the sole proprietor are also unavailable to partnerships.

When it comes to raising money, the partnership has an advantage in that banks now have potentially greater assets to use as collateral to secure loans. They will ask for personal guarantees from each partner. In addition, partnerships are often used as a method to raise capital by adding owners. If your partnership now has two individuals owning 50 percent each, it may be possible to entice a third partner to bring extra money into the business by giving up part of that ownership. For instance, you may need fifty thousand dollars. A potential investor who likes your business says he is willing to put in the funds for 40 percent of the business. This would leave you and your original partner with 30 percent each. It is possible to do this as often as you like. There is no limit to the number of partners in a partnership.

Limited partnerships. This form is much like a regular partnership except that only the “general partners” have unlimited liability. The “limited partners” (investors) have their liability limited to the amount of their investment. The determination of who is a general and who is a limited partner is decided solely by the partners. And generally, limited partners are not actively involved with the day-to-day running of the business.

Corporations. The second most popular form of enterprise is the corporation. It provides the ultimate protection from personal liability and the maximum amount of flexibility. In addition, the small corporation may be the least scrutinized form of business by government or tax authorities. The corporation generally has a wider range of ways to raise funds. Finally, the corporation enjoys the widest range of opportunities for special tax benefits.

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