Sasser Sefton Tipton & Davis

Sasser, Sefton, Tipton & Davis, P.C.
Montgomery, Alabama

Business planning is important for every business regardless of size. From locally owned single person businesses to large corporations, business planning is essential for many vital reasons. This article will outline in a general way some of the most important reasons to engage in business planning and the vehicles utilized to accomplish business planning objectives.

For tax, legal and practical reasons, it is highly important to select a business entity that suits the needs of both the business and its participants. Selecting an improper business entity can result in the assessment of unnecessary taxes against the business or its participants, either during the course of operation or upon its sale or termination. Selecting an improper entity can also result in the needless exposure of one or more of the business participants to personal liability for the debts and liabilities of the business or in the imposition of a management or organizational structure that does not fit the needs of the business. With the numerous entity options available, it is important to take the time necessary to meaningfully select a business entity that fits all of the needs of the business at hand and its participants.

For purposes of selecting a business entity, single person businesses should be distinguished from multi person businesses. The business entities available to a single person business are a sole proprietorship, a corporation, and, in many states, a limited liability company. The corporation may be a C corporation or an S corporation and in some states may be a close corporation. The business entities available to a multi-person business include a corporation, a limited liability company, a general partnership, a limited partnership, a joint venture, and, in some states, a limited liability partnership. Again, the corporation may be a C corporation or an S corporation and in some states may be a close corporation.

A C corporation is a non-Subchapter S corporation; that is, a corporation for which a Subchapter S election is not in effect (such a corporation is referred to as a C corporation in the Internal Revenue Code). A close corporation, which is not provided for in many states, may be a C corporation or an S corporation, but must be organized under a close corporation statute or code. A limited liability company must be organized in accordance with the state Limited Liability Company Act and usually consists of two or more members. Some states, like Alabama, have adopted or are in the process of adopting, provisions to allow single member limited liability companies.

A general partnership consists of two or more general partners and may be created formally or informally. A limited partnership consists of one or more general partners and one or more limited partners and may be formed only by complying with specified statutory requirements. Joint ventures have most of the legal characteristics of general partnerships except that the scope or purpose of the enterprise is narrower. A sole proprietorship is a business that is owned and managed by one person.

STEP ONE

The first step in the process of selecting a business entity is to ascertain the needs and desires of the business and its participants. If there will be minority interests in the business enterprise, it is important to consider their interests as well as the controlling interests. It often happens that the business needs and desires of these groups differs greatly.

In selecting an entity for a small business enterprise, there are several factors that should be considered. The relative importance of each factor varies with the business setting. The factors that should be considered include the following:

(1) Whether the business is a one or multi person business;
(2) Whether the business is startup or established;
(3) The capitalization of the business and the resources of the business participants;
(4) The number of business participants, their relationship with one another, and each participant's degree of involvement in the business;
(5) The importance to the business participants of personal liability protection;
(6) The importance to the business participants of being able to withdraw from the business in an orderly and equitable manner;
(7) The importance to the business participants of the income tax aspects of the business;
(8) The extent to which each participant wishes to have control over the important functions of the business;
(9) The extent to which each participant wishes to be able to control the transfer of ownership interests in the business;
(10) Whether and the extent to which the participants wish to be able to raise capital by selling interests in the business to outsiders;
(11) Whether the business is likely to expand significantly in the foreseeable future, either in its present field or in others; and
(12) The amount or organizational expense that the participants can afford to incur.

STEP TWO

The next step in selecting a business entity is to weigh the needs and desires of the business and its participants against the advantages and disadvantages of each type of business entity. The advantages and disadvantages of each type of business entity for single person businesses and for multi person businesses are as follows:

SINGLE PERSON BUSINESS

A single person business is a business that is owned and managed by one person. There may be other persons involved in the business, but they will be employees or agents of the owner. While the owner may delegate certain management or supervisory powers to employees or agents, the source of delegated authority must come from the owner.

The entity types available to a single person business include a sole proprietorship, an S corporation, a C corporation, and, in some states, a limited liability company. The advantages and disadvantages afforded a single person business with each of these types are as follows:

Sole Proprietorship

The advantages of a sole proprietorship are:

(1) there are few, if any, organizational (start-up) expenses;
(2) for income tax purposes, the profits and losses of the business are those of the owner which means that business losses are deductible by the owner in the year the are incurred and the business profits are not taxed twice;
(3) the owner can organize and manage the business without statutory restriction; and
(4) the owneris not required to register the business with any public official, file any reports or pay any annual fees and may conduct business in any state with registration and qualification.

The disadvantages of a sole proprietorship are:

(1) the owner is personally liable for all debts and obligations of the business; and
(2) it is impossible to add additional owners or partners to the business without changing the business entity.

S Corporation

The advantages of an S corporation in a single-person business are:

(1) the business owner is shielded from personal liability for the debts and obligations of the business;
(2) because the profits and losses of the business are passed through to the owner and reported on the individual tax return of the owner in the year incurred, there is no danger of a double tax; and
(3) additional owners (up to a maximum of 75) may be added to the business without changing the business entity.

The disadvantages of an S corporation in a single-person business are:

(1) unless a close corporation code or statute is applicable, management and organizational
flexibility is limited by the requirements of the state corporation laws;
(2) the business must be registered with the filing official in each state where it conducts significant business and periodic reports must be filed and fees paid; and
(3) organizational (start-up) expenses can be substantial.

C Corporation

The advantages of a C corporation in a single-person business are:

(1) the business owner is shielded from personal liability for the debts and obligations of the business; and
(2) additional owners or partners may be added to the business without changing the business entity.

The disadvantages of a C corporation in a single-person business are:

(1) because a C corporation is a separate taxable entity, there is a danger of a tax at both the corporate and the shareholder level being imposed and business losses may not be personally deductible to the business owner in the year incurred;
(2) unless a close corporation code or statute is applicable, management and organizational flexibility is limited by the requirements of the state corporation laws;
(3) the business must be registered with the filing official in each state where it conducts significant business and periodic reports/fees must be filed/paid; and
(4) the organizational (start-up) expenses can be substantial.

Limited Liability Company (LLC)

In the past, the limited liability company form was not available to single-person businesses. Most states, however, have or are in the process of adopting single person (member) limited liability company statutes. The advantages of a single member limited liability company are:

(1) the business owner is shielded from personal liability for the debts and obligations of the business;
(2) because the entity is disregarded for tax purposes, the profits and losses of the business are treated in the same way as a sole proprietorship (reported on owner's individual tax return);
(3) additional owners or partners may be added to the business without changing the business; and 
(4) because there are few, if any, statutory organizational or management requirements, the owner can organize and manage the business without restriction.

The disadvantages of a single member limited liability company are:

(1) the business must be registered with the filing official in each state where it conducts significant business and periodic reports must be filed and fees must be paid; and
(2) there may be significant organizational (start-up) expenses, but since the company is member-managed such expenses can be kept to a minimum.

MULTI-PERSON BUSINESS

A multi-person business is a business that is owned and managed to some degree by two or more persons. As indicated above, the entities available to a multiperson business include a general partnership, a limited partnership, a limited liability company, a joint venture, an S corporation, a C corporation, and in some states a limited liability partnership. The advantages and disadvantages of each of these entities to a multiperson business are as follows:

General Partnership

The advantages of a general partnership to a small business include the following:

(1) management and organizational flexibility in that the partners may organize and manage the business without statutory restriction;
(2) organizational control whereby each partner has control over important partnership matters such as the admission of new partners and acts in contravention of the partnership agreement;
(3) pass-through taxation whereby the profits and losses of the business are attributed directly to the partners thus avoiding a double tax and rendering business losses deductible by the partners in the year of the loss;
(4) ease of equitable withdrawal whereby each partner can withdraw from the business and obtain equitable compensation for his or her interest in the business;
(5) no requirement for central registration with the state, periodic reports or annual fees;
(6) ease of convertibility from a general partnership to a corporation or a limited liability company; and
(7) the organizational (start-up) expenses are usually less than for other entities.

The disadvantages of general partnerships are:

(1) each partner is personally liable, without limitation , for all partnership debts and liabilities, including those incurred by other partners in the course of partnership business,
(2) interests in the business are not readily transferable; and
(3) it is difficult to raise capital by selling interests in the business to outsiders, especially in large numbers.

Limited Partnership

The advantages of a limited partnership to a small business include the following:

(1) pass-through taxation whereby the profits and losses of the business are attributed directly to the partners thus avoiding a double tax and rendering business losses deductible by the partners in the year of the loss;
(2) personal liability protection for limited partners who do not participate in the control of the partnership business;
(3) management and organizational flexibility;
(4) interests in business are readily transferable; and
(5) capital can be raised by selling limited partnership interests in the business to any number of outsiders.

The disadvantages of limited partnerships are:

(1) there is no personal liability protection for general partners or for limited partners who participate in the control and management of the partnership business,
(2) limited partners may not participate in the control of the partnership business without becoming liable for the partnership debts and may not deduct losses in the year incurred (passive);
(3) the business must be registered with the filing official in every state where significant
business is conducted and periodic reports /fees must be filed/paid; and,
(4) the organizational (start-up) expenses can be substantial.

Limited Liability Company (LLC)

The advantages of a limited liability company (LLC) to a small business include the following:

(1) all of the business owners (members) are shielded from personal liability for the debts and obligations of the business;
(2) if properly organized, a limited liability company is entitled to pass-through partnership taxation in the manner described above for a general partnership;
(3) organizational and management flexibility because of few, if any, statutory restrictions thereon;
(4) ease of equitable withdrawal of interest by withdrawing or deceased member;
(5) ease of conversion from a limited liability company to another entity; and
(6) the organizational (start-up) and annual record keeping expenses are usually less than for a corporation or limited partnership.

The disadvantages of a limited liability company are:

(1) the business must be registered with the filing official in every state where significant business is conducted and periodic reports/ fees must be filed /paid; and
(2) because there is no universally recognized indicia of ownership, it may be difficult to sell interests in the business to outsiders, especially in large numbers.

Joint Venture

A joint venture is an association of two or more persons for the purpose of accomplishing a limited purpose. The advantages and disadvantages of a joint venture are generally the same as those described above for a general partnership. An additional disadvantage of a joint venture is it usually terminates upon the completion of the venture for which it was formed making it difficult to use for a continuing business.

S corporation

The advantages of an S corporation to a small business include the following:

(1) the business participants are shielded from liability for the debts and obligations of the business; and
(2) the benefits of pass-through taxation (as described above for a general partnership).

The disadvantages of an S corporation are:

(1) rigid membership and organizational restrictions are imposed by Subchapter S of the Internal Revenue Code (75 or fewer shareholders, one class of stock, etc.);
(2) the business must be registered with the filing official in every state where significant business is conducted and periodic reports/fees must be filed/paid;
(3) management and organizational flexibility is restricted by the requirements of the state corporation laws and by the Subchapter S restrictions,
(4) unless special provisions are made, it can be difficult for a deceased or withdrawing participant to be compensated for their interest in the business,
(5) conversion from an S corporation to another entity other than a C corporation is difficult; and
(6) the organizational (start-up) and annual record keeping expenses can be substantial.

C Corporation

The advantages of a C corporation to a small business include the following:

(1) the business participants are protected from personal liability for the debts and obligations of the business;
(2) the business can be expanded indefinitely without the necessity of changing the business entity;
(3) if desired, interests in the business can be sold or transferred without restriction to any number of outsiders;
(4) the status of a corporation as a business entity is universally recognized;
(5) the availability of certain types of fringe benefits that are available only to employees of C corporations; and
(6) business earnings can be retained in the business for expansion or other purposes up to certain limits without being taxable to the participants.

The disadvantages of a C corporation are:

(1) because a C corporation is a separate taxable entity, there is a danger of a double tax (i.e., an income tax being assessed at both the corporate and the shareholder level), especially if the business is highly profitable;
(2) management and organizational flexibility is limited by the requirements of the state corporation laws;
(3) the business must be registered with the filing official in every state where significant business is conducted and periodic reports/fees must be filed/paid;
(4) unless special provisions are made, it can be difficult for a deceased or withdrawing participant to be compensated for their interest in the business;
(5) conversion from a C corporation to another entity is difficult; and
(6) the organizational (start-up) and annual record keeping expenses can be substantial.

Limited Liability Partnership (LLP)

A limited liability partnership may only be formed in those states, which includes Alabama, that have amended their partnership laws so as to provide for registered limited liability partnerships. The advantages and disadvantages of a limited liability partnership are the same as those listed above for a general partnership with one major exception--the partners are shielded from personal liability for some or all of the partnership debts and obligations. Limited liability partnerships are used primarily by professionals.

CONCLUSION

In selecting a business entity there are no infallible general rules that are applicable to every small business. Each situation is unique and must be dealt with separately. In selecting the entity best suited to a particular business, the various factors listed above should be applied, considering both the business itself and the personal situations of the participants. The business participants may disagree among themselves on the choice of a business entity, usually because of differing personal or financial situations. Obviously, such disagreements must be resolved before the organization of the business can proceed. It may be possible to accommodate the disagreeing parties by using more than one entity in organizing the business, such as a partnership of limited liability companies.

Many times the business participants will have decided in advance on the type of business entity, either on their own or on the advice of an acquaintance. In such cases, the participants should at least be made aware of the advantages, if any, offered by other business entities, and, more importantly, advised of any pitfalls or disadvantages inherent in the entity they have chosen. In the final analysis, of course, the decision on the choice of business entity must be made by the business participants, but it is important that the decision be an informed one.

In order to effectively select and form a business entity, it is essential that legal counsel be consulted. The law is constantly changing and evolving and such changes in the law may affect entity selection. Furthermore, the choice of entity will be greatly influenced by the specifics of each particular transaction. As a result, each individual circumstance cannot be fully analyzed and explained in a general manner, but must be addressed on an individual basis. For these reasons, professional legal counsel should be sought to select and form any business entity.

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