Businesses in America are constantly evolving, but how they get started has not changed much over the years. We have many different business models, there are Partnerships, Joint Ventures, Franchises, non-profits, Sole Proprietorships, Limited Liability and Corporations. Many of the corporations operating in the country today, started as Sole Proprietorships. According to the Foundations of Business 73% or 31 million of the businesses operating today are run as a Sole Proprietorship.
Many people start this way to minimize cost and wait to see if the business is going to succeed.
Today we are going to explore the advantages and disadvantages of changing a business that is a Sole Proprietorship or Partnership to a Corporation. We know with Sole Proprietorship there is one owner and that individual is solely liable for every aspect of the business. If something goes wrong and a lawsuit ensues, the suing party will go after the owner personally. The business and personal assets of the owner will be at risk. Also, with Sole Proprietorship you have a lack of continuity. This means if the owner dies or is unable to continue working due to illness the business will cease to operate. There is also the problem of having enough money to keep the business going, as most banks and lenders don’t like to lend large sums of money to Sole Proprietors. The same holds true for partnerships, except the liability is spread across more individuals.
Let’s explore changing the business from a Sole Proprietorship or Partnership to a Corporation.
One of the most important advantages is liability to the owner and/or partners. This is huge, because it helps to protect the personal assets of the owner and/or partners. This also means that the Corporation is responsible for the debt of the business, which protects the owner and/or partner from creditors. When the Corporation is in place it helps with the continuity of the business, if there are multiple members or shareholders, they have the option of keeping the business going if something was to happen to the owner or principle member.
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The business will exist until they choose to close it. Sole Proprietors and/or Partnerships do not have to pay business taxes but instead the profits and losses are “passed through” to the individual general partners, according to the U.S. Small Business Administration. Sole Proprietors and/or Partnerships must file a tax return to report losses and profits to the Internal Revenue Service, and general partners include their share of profits and loss in the return. Corporations are required to pay state and national taxes, and shareholders must also pay taxes on their salaries, bonuses and dividends. The corporate tax rate is usually lower than the individual income tax rate, according to the SBA. The Corporation operates as its own entity and this makes raising money come with more options. The company can still borrow for banks or lending institutions, but they can also raise money by selling stock. Some corporations have raised billions of dollars through Initial Public Offerings or I.P.O’s. This money can be used to expand the business or help reduce debt. The transfer of ownership is also an advantage with the Corporation. If the owner/CEO dies, the company has board members and directors who help run the business and it doesn’t rely on one person to keep it going. As the company gets larger, they can attract better managers with specialized training that can assist in the growth of the company.
The disadvantages of setting up a Corporation can be the cost. You will need legal help to properly set up the company. The cost for this can range from $2,500 – $5,000 and more depending on the complete legal needs. There are many forms that are required to be submitted to the secretary of state, which can be daunting if one is not prepared. One of the biggest disadvantages is all the extra paperwork. Once you go public there is no secrecy, stockholders and the government require many detailed reports. The company’s finances and all other activities become public record.
As an example, the Sarbanes Oxley Act of 2002 helped to crack down on corporate accounting fraud by requiring officers and directors to sign off on all reports. This also held them personally responsible for and discrepancies in the reports. This is a good thing, but it just generated more paperwork. There is also a chance of double taxes for the Corporation. The company is taxed for profit’s and then the stockholders can be taxed for profit as well. The company may experience conflicts as more employees are added. The bigger the company becomes the more prevalent conflicts can be and the costlier they can become.
There are many things to consider when changing from Sole Proprietorship to a L.L.C or Corporation. One of the biggest questions is “when should the company make the move?”. If it is looking to protect the owner’s assets, then the answer is now. If this is happening towards the end of the year it might be wise to wait until the first of the year. Depending on taxes the owner does not want to have to file one way for half the year and another for the other half of the year. This will also incur extra cost that are unnecessary.
What is best for the business?
This is a question each business owner must ask themselves. Incorporation or L.L.C really depends on the type of business that is being run, who the owners are and the financial strength of the business. In the end there is not an easy answer as to which way a business should go. It is always best to look at all the advantages and disadvantages and choose what will work best for the business model.
Mayer, Don; Warner Daniel; Siedel, George and Kapor, Lieberman, Jethro K. (2012) Foundations of Business Law and the Legal Enviroment . FlatWorld McDonald, Ann (2015) Is it Time to Convert Your Sole Proprietorship to a Corporation or LLC
Cromwell, John (2014) The Advantages & Disadvantages of Changing the Company Organization From a Sole Proprietorship Belle Wong, J.D. (2015) LLC vs. Sole Proprietorship: www.LegalZoom.com/articles
Bloom, Kenneth J. (2013) Understanding the Pros and Cons of Corporation Versus Sole Proprietorship Vital Before Starting a New Business: bloomlawfirm.com/articles
Kunz, Marnie (2019) 5 Major Differences Between a Corporation and a Partnership. www.smallbusiness.chron.com