NFIB

Selecting the Best Legal Structure for Growth: Part I - Proprietorship
10/ 01/ 2002

by Andrew Sherman

Choosing or changing the appropriate legal structure--proprietorship, partnership, corporation or limited-liability company--is a complex issue because of the inherent tax consequences and liabilities for the owner(s), and because the structure selected will determine what capital-formation options are available. Many factors will affect your choice, including the number of owners involved, the need for management flexibility and the level of interaction with the public. Today's and following workshops will give you an overview and comparison of the basic business formats to consider, both at the outset of a new venture and periodically throughout your company's growth.

Proprietorship

A sole proprietorship is the simplest business form: an unincorporated company owned and operated by one person who directly and personally owns the assets used in the company. To establish a sole proprietorship, you need only whatever licenses are required in your line of work--there are no annual fees required to maintain ownership. All profits and losses flow directly to you and appear on your federal tax returns. In lieu of Social Security taxes paid equally by an employer and employee, your company's net earnings are subject to self-employment tax. Generally, any payments for personal coverage under hospitalization, life insurance or medical plans can't be deducted as a business expense, but payments for employee coverage are deductible. You may establish a retirement plan and deduct contributions as an adjustment to total gross income but not as a deduction from income.

The biggest advantages to a proprietorship are that you maintain exclusive control, it's simple (compared with other forms of ownership), there are lower start-up costs and you are not taxed as both an individual and a business (commonly referred to as "double taxation").

The primary disadvantage is that, as the proprietor, you are personally responsible for all business liabilities and, therefore, creditors may force you to use your personal assets to satisfy the company's debts. However, insurance may be available that will limit your liability for business debts. Another significant drawback that becomes relevant if you want to raise capital is that the proprietorship structure significantly inhibits the range of available money-raising strategies because there's no way to share equity, and you'll need to personally guarantee any debt.

The proprietorship may seem most appropriate to a typical "mom-and-pop" operation, but if the business fails, you and your family could face disaster. For most small businesses, it's better to choose a form of ownership that provides for limited personal liability.

Andrew Sherman is internationally recognized as an authority on the legal and strategic aspects of entrepreneurship and business growth. As a senior partner with McDermott, Will & Emery, he manages a multi-million dollar corporate and transactional practice, representing Fortune 1000 corporations as well as hundreds of technology-driven, netcentric and rapidly growing businesses.

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