Small businesses have four different ways of organizing, depending on the particular needs of the owner(s):
Each of the above forms of doing business has advantages and disadvantages. The tradeoffs involve ease of organization, formation expense, personal liability, and tax consequences. There is no one way to do business. Each business has to consider its own individual characteristics and not adopt a form that is a current "buzz" among people.
Sole Proprietorship
Sole proprietorship is the easiest and quickest form of doing business. There is only one owner of the business, and there are no organizational documents needed.
A business license has to be obtained from the City and/or County in which the business operates and a sales tax number has to be obtained from the State for retail sales. The owner needs to apply to IRS for a taxpayer identification number---this is sometimes called a "62 number" since it usually begins with 62 followed by seven digits.
Net earnings of a sole proprietorship are taxed directly to the individual owner, although there is no Tennessee income tax. The owner files a Schedule C with his income tax return which reports gross receipts, allowable expenses, and net profit which is then included in the owner's income on form 1040. Some small sole proprietorships can prepare and file their own tax returns, but it is advisable to have at least initial tax advice from a professional. Certain tax aspects, such as depreciation and payroll taxes, require professional assistance.
The disadvantages of a sole proprietorship include unlimited personal liability of the owner and difficulty in transferring ownership to others. The owner is individually liable for everything associated with the business. Creditors can reach any and all of the owner's personal assets. The only method of protecting the owner is to obtain requisite liability insurance. Consult your insurance agent for the proper kind of insurance you need, paying close attention to the kind of coverages available before deciding the cost of the coverages.
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Partnership
A partnership is similar to sole proprietorship, except it is for two or more owners. A partnership can be either general or limited. In a general partnership each partner participates in management of the business and shares profits according to investment. However, each partner is liable jointly and individually for debts and liabilities of the partnership. In a limited partnership there is one or more general partners who run the business and accept personal liability, and other partners called limited partners (sometimes called "silent" partners). Limited partners cannot participate in running the business, but share in profits, losses, and liabilities according to their investment. Limited partners do not have personal liability.
Although there is no requirement of a partnership agreement (the State's Uniform Partnership Act provides an implied agreement in default of an actual agreement), it is recommended that the partners have a written partnership agreement prepared by a professional setting forth their rights and responsibilities.
The tax advantage to a partnership is that losses can be claimed by the owners on their personal income tax in the year in which the loss occurs. A partnership income tax return is filed which includes Schedules K-1 that reports any profits or losses to each partner. The partnership itself does not pay income tax, Federal or State.
Partnership property is considered "personal property" even though the partnership owns real property.
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Corporation
A third form for an entity doing business is the corporation. The corporation is a separate entity from the owners, and in law is generally considered a "person." Owners are shareholders who have limited ownership rights to the corporation. Shareholders generally do not participate in management or decision making unless they are also a director of the corporation.
Shareholders do not have personal liability for the corporation, although they can lose their investment in the corporation. Even though there is no personal liability, it is still recommended that the company carry sufficient and appropriate liability insurance.
Formation of a corporation requires a charter and bylaws as a minimum. The charter is filed with the Secretary of State and recorded in the Register of Deeds Office in the county of its principal office. The charter contains various required information as well as optional provisions. A corporation's charter is similar to a constitution for a government. It contains the most basic provisions and is the most difficult to change. Bylaws are similar to the laws of a government---they set forth the basic day-to-day provisions of the corporation, such as number of directors, officers of the corporation, voting rights of shareholders and board of directors, etc. Bylaws are not filed with the State, but must be furnished to each shareholder.
Generally, a corporation can be formed and owned by one or more individuals. However, two people are required for officers since the secretary and president cannot be the same person. An officer does not have to be a shareholder.
The disadvantages of a corporation include non-recognition of losses on owner's personal tax returns, and complexity of operation. Corporate losses generally are not recognized by the shareholders, but are carried forward to be off-set against future profits. A corporation has to conduct board of director meetings and shareholder meetings as well as minutes of such actions, although many actions can be taken by written consent.
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Limited Liability Company
Tennessee recently adopted the Uniform Limited Liability Company Act with a few modifications. The Act essentially establishes a new form of business enterprise that has the advantages of being taxed as a partnership but retaining the limited liability of a corporation.
There are Limited Liability Companies (LLC's) for general business, and Professional Limited Liability Companies (PLLC's) for certain professional organizations, such as doctors, attorneys and accountants.
The limited liability company has many of the same characteristics of partnerships---two or more owners, profits and losses shared according to investment, losses can be recognized by owners individually in the year in which they occur. An LLC is also like a corporation because the owners have limited liability and management is performed by a board of directors.
Tennessee LLC's are now taxed similar to corporations. The corporate franchise and excise tax is applicable to LLC's and taxes both net income and a percentage of the value of assets. For the small business, however, the F&E tax is not a real detriment to this business entity because the Federal income tax advantages are generally superior to a general partnership.
An LLC, similar to a corporation, files Articles of Organization with the Tennessee Secretary of State and records the same with the Register of Deeds Office. An Operating Agreement replaces the bylaws of a corporation. Other terminology of officers and owners is different, but follows the scheme of a corporation.
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