This is a first of a series of articles on business entity selection that will discuss the general considerations of selecting a business entity and discuss the attributes of sole proprietorships.
In Pennsylvania, there are a wide variety of business forms available to business owners, including the following:
Limited liability company (LLC)
There are advantages and disadvantages to each of these forms of ownership. This article will touch upon some of the advantages and disadvantages of each business form. Obviously, this is a complex issue as every business has its unique issues so we strongly advise engaging legal counsel to assist in making this decision.
One of the most critical decisions a business owner will make is choosing a legal entity for the business. There are a variety of factors that influence this decision with the main considerations being the following:
Degree of control
Cost of establishing and administering business entity
Ability to raise capital
Taxation—federal, state and local
Division of profits
Business succession issues
Degree of control refers to the amount of control an owner wishes to exercise over the business. Depending on the form of ownership chosen the business may be controlled by one individual or the creator of the business may be just one voice among many. Many factors influence the degree of control that an owner may desire, including the size, financing needs, complexity as well as other factors.
Different ownership forms also come with different costs of establishing and administering the business. Factors influencing costs are government fees, regulatory compliance costs, fiduciary considerations among many others.
The ability to raise capital for the business is directly affected by the form of ownership chosen. The need for capital is influenced by the type of business (manufacturing usually being more capital intensive than service industries), the size of the business as well as the personal resources of the business’ founders.
Different forms of ownership also come with different degrees of personal liability for the business owner. These differences are generally dictated by state law.
Taxation is a very important consideration in choosing a form of ownership. There are various tax advantages and disadvantages depending upon the form of ownership chosen. The type of business, the size of the business and business succession considerations all impact this decision.
Different forms of ownership also accommodate different divisions of profits. Choosing a form of ownership that divides profits between more than one person is usually related to the business’ need for capital.
Business creators can have various ideas for the continuation of their business beyond their involvement. Depending upon circumstances, some businesses simply close when their creator ends his or her involvement others may desire for the business to continue without their direct involvement and still others desire to sell their interest. The ability to carry out these intentions is very much affected by the form of business chosen.
In this first installment of our articles on business formation we start with a discussion of the simplest form – a sole proprietorship.
Simply stated, sole proprietorship is ownership by one individual. This entity offers an owner complete control of his or her business and entitles the owner to all the profits. One of the downsides to this form of business however, is the inability to raise capital from outside investors. Any financial needs of the business that cannot be satisfied by the individual proprietor would have to come from loans, which obviously come with a cost. Thus, this form of ownership may not be suitable for a capital-intensive business that plans to grow quickly.
The cost of establishing a sole proprietorship is minimal compared to other forms of ownership. If the business wishes to operate under a fictitious name it must register the name with the Pennsylvania Department of State for a $70 fee. The fictitious name registration must also be advertised in two newspapers which costs between $150 and $200.
While sole proprietors enjoy complete control of the business, they also remain personally liable for all aspects of the business, including claims of creditors, damages from lawsuits and the obligation to pay all taxes of the business. These liabilities can be mitigated to some extent by insurance but they cannot be completely avoided. Individuals with significant personal assets may find putting their personal assets at risk an unattractive idea and may be better off with a different entity.
Sole proprietorships pay federal taxes through the owner’s tax return by filling out a Schedule C to IRS Form 1040. Sole proprietorships are also subject to the federal self-employment tax which for 2017 is 15.3% on income up to $127,000.00 and 2.9% on income above that rate. In Pennsylvania, sole proprietorship profits are subject to the state income tax which is 3.07 as well as local wage tax which varies by municipality.
Sole proprietorships can also create some issues if an owner wants to sell the business. As a sole proprietorship, in many cases there is no separate business entity that can be sold so usually the only thing that can be sold are the assets of the business. Prospective buyers may not be willing to pay as much as they would for an actual business entity, especially in cases where the business entity has built up a good reputation over the years that has generated a lot of goodwill with its clients.
Because many sole proprietors wish to retain some participation in the business, they are often not sold but instead the assets pass at the owner’s death. The assets of the sole proprietor could be subject to Pennsylvania inheritance tax at the death of the sole proprietor. Pennsylvania inheritance tax rates for transfers at death are 0% to spouses, 4.5% to direct descendants are lineal heirs, 12% to siblings and 15% to others. Thus, sole proprietors need to think through business succession issues.