Bulletin #3009, Home-Based Business Fact Sheet: How to Organize Your Business

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Adapted for Maine from Iowa by Jim McConnon, Extension Business and Economics Specialist

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Table of Contents:

One of the first things to think about if you’re starting a small business is how you want to organize it. Answering the following questions will help you decide.

  • What is the source and amount of borrowed money for the business?
  • What skills will the business need that I cannot provide?
  • How much personal control do I want to maintain over business decisions?
  • What form of organization will minimize taxation of the business?
  • How much personal responsibility should I take for business debts and liabilities?
  • What will happen to the business if I can no longer manage it?
  • What organization form will best help me to achieve my short-and long-term business goals?

Your answers will strongly influence and be influenced by the legal business form you select. However, that form may change with the growth and needs of the enterprise. One example of a form changing would be a sole proprietorship evolving into a partnership (which could add shared expertise and resources) and then to a corporate structure, which could enhance management continuity and financing capabilities (if shares are sold).

Basically, the form of organization depends on the type of business, how many owners or investors are involved and how tax and liability issues will best be handled. Some businesses, especially for tax and liability reasons, will want to incorporate from the beginning. Others may operate for their lifetime as sole proprietorships. Any time two or more unrelated people are involved in a business, they will probably want to create some type of partnership agreement or a corporation. If you’re considering this option, get help from a tax and legal expert.

The basic forms of business organization, with some advantages and disadvantages, are discussed in this fact sheet.

Sole proprietorship

The sole proprietorship is a business that is owned and operated by one person. It is the simplest and least expensive business structure to form. Many start-up companies choose this form until it becomes profitable to enter into a partnership or corporation. The sole proprietorship form is often useful for a new business because it has a simple structure and is easy to set up. It is the least regulated form of business organization. Its profits are taxed as part of the owner’s individual income. The business owner in a sole proprietorship is responsible for all financing, management decisions and liabilities of the business.

Advantages

  • You are your own boss
  • Less government regulation than other forms
  • Simple structure
  • Ease of formation
  • Business losses lower personal tax

Disadvantages

  • Risk losing business with death or disability
  • Total personal liability
  • Profits taxed as personal income
  • Limited financial resources
  • Limited management potential can only expand with “after-tax dollars”

General partnership

A general partnership is a legal business relationship in which two or more persons agree to share ownership and management of a business. With a general partnership, you can pool capital and management resources of two or more people. It is easy to set up and needs no special registration (except for any trade names the partners use).

A written agreement among partners is not required by law but helps clarify business arrangements and avoid misunderstandings. You may want a lawyer to draw up a written partnership agreement. Any agreement must follow the Maine Code on general partnerships. When signed by all partners, the agreement is an enforceable contract.

The partnership agreement should include:

  • a list of the rights and responsibilities of each partner and his or her heirs
  • the management and continuity arrangements for the business in the event of death or disability of one of the partners
  • the profit distribution plan
  • any special conditions or arrangements that may affect any of the partners through operation of the business

Withdrawal of one partner or adding another automatically ends a partnership unless the agreement says otherwise. So you can avoid business liquidation with a partnership agreement that covers the transition of ownership and continuity of the business.

Partnership liabilities extend to personal assets of each of the general partners. Each general partner is held personally liable for all business obligations of the partnership. Each partner is taxed at his or her personal tax rate on his/her share of the partnership income.

Advantages

  • Simple organization
  • Shared personal resources
  • Shared financial resources
  • The right to select partners

Disadvantages

  • Cost of organization
  • Unlimited liability
  • Limited decision-making
  • Limited life of business
  • Sharing of profit

Limited partnership

A limited partnership is a particular form of partnership that gives investors special tax advantages and protection from liability. The limited partnership is like a corporation in many respects. It allows people to invest in the business, but their liability is limited to the amount of their investment or as agreed in the limited partnership agreement. The partnership must include at least one general partner who has general liability for the debts of the limited partnership. The limited partner usually exercises no control over the business of the partnership but is merely an investor. The general partner usually manages the business.

This form is often typically used to get more funds for a business. Both general and limited partners are taxed at their personal rate on their share of taxable income from the business. The limited partnership itself is not taxed.

A summary of the limited partnership agreement, along with the business name, must be filed with the secretary of state’s office, which sends a copy to the county recorder’s office.

Advantages

  • General partner maintains control of business
  • Limited partner can invest with limit on liability
  • Easy way to secure financial resources
  • The business is not directly taxed

Disadvantages

  • More complex organization
  • Limited partner has no control of business
  • General partner has general liability for the business

Corporation

A corporation is a separate legal entity from its owners, the shareholders. It can make contracts, it is liable for any obligations, and it pays taxes on earnings. It is a legal “person.”

A corporation attracts capital investment funds by selling shares of stock in the company to investors, or trading stocks for assets. Generally, stockholders are not liable for claims in excess of the current value of their shares. Corporate officers may become personally liable in some cases, but generally, creditors can only lay claim on the assets of a corporation.

The corporation’s identity makes its continued life possible. A death or stock sale has little effect on corporate management’s ability to continue with business.

Corporate income is taxed at its own rate. More attractive corporate business tax rates were set with the Tax Reform Act of 1986. The portion of corporate after-tax income given to shareholders as dividends are taxed again as personal income of shareholders.

To incorporate, you must apply to the secretary of state by filing articles of incorporation. The secretary then grants a certificate of incorporation. Sale and exchange of stock are governed by state law, to protect the public investor, and special registration is needed to sell stock to the public. The name of the corporation must be approved by the secretary of state to avoid duplication. The state charges a one-time fee for filing the articles of incorporation with the secretary of state.

After receiving and filing the articles of incorporation and approving the corporate name, the secretary of state sends the document to the county recorder’s office in the county where the office of the registered agent for the corporation is located. The county recorder files the articles of incorporation in the county. There is a one-time charge for this service.

After the county recorder has filed the articles of incorporation, the corporation receives a certificate of incorporation from the secretary of state. The corporation can start doing business, right after the certificate of incorporation is issued by the secretary of state. The corporation must also print a notice of intent to do business in a newspaper with county-wide distribution to establish “good standing” in the county.

Articles of incorporation can be written by members of the corporation or a lawyer. However, using a lawyer or accountant can sometimes help you avoid many problems and pitfalls of establishing a legal corporation in Maine.

Dissolving a corporation in Maine requires two filings with the secretary of state: a statement of intent to dissolve and articles of dissolution.

Corporations are a more costly and complicated form of business organization than partnerships. Articles of incorporation must also be filed in counties where offices are located or real estate is held. Each year, an annual report must be filed with the state. There is a small charge for filing, but the fee goes up as capital assets of the corporation increase.

Many sole proprietors feel they should incorporate to limit their business liability. This certainly is an advantage, but unless the assets of the business are substantial, the officer-shareholder may still have to sign for the business.

Advantages

  • Shared personal resources
  • Shared financial resources
  • Perpetual life increased management capability
  • Easy transfer of business
  • Limited personal liability

Disadvantages

  • Possibility of double taxation
  • Complex organization
  • More costly operations
  • More complicated management
  • More government

“S” corporation

Entrepreneurs who decide on a corporate form of business may want to consider “S” corporate status. Besides limiting liability, the tax advantages are a factor to consider for this option. To qualify for a “S” Corporation structure, a corporation must meet all of the five following requirements.

  1. It must be a domestic (United States) corporation.
  2. It must have no more than 35 shareholders.
  3. It must have only one class of stock.
  4. All shareholders must be individuals, estates or certain trusts.
  5. None of the shareholders can be non-resident aliens.

The “S” structure is a corporate form for smaller businesses that allows a tax burden shift to shareholders. The “S” corporation is not taxed but must file an informational return. Income is given to shareholders and is taxable to the shareholders whether or not it’s distributed to them. Ordinary tax losses are also personal deductions.

You set up an “S” corporation the same way you set up a regular corporation. The “S” structure merely allows for business profits to be taxed on personal income.

Limited Liability Company

The Maine legislature has recently approved a new form of business organization called a “Limited Liability Company” (LLC). The LLC form of organization combines some of the best features of the S corporation and the partnership forms of business. Limited liability companies enjoy the benefits of limited liability associated with S corporations, together with the flexibility of partnerships (in terms of taxation economics and number and types of owners). Contact the secretary of state to learn how to form a limited liability company in Maine.

Conclusion

There is no best method of determining the right form of business organization for your enterprise. You should think about all the factors before you make a decision. If you’re considering starting a business, consult lawyers, tax accountants and other professionals (depending on the nature of the business) for advice.

References

Anthony, Edward L. “Choosing the Legal Structure of Your Firm,” Small Business Administration, Management Aids for Small Manufacturers No. 80, January 1966.

“Steps in Incorporating a Business. Small Business Administration,” Management Aids for Small Manufacturers No. 111, January 1960.

“Steps to Starting a Business.” Small Business Reporter, Bank of America, 1981.

Tax Guide for Small Business. Internal Revenue Service Publication No. 334.

The Home-Based Business Fact Sheet Series

This is one of a series of publications designed for the person entering or considering a new business operation. See the University of Maine Cooperative Extension Online Publications Catalog for the complete Home-Based Business fact sheet series.

Information in this publication is provided purely for educational purposes. No responsibility is assumed for any problems associated with the use of products or services mentioned. No endorsement of products or companies is intended, nor is criticism of unnamed products or companies implied.

© 2001, 2008

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