What is a Sole Proprietorship? Part 3 of 3: Formation

This is the third and final part of three covering the Sole Proprietorship entity.  What follows is a (very) brief discussion of its general formation.

 

There are generally no state or federal registration requirements for forming a sole proprietorship.  The most important, and sometimes only, step in forming a sole proprietorship is obtaining a business license from your municipal or local governmental authority.  Prior to engaging in any business, however, be sure that you obtain any and all necessary licenses, permits, or exemptions.  For instance, you may need a use permit or exemption if you plan on running your business out of your home as there are often zoning restrictions in residential neighborhoods that limit or prohibit business operations.

 

If you intend on using a business name that is different from your personal name, then you will likely have to file a “fictitious business name statement” or a “doing business as” with your municipal or local governmental authority, and then publish your “d.b.a.” in the local newspaper for a required period of time.

 

If you do not hire employees, then your Social Security Number will double as the business’s tax identification number.  If, however, do you hire any employees, you will need to obtain a federal employer identification number (“FEIN”) by filling out and filing IRS Form SS-4, or just doing it online.  As a final matter, because you have no sheild against liability, like you can enjoy with a corporation or LLC, investing in a solid insurance policy (and possibly with umbrella coverage) is critical.

 

Take Away Thoughts

 

Sole proprietorships offer an entrepreneur the opportunity to form a business entity quickly, easily, and cheaply.  An entrepreneur must be mindful that in operating as a sole proprietor, however, his or her personal assets will be exposed to the business’s creditors.  The self employment tax also can sting.

What is a Sole Proprietorship? Part 2 of 3: Taxation

This is the second part of three covering the Sole Proprietorship entity.  What follows is a (very) brief discussion of its general tax treatment.

Federal and state income tax authorities consider a sole proprietorship to be a “disregarded entity,” and treat all income and expenses of the business to be the owner’s personal income and expenses.  A sole proprietor must also pay the federal “self employment tax,” which is currently assessed around fifteen percent (15%) of all net earnings.  This can end up being quite a lot, and a common strategy to minimize this burden is to form an S corporation and pay yourself a reasonable, yet small salary.  That gets into some higher level stuff, but keep that idea in your arsenal when you go to meet with your attorney.

A sole proprietor who hires employees will have to pay all relevant taxes and withholdings associated with employment.  A sole proprietor will also have to pay other miscellaneous state taxes, such as sales tax and the like.  A sole proprietorship is no different than any other business entity in this regard.

What is a Sole Proprietorship? Part 1 of 3: Organization and Structure

The following is the first part of three discussing the basics of a sole proprietorship entity.  This will be an ongoing blog series involving different entity choices and aspects of them.  Visit back from time to time to learn more and see when new posts are available!

 

Organization and Structure

 

A sole proprietorship essentially comes into existence when a single individual begins running his or her own business.  Yes, you should get a business license, a federal employer ID number, insurance coverage, and file a fictitious name statement, but “hanging a shingle” is about all there is.  A sole proprietor can hire employees or independent contractors, but the sole proprietor is the only owner.  If a sole proprietor takes on another owner—or vests someone else with enough responsibility to make them a de facto owner—the law will very likely treat that business entity as a partnership.

 

The benefits of a sole proprietorship are that it is often the simplest, quickest, and cheapest business entity to form and manage.  As a sole proprietor, sole management authority rests in you as the business owner.  Depending on your personality and risk tolerance, this characteristic can either be a benefit or a drawback.

 

With sole ownership and management responsibility comes personal liability.  This is the most important point about sole proprietorships: a sole proprietor is personally liable for all of the debts and obligations of the business.  In other words, if you were subject to a judgment from a lawsuit that exceeded the amount of capital you had contributed to your business plus any accumulated revenue, the defendants could go after your personal assets to satisfy the judgment.

 

Taxation and Formation forthcoming in future blog posts!

Options and Rights of First Refusal

Whether I am dealing with business partners or parties to a real estate transaction (whether a purchase or lease), one main concern that pops up is what will happen to the asset in the future.  In particular, one or more of the parties will want to have some kind of obligation that the other must deal with them when it comes to the future ownership of the asset.  This is where options and rights of first refusals come in.  While they are very similar types of agreements, they have some important differences.  In fact, poor drafting can lead to a misunderstanding between the parties as to what kind of right they are dealing with.  This is especially the case if a single agreement couples an option with a right of first refusal.  Unless extreme care is taken to distinguish between the two rights, especially if applied to the same property or asset, you may find yourself in a messy lawsuit later.

What follows is a quick snapshot of these and related rights and agreements.

Options:

Options are most commonly found with relation to real property, and not personal property or business assets.  An option gives the option holder (called an Optionee) the right to purchase the subject real property and the right to compel the owner of the property to make the sale.  The Optionee has the discretion of determining when to agree to purchase the property (called “exercising the option”) so long as the option is exercised within the time specific in the agreement.  For instance, the agreement may give an Optionee five years in which to exercise the option.  If the Optionee attempts to do so after that time, the option will have expired, along with any rights it may have conferred.

Options can exist on their own or be made part of a lease or real estate purchase deal.  In a lease transaction, the landlord would grant the tenant a right to compel the landlord to sell the property at the tenant’s discretion.

Of all the rights I will discuss in this posting, option rights are the strongest.  The Optionee has the ability to acquire the property regardless of whether the owner wants to sell.  So long as the Optionee exercises the option in the appropriate time and pays the appropriate purchase price (which may be agreed-to later), the owner must sell.  For this reason, options ordinarily require payment, or consideration, in exchange for granting the right.  This is because the owner is giving up a significant right itself: the free alienability of the property.  The owner cannot freely sell the property once an option is attached.  To make up for this burden, the Optionee has to compensate the owner.  This compensation is over and above the price paid for the property, if the option is exercised.

Due to the fact this right costs the Optionee money out of pocket and because it significantly limits the owner, the parties may wish to pursue one of the following rights.

Rights of First Refusal:

Rights of First Refusal (ROFR) are common in both real estate and business law transactions.  A ROFR gives a party the right to purchase the subject asset IF the other party wishes or attempts to transfer the asset to a third party.

Applied to business law, rights of first refusal are critical if you have business partners.  Whether a true partnership, a corporation, or a limited liability company, the owners of those entities should square away what happens when any of them leaves, sells, or dies.  If the other owners want first crack at buying away the ownership from a third party, a ROFR is a vital solution.

Applied to real estate transactions, this gives the ROFR a weaker right than an option.  Unlike an option, an ROFR holder does not have the right to compel a sale.  The holder only has the right to buy the asset on the same terms as the third party is proposing to buy the asset.  Although this is weaker than an option, it still creates some barriers to the free alienability of the land.  If that is still a major concern for the property owner, the owner can avail itself of two other, less-commonly used rights, discussed below.

Rights of First Offer:

Even weaker than the ROFR is the Right of First Offer (ROFO).  A ROFO gives the right holder the right to present the owner of the property with the first offer price for the property prior to taking any other third party offers.  The trick is that the terms of the agreement restrict the owner from accepting any later third party offers that are the same price or cheaper than what the holder offered (the exact terms of which can be subject to negotiation).  The major limitation from the holder’s perspective is that the holder has to make an offer blindly, without knowing what third parties will be offering.  With the ROFR, the third party has already made an offer, and now the holder must match it.  The ROFO is obviously more advantageous to the property owner than the right holder.

Rights of First Negotiation:

Arguably the weakest of these rights is the Right of First Negotiation (ROFN).  The ROFN gives the holder the exclusively right to negotiate with the owner of the property for a set period of time if and when the owner decides to sell the property.  Although such an agreement would contain obligations to deal with each other in good faith, there is no affirmative obligation on the part of the owner to sell to the holder.  Obviously, this would be a disfavored right by any truly interested purchaser.

The outline above was intended to give you a small outline of some of the possibilities that are available in this area of law.  Each of these rights must be drafted with particularity and to avoid any ambiguity.  Chances are the holder will have these rights for years to come, so it is importantly it is done correctly at the beginning.  If you need any assistance with this complicated area of the law, contact our law offices.