How Do You Own Your Business?

A question often put to attorneys is: "Should I incorporate my (fill in the blank) business?" The answer depends on several factors, and involves weighing the advantages and disadvantages of the various forms of ownership that can be chosen for a business venture. Whether you are just starting in the horse business, or are contemplating a change in the structure of an established operation, you should consider the tax implications of the various forms of ownership, legal requirements and formalities, the type of business you want to run, and your own personality and goals.

If you need to raise capital from investors for your business, for example, and you are counting on a public offering of stock to do that, the answer should be an unqualified "Yes." Incorporation might be the only alternative for you. More likely, though, the question arises from an interest in taking advantage of some other traditional reasons for small business incorporation--favorable tax treatment and protection of personal assets from business creditors. For a business person with those goals in mind, incorporation might not be the best choice, and other forms of ownership might be more appropriate. This article provides an overview of the most common forms of ownership, along with some advantages and disadvantages associated with each type. Every situation is unique, though, and you should seek advice from an attorney familiar with equine law and the laws of your state before settling on a particular type of ownership for your business.

A Sole Proprietorship, where the business is owned and operated by a single individual, is the simplest and most common type of ownership. Your horseshoer, your friend who ekes out a living giving riding lessons, your neighbor who boards a few broodmares all are sole proprietors. Quintessential entrepreneurs, they put up the operating capital for their businesses, they make the decisions, they keep the profits and absorb the losses, and they are personally responsible for any debts incurred on behalf of their businesses. The trade-off for the simplicity and flexibility of a sole proprietorship is unlimited personal liability for business debts. At tax time, a sole proprietor records business income and expenses on his or her personal tax return, and pays tax at the individual rate.

A Partnership is a business owned and operated by two or more people. Individuals can form a partnership with little formality, and such "handshake" arrangements long have been common in the horse business. Although a written agreement is not required for a partnership to be valid, committing the partnership arrangement to writing prevents surprises and disagreements. One area of partnership operations where misunderstandings easily can arise involves the distribution of profits or losses to the partners. Potential problems with partnership distributions are a good illustration of the need for a written partnership agreement.

At the time a partnership is formed, each partner contributes money, or assets, or both to the business. Then, at regular intervals, profits and losses from the business are distributed to each partner. If there is no written partnership agreement, and a dispute arises over the amount due each partner, a court might look to default provisions of the Uniform Partnership Act, a statute setting out a model partnership agreement. Some version of the UPA has been adopted in most states, and you should become familiar with the law as it has been enacted where you live.

The default provision of the UPA that governs distributions to partners, for example, requires that profits and losses be shared equally among the partners. The partners can deviate from the default provision, and distribute profits and losses in another manner, distributing a larger share to one partner, for example. In that case, though, the agreement must be in writing. A partnership files an informational tax return, but the business itself pays no taxes. Instead, business profits or losses pass through the partnership to the partners, each of whom records the appropriate share of the profit or loss on his or her individual tax return. The tax each partner pays is determined by the individual tax rate applicable to him or her.

One important advantage of a partnership is access to capital. A few partners can pool their resources and have more capital to start and operate the business than a single individual. One potential disadvantage is that the partners have unlimited personal liability for partnership debts, even if the debts are incurred by only one partner without the knowledge of the other partners.

There are two basic types of partnerships, General Partnerships and Limited Partnerships. In a general partnership, each partner participates in the operation of the business and has unlimited liability for partnership debts. A limited partnership, on the other hand, consists of two kinds of participants, a general partner (or partners), who actually run the business, and limited partners, who have contributed capital to the partnership, but who do not actively participate in the management decisions. A general partner has unlimited personal liability for partnership debts, while a limited partner is personally liable only to the extent of his or her capital investment.

Dogwood Stable president W. Cothran Campbell pioneered limited partnerships for racehorses a few years ago as a vehicle to give persons with limited resources or expertise access to the Thoroughbred business. Campbell, the general partner, became a major player at prominent yearling sales, and the Dogwood Stable horses won a number of important races. The limited partners showed up at racetracks in droves, and it often looked as though the population of a small community were in the winner's circle following a Dogwood Stable victory.

Popularity of limited partnerships for racing purposes has declined in recent years. General partnerships remain an important form of ownership, particularly when a small number of people want to own one or two horses for competition or for breeding.

Running a horse business as a Corporation is a reasonable option for many people, although disadvantages often outweigh the benefits. Today, the primary advantage of the corporate form of ownership is that the owners of the business are not personally liable for the debts of the corporation. Once you make the decision to incorporate, a secondary question is whether to operate as a C corporation or as an S corporation. Under current law, favorable tax treatment for S corporations makes that option a better choice for many small businesses.

Unlike a partnership, which does not pay taxes itself, a C corporation is a taxable entity in its own right, creating a scheme of double taxation. The earnings of a C corporation are taxed twice. The corporation pays taxes on earnings first, then the earnings are taxed a second time on shareholders' individual tax returns, when the earnings are distributed to shareholders as dividends. The initial tax is computed at a corporate rate, while the second tax is based on the shareholders' individual tax rates. Giving the Internal Revenue Service two bites at the apple appears to make little sense, but for years the maximum corporate tax rate was substantially lower than the maximum individual tax rate. A typical business strategy was to distribute corporate earnings to owners and employees as tax-deductible compensation, while accumulating what was left in the corporation. Those accumulated profits would grow at a lower tax rate and later could be withdrawn at a preferential capital gains tax rate when the business was sold.

The Tax Reform Act of 1986 made operation of a C corporation far less attractive by reducing the maximum individual tax rate to a level lower than the maximum corporate rate and by repealing the capital gains preference.

A better alternative for many small businesses is the S corporation, which functions like a partnership for tax purposes while still insulating the business owners from personal liability. There are limits on the number and type of shareholders and the classes of stock that can be issued, and all shareholders must agree to the decision to operate as an S corporation.

Whether you choose a C corporation or an S corporation, you must register the business with the proper officials in your state. Then there are various formalities that must be observed, including regular stockholder meetings, minutes of all meetings, the issuance of stock certificates, election of officers, and maintenance of comprehensive corporate records. If the complexities of operation are not vexing, an S corporation might be a good choice for a small horse operation.

There also are at least two new forms of business ownership, both of which are hybrids of traditional forms. They might or might not be available in your state, and both are too new to have a record establishing whether they are appropriate for horse businesses.

A Limited Liability Company has characteristics of both a partnership and a corporation. The business is treated like a partnership for tax purposes, while shielding the owners from personal liability for business debts like a corporation. A limited liability company provides more flexibility than an S corporation because there are fewer restrictions on the number and type of stockholders. If your state allows limited liability companies to be established, the business must be registered with the appropriate agency, then there are other procedures that must be followed.

Similar is a Registered Limited Liability Partnership. This form of ownership is essentially a traditional general partnership in which the personal liability of the partners is limited in some circumstances, but not eliminated altogether. A filing with the appropriate state agency is required. The tax scheme for a registered limited liability partnership is the same as that for a general partnership.

A disadvantage of both limited liability companies and registered limited liability partnerships is the fact that not all states have adopted legislation authorizing them. It is unclear how a business operating lawfully as either an LLC or RLLP in one state will be received in a state where those forms of ownership are not recognized. If your horse operation does a significant amount of interstate business, a more traditional form of ownership might be a better choice.

When you consider the best form of ownership for your horse business, the first step probably should be a realistic assessment of which factors are most important to you--tax treatment, personal liability for business debts, formalities that must be followed, whether you are willing to share management decisions, and the need for capital. The next step should be advice from your attorney and tax consultant, because they are in the best position to let you know the ramifications of the decisions you make.

About the Author

Milt Toby, JD

Milt Toby is an author and attorney who has been writing about horses and legal issues affecting the equine industry for more than 40 years. Former Chair of the Kentucky Bar Association's Equine Law Section, Milt has written eight nonfiction books, including national award winners Dancer’s Image and Noor. He teaches Equine Commercial Law in the University of Louisville's Equine Industry Program.

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