Starting a new business is one of the most stressful events in a person’s life. Where do I begin? What do I sell/make/provide? How much is it going to cost? How do I finance it? What type of business entity do I form?
While we’re available to help you with any and all of these questions, today we’ll give you a brief overview of the different types of entities available to help ease the burden of deciding which one best suits your business.
The simplest option is the sole proprietorship. A person who undertakes a business without any of the formalities associated with other forms of organization has created a sole proprietorship. No state filing is required and no separate tax return is prepared. The minimum amount of paperwork required is filing a DBA if you are operating a sole proprietorship under a name other than your personal legal name. The business owner reports their income and expenses on a Schedule C attached to their 1040 so no separate tax return is necessary. The individual and the business are one and the same for tax and legal purposes. This is good for tax purposes, but it also means that if the business is sued, then the personal assets of the owner (car, house, personal belongings) can be taken to satisfy an adverse judgment. The risk of losing personal assets must be weighed against the simplicity of starting your business as a sole proprietorship.
Technically, partnerships are just as easy to form as sole proprietorships as all it takes is two or more individuals to “carry on as co-owners of a business.” Also like sole proprietorships, if the business is not in the name of one of the individuals, a DBA must be filed with the County Clerk’s office to register the business’ official name. Unlike a sole proprietorship however, a partnership is considered its own legal entity, meaning it exists separately from its owners. Be aware that a signed, written agreement is not required to form a partnership. Two or more people acting together to run a business will be viewed by the court as a partnership. Again, similar to sole proprietorships, partners are personally liable for any and all debts and obligations incurred by the partnership and furthermore, partners are jointly and severally liable. This means that one partner could end up paying all the obligations of the partnership, even if incurred by one of the other partners. Partners are individually taxed on the income of the partnership, but a separate tax return must be prepared to determine each partner’s share. Many partners often believe that if they do not take any money out of the partnership that they will avoid income tax. This is not the case. A partner is taxed on the earnings of a partnership whether or not the partnership makes a distribution. Lastly, it is important for all partnerships to have a partnership agreement. While not required, if one does not exist, then the Revised Uniform Partnership Act will provide all the rules that govern the partnership.
Corporations are the most regulated business entity, meaning there are many organizational formalities that must be followed in order to be recognized. Like partnerships, once formed they are a separate, distinct legal entity. The primary downside to forming a corporation is the concept of “double taxation.” This means that profits are taxed twice, once when earned by the corporation and again when distributed to the shareholders. For many closely-held corporations this is not necessarily an issue as they typically do not distribute “dividends.” However, there are instances when certain transactions will be treated as a dividend even if not intended to be as much and will therefore be subject to taxation. One of the corporation’s advantages and unlike sole proprietorships and partnerships, the owners of a corporation are not personally liable for any debts or obligations incurred by the corporation. There is an exception to this known as “piercing the corporate veil” where in certain situations owners can be held personally liable. Sub-S corporations are a popular option because they incorporate some of the advantages of partnerships, such as “flow-through” taxation while maintaining liability protection for the owners. There are specific requirements that must be met to gain Sub-S status that may limit some business from utilizing this option.
To form a limited partnership you must have at least 1 general partner and 1 limited partner. General partners participate in management and are personally liable for the debts of the limited partnership. Limited partners are not personally liable (there are, of course, some exceptions) and typically have no voice in the management of the business. A good way to plan around this is to have a general partner be a limited liability entity such as a corporation that the general partners own. This corporate entity manages the business, shielding the owners from liability, but the limited partnership recognizes the profits, thus avoiding the corporate double taxation. Limited partnerships must file a certificate of limited partnership with the state.
LIMITED LIABILITY PARTNERSHIP
LLP’s require a filing with the state to be valid. Practically, it’s very similar to a general partnership in that its primary advantage is flow-through taxation but offers limited liability by protecting each partner from the tortious conduct of any of the other partners. Mostly professional service providers create LLP’s in order to shield themselves from their partner’s tortious acts.
LIMITED LIABILITY COMPANY
An LLC has organizational features that are part limited partnership and part corporation. The first LLC was formed in Wyoming in the 1970’s and they are currently a very popular option. The LLC differs from a limited partnership in that all participants may actively take part in control of the business without restriction and without personal liability for business obligations. A member-managed LLC is similar to a general partnership, minus the personal liability of partners for partnership obligations. Alternatively, LLC’s can be manager managed, similar to how corporations are managed. LLC’s are only taxed once on their earnings as opposed to twice like corporate earnings are. Similar to corporations, the LLC “veil” can be pierced and members can be found liable for obligations incurred by the business. Another difference between an LLP or LP and LLC is that an LLC can have a single owner whereas an LP or LLP requires at least 2 owners. Since LLC’s are relatively new, it is very important to examine the laws regarding operation and formation of an LLC in the governing jurisdiction as they can differ widely. To form an LLC, Articles of Organization must be filed with the state.
Every business is different and it’s crucial to pick an organizational structure that best helps you obtain your goals. The above information is a very basic introduction into some of the different options you have. Speak to other small business owners about what works for them. Talk to an accountant. Talk to your lawyer. If there was one last piece of advice to give it would be: make sure you have an operating agreement that defines how you want the company to be run. Picking the right entity is meaningless if you don’t specify how it is going to be managed, and in most instances, if you’re operating agreement doesn’t cover a topic, there’s a law out there that’s going to fill in that gap, and it may not be beneficial to you. Ultimately, proper planning prior to beginning business can save lots of stress and lots of money down the road.
As always, we are available to answer any questions you may have regarding the above material or any legal or business related inquiry. Please don’t hesitate to contact us.
This information is designed for general informational purposes only. The information presented in this site should not be construed to be formal legal advice nor as the formation of a lawyer/client relationship.