Starting a business is difficult enough on its own. Deciding on the right form of business entity can be equally as frustrating. So many different factors go into deciding what is the best business entity for your business? This article is meant to be a primer for you to build up your knowledge base and start contributing to the foundation of what will lead you to success in your business. While each entity form has its own perks, pitfalls, and potential liabilities, with the proper guidance from a business lawyer, having to decide what business entity is right for you will be the least of your problems. Before you can get to that point, however, educating yourself on what business organizations are available for you is the first step. A good lawyer will be involved from the earliest stages of your business’ formation, from filing the necessary paperwork with the Secretary of State to the preparation of any Articles and Agreements necessary for business operations. A lawyer will assist in drafting paperwork for the financing of corporations, limited liability companies, general, limited and limited liability partnerships, and joint ventures, and also coordinate the sale and dissolution of mature businesses. Find a lawyer who can work with you from inception to success.
(and if you want or need tax advice, hire a tax attorney or CPA. I don’t do tax. never. ever. now go.)
A Sole Proprietorship is an unincorporated business owned and operated by a single individual, the sole proprietor, who is responsible for all the debts and obligations of the business. Sole proprietorships are nice because there are very few legal requirements to be met to establish one. Really, any individual can operate the business under a name other than his/her own full first and last legal names. The only legal requirement is that any business name, or trade name, must be registered with the secretary of state’s office. Overall, it really is the most common form of legal structure for new small businesses.
What are some of the advantages? Well, the sole proprietor gets full management authority with minimal formalities. A sole proprietorship is easy to form and it’s easy to terminate.
What are the disadvantages? You are going to be in a tough position and have a restricted ability to raise capital for your business. In addition, you will be faced with unlimited personal liability for business obligations.
Believe it or not, depending on what state you live in, there are actually four different types of partnerships you could find yourself involved with. There are General Partnerships (GP), Limited Partnerships (LP), Limited Liability Partnerships (LLP), and Limited Liability Limited Partnership (LLLP). For this article, I am going to stick with the GP. I’ll delve into the grit and grime of the other types of partnerships in another article.
A General Partnership is a business owned by two or more individuals or other business entities who will carry on as co-owners a business for profit. The key to a GP is you MUST have at least two individuals involved. You cannot have a partnership with less than two individuals. Although it is not required, it is strongly recommended that the individuals engaged in a general partnership prepare a written partnership agreement that outlines the business’ structure and each partner’s responsibilities. I can’t tell you how many phone calls a day I get from people who have started businesses with people and have not maintained a partnership agreement. Again, this is a topic for another time and another place, but please trust me when I tell you, get an agreement together.
What are the advantages? All the partners are entitled to manage the partnership. There are minimal formalities (aside from the partnership agreement) in creating the entity and you get a lot of flexibility in the management of the business. If you are going to open up a Limited Liability Partnership, you will need to register the entity with the secretary of state’s office. For tax purposes, there is “pass-through” tax liability, meaning taxes are paid by the partners only and not the entity. GPs are also easy to terminate.
What are the disadvantages? There is unlimited legal liability for the business debts and judgments against the business unless it’s an LLP. And each partner is jointly and severally liable. This means each partner is liable for 100% of the business debts and legal judgments of the business. Last, usually, there are restrictions on transfer and buy/sell provisions limiting the purchase and sale of partnership interests.
Limited Liability Company
An LLC combines the concepts of partnerships for tax purposes and corporations for liability purposes. LLC.s are created by filing “Articles of Organization” with the Secretary of State. While similar, LLCs are NOT corporations. In an LLC, the owners are called members. The members may elect or hire a manager(s) to run the business. As in a corporation, the owner(s)/member(s) may elect themselves to be the manager(s). LLC’s are governed by an operating agreement which is the official rules and regulations guiding the company’s management. An LLC is owned by its members.
What are the advantages? Members are not liable for business debts and legal judgments of the LLC. The LLC is a separate, legal entity. There are no restriction as to the number of members and members can be individuals or other business entities. There is pass-through tax liability where each member pays any taxes on his/her personal tax return. Profit and losses can be passed on to members as they choose, regardless of their ownership percentage and members can easily remove assets from the business.
What are the disadvantages? The operating agreement should be drafted to reflect the members’ intent for governance. Typically, such agreements will have restrictions on and buy/sell provisions limited to what an owner can do with her shares.
A corporation is a legal entity that exists separately from the people who create it. A corporation is owned by its shareholders and run by a board of directors elected by the shareholders. In a large corporation, the directors hire corporate officers to manage the day-to-day operations of the business. Conversely, in a small corporation, the directors and the corporate officers are usually the same individual(s). Corporations are created by filing “Articles of Incorporation” with the Secretary of State and by adopting corporate bylaws. Corporations are difficult to manage because there are certain formalities a corporation must adhere to, including Procedures for annual shareholder meetings; The election of the board of directors; Maintenance of corporate records; Adoption of bylaws; Complete separation of personal and business finances; Proper filings with the Secretary of State. Although many of the requirements may seem unnecessary for a small corporation, they are important to preserve the corporate form. Maintaining “corporate formalities” is an essential part of running a corporation. There are two types of corporations: C Corporations and S Corporations. (non-profit corporations are also considered, but beyond the scope of this article). The designation depends on how one would elect to register with the IRS. It’s a tax designation where those who elect to be a Sub Chapter S have chosen to be taxed as a partnership (see above). As a C corporation, you will encounter “double taxation” where the corporation pays its taxes and then the shareholders pay their taxes in addition.
What are the advantages? Limited liability for the shareholders whose number can be unlimited. Shareholders are not liable for the business debts and legal judgments of the corporation. Shareholders can be individuals or other business entities. Depending on the form of election, there are certain tax advantages shareholders can take advantage of. (Consult a tax lawyer or CPA for more information. Don’t ask me for tax advice, I don’t give it.)
What are the disadvantages? Profits are based on the number of shares owned. S corps have a limited number of shareholders allowed and the shareholders must be individuals. And let’s not forget that “double taxation” problem with C Corps.
Well, this has been a primer to bring you some general background on the various business entities out there for your startup. Each one is very unique and before you decide which one is right for your company, consult with an attorney and tax advisor who can help you navigate the maze and help you find the right path. Don’t just take a shot in the dark and pick an entity just because “everyone else is doing it.” Take the time to educate yourself and decide the best entity for you. Good luck!
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