The choice of an entity is often the first important legal decision an entrepreneur has to make. In recent years the choices have gotten bigger. An individual business owner can have a sole proprietorship, a corporation (C or S) or a limited liability company. An organization with multiple owners can be formed as a general partnership, corporation, or Limited Liability Company (“LLC”) (note limited partnerships and Limited Partnerships are not discussed in this article). On what basis did the company make this important decision? Certain key factors help form a guide in answering this question.
Sole Proprietorship
It is the easiest, cheapest, and least regulated type of organization for individuals. The only legal need to form this business is to start operations. It is recommended to file fictitious name registrations in all states where the business will operate and check the zoning and licensing laws for business locations. In addition, all marketing materials must be trademarked and/or copyrighted.
As a result of the simplicity and low costs involved in sole proprietorship, many individually owned businesses choose this option. However, there are some negative aspects to consider. The most important reason for choosing one of the other options is that the individual is solely responsible for any and all claims by customers, employees, vendors or others.
General partnership
Similar to a sole proprietorship in ease of formation, the only requirement for forming a general partnership is that two or more people engage in business activities for profit (Uniform Partnership Act). Expenses and profits do not need to be divided equally. Although there is no formal requirement, it is highly recommended that a written partnership agreement be executed between the partners. Like sole proprietorships, general partnerships are not taxed as an “entity”.
There are downsides to a general partnership. The partners in a general partnership have unlimited personal liability not only for their own torts and contracts, but also for the other partners. The death or withdrawal of one of the partners results in the dissolution of the general partnership. Care should be taken to avoid partnerships being seen by the IRS as corporations and then being taxed as such.
Company
A corporation owned by a limited number of people is known as a “held corporation”. Like partnerships, most, if not all, of the shareholders are involved in managing the business. However, unlike a partnership, all shareholders, or owners of a corporation, have limited liability for the acts and omissions of the other owners. In addition, avoiding personal liability for business debts and court judgments is another advantage of corporations. In general, creditors can only collect from business assets, not against the owner’s personal assets.
Because a corporation is a legal entity separate from its shareholders in particular, business continues regardless of who owns the shares. Corporations offer the opportunity to bring in investors who can own shares in the company without having to worry about personal liability. Tax deductions can be taken for benefits provided to employees and owners. Corporations often have a more favorable tax rate structure to allow owners to keep income at a lower rate.
There are two types of for-profit corporations, “C” corporations and “S” corporations. This refers to IRS laws that define different tax treatment for the two types of entities. “C” corporations are required to pay corporate tax on profits and shareholders pay tax on their compensation and/or dividends. For this reason many small organizations choose to become “S” corporations. “S” corporations pay no taxes on profits; profits and losses are passed on to the owners. However, the owner of an “S” corporation cannot be a corporation, partnership, or LLC.
Some of the disadvantages of forming a corporation are the costs and formalities involved. The cost to enter varies by location, but is usually up to several hundred dollars. Corporations are required to hold annual board and shareholder meetings and director minutes and shareholder acts must be maintained.
Limited liability company
LLC is a relatively new entity. It was created to combine some of the advantages of general partnerships and corporations while eliminating some of the disadvantages of both. LLC owners, called “members,” have limited liability similar to that of corporation stockholders. However, structurally, an LLC is more like a partnership.
LLCs can be managed by members or by a manager. There is usually no board of directors or officers. Company formalities such as meetings and minutes are not required. Gains and losses are passed on to owners on their personal tax returns and are not taxed separately to the entity. LLC members do not have to be individuals and voting rights and profit and loss sharing do not have to be identical; for example, an owner may receive X% of the profits and own Y% of the LLC and own Z% of the voting rights. It is clear why LLCs are so popular.
In conclusion, there are many factors to consider when choosing an entity form for your business. The advice of your accountant or tax adviser and attorney should be considered before making a choice. We welcome any questions you may have.
THIS ARTICLE IS NOT INTENDED TO GIVE LEGAL ADVICE OR BUILD A LAWYER-CLIENT RELATIONSHIP.
