Business Entity Types
So you’ve decided to embark on a career as an entrepreneur? Well, that’s great. However, entrepreneurs are faced with the burden of making tough decisions. Over the course of building a business, many decisions need to be made which can and will have great impact on the future of the business.
But, here you are… you’ve made your first big decision and that is to start a business. You’ve decided to turn your idea into reality and take the plunge. Now you are faced with your next big decision. There are several different types of business entities, but what IS the best legal structure for your business? Each business entity has its own pros and cons impacting everything from management, banking, ownership, taxes and liability. You’re choices consist of a Sole Proprietorship, a Partnership, a Limited Liability Company, and a Corporation.
The sole proprietorship is the simplest business form under which one can operate a business. However, as a business entity it legally has no separate existence from its owner. The sole proprietorship is not considered a legal entity. It simply refers to a person who owns the business and who is personally responsible for its debts and actions. The sole proprietorships are the most common form of business organization in the U.S. with currently over 23 million people that are sole proprietors, representing 73% of all businesses in the U.S. today.
The Sole Proprietorship is the easiest to form, with no formal filing requirements to be registered within a state. It’s the easiest to manage. The owner has complete control and the owner gets to keep all the profits of the business. Those are some great advantages to the Sole Proprietorship, but there are some pretty serious disadvantages as well.
The biggest disadvantage of the sole proprietorship is that the owner’s personal legal and financial situation and the financial and legal situation of the sole proprietorship are one and the same. If the business has to file for bankruptcy the owner will be personally affected. Furthermore, any lawsuits against the business can affect the owner’s personal assets as well.
Another disadvantage of this business type is that owner must pay income taxes and self-employment taxes (Social Security and Medicare tax) on the entire income of the business. If the business is profitable, that can be a big pill to swallow, and let’s be honest here; no entrepreneur starts a business with the idea of never achieving profitability. The big takeaway here is the Sole Proprietorship has unlimited personal liability. The owner is personally liable for all debts and all actions of the business.
A partnership is a business with multiple owners, each of whom has invested in the business. Some partnerships include individuals who work in the business, while other partnerships may include partners who have limited participation and also limited liability for the debts and lawsuits against the business. The legal definition of a “Partnership” is: a legal form of business operation between two or more individuals who share management and profits. The federal government recognizes several types of partnerships. The two most common are general and limited partnerships.
In General Partnerships, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. Limited Partnerships have both general and Limited Partners. The General Partners own and operate the business and assume liability for the partnership’s debts and actions, while the Limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the General Partners.
Partnerships are usually registered with the state in which they do business, but the requirement to register varies from state to state. Partnerships use a Partnership Agreement to clarify the relationship between the partners, the roles and responsibilities of the partners, and their respective shares in the profits or losses of the partnership.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.
Limited Liability Company
The Limited Liability Company or LLC is a pretty uncomplicated and flexible business structure that gives an owner the added benefit of looking more “legit” than a Sole Proprietorship. The LLC ownership is defined by a percentage of ownership via “member percentages or units”. An LLC can be managed by the owners, known as Member Managed, or it can be managed by managers, known as “Manager Managed”.
The LLC business structure combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation, creating the best of both worlds for business owners. This means that if an owner chooses to form an LLC, that business will become its own legal entity that has separate debts and legal matters from himself.
The LLC is a great choice for small business owners, as it can provide the same limited liability protection as a corporation, without many of the complexities and formalities associated with them and this entity type also has the benefit of choosing how it deals with its taxes. In some situations, business owners have state-law reasons for wanting their business to be formed as a limited liability company (LLC), but for tax purposes they would prefer S-corporation, or S-Corp (rather than partnership) tax treatment. For example, S-Corp status may be desired because a partner in a partnership is subject to self-employment tax on his or her distributive share of the partnership’s trade or business income, while an S-Corp owner is not subject to self-employment tax on his or her pass-through income or distributions from the S-Corp. This is known as Corporation Election Status and can be initiated in one of two ways, with IRS Form 2553 to elected to taxed as an S-Corp, or with Form 8832 to elect to be taxed as a corporation.
If the owner’s decide to change the LLC’s tax status to a Corporation or S-Corp, the legal status of the LLC remains the same. In other words, it still functions as an LLC in every way except during tax time. The LLC is a very flexible business entity and this inherent flexibility is the prevailing reasons for why the LLC to the business entity of choice for many entrepreneurs.
A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes. Corporations are owned by their stockholders (shareholders) who share in profits and losses generated through the firm’s operations, and have three distinct characteristics (1) Legal existence: a firm can (like a person) buy, sell, own, enter into a contract, and sue other persons and firms, and be sued by them.
An owner can incorporate his/her business by filing Articles of Incorporation with the appropriate agency in his/her state. After incorporation, stock is issued to the company’s shareholder owners in exchange for the cash or other assets they transfer to it in return for that stock (consideration). Once a year, the shareholders elect the board of directors, who meet to discuss and guide corporate affairs anywhere from once a month to once a year.
Each year, the directors elect officers such as a president, secretary and treasurer to conduct the day-to-day affairs of the corporate business. There also may be additional officers such as vice presidents, if the directors so decide. Along with the Articles of Incorporation, the directors and shareholders usually adopt corporate bylaws that govern the powers and authority of the directors, officers and shareholders.
Corporations, much like LLCs, provide limited liability for the owners of the business. For owners of shares in a corporation that cannot pay its debts and is sued by its creditors, the assets of the company may be seized and sold. Although the owners can lose their investment, the creditors cannot attach the owners’ personal assets (such as cars, houses, or bank accounts) to satisfy creditor claims.
The limited liability provided by the corporate structure is known as the “corporate veil of limited liability.” However, there are some important exceptions to this rule. Personal liability can attach to the owners under certain conditions. If the business affairs of a corporation and its shareholders are so entangled that they are, in effect, one and the same, an opponent in a lawsuit may be able to convince a court to “pierce the corporate veil” and impose personal liability, or responsibility, on the active shareholders. Personal liability may also be imposed if the corporation does not comply with required legal Corporate Formalities or if it fails to keep proper corporate records.
Corporate Formalities are extremely important to follow in order to preserve the “veil”. The individual requirements for Corporate Formalities can vary widely by state, and according to the specific type of corporation that the business has filed as. The following is are some examples of what “Corporate Formalities” consists of:
- Hold Scheduled Meetings: The corporation should hold an annual shareholder’s meeting. The date, time, and details for the meeting may be clearly stated in company bylaws, and should be held at a similar date and time each year. An annual board of directors meetings is usually held immediately after the shareholder’s meeting.
- Hold Special Meetings: Special meetings need to be scheduled whenever important corporate decisions must be made, such as opening a bank account, changing officer salaries, or entering into a new business venture. Such meetings should end in a vote, and the any newly adopted resolutions need to be signed by the Officers/Directors. Notice, or Waiver of Notice of any special meetings should be given to the required participants.
- Accurate Records Policies: The corporation should keep accurate financial records and records of other corporate activities such as asset acquisitions. Records should also include meetings of minutes, as well as corporate tax activity. Keeping clear, accurate and separate records helps prevent abuses of corporate assets.
- Exercise Fiduciary Duties to the Corporation: Officers and directors are specifically barred from using corporate assets or opportunities for personal gain. Officers and director are responsible for keeping corporate matters private and confidential.
- Develop a Planning Routine: An organized business plan can help avoid errors and liability in the future. The business plan should cover matters such as both long-term and short term goals, reviews of each year’s performance, tax planning, yearly and quarterly company budgets.
- Address Company Contract/Policy Procedures: Standard Operating Procedures (SOPs) for negotiating and signing business contracts should be enforced such as having an authorized officer to sign contracts, all purchases should be in the corporation’s name, and maintaining separate corporate accounts.
- Follow company Bylaws, Articles of Incorporation, and other documents: Failing to comply with company documents can expose directors and shareholders to liabilities that they should not have to incur.
As you can see, a corporation is much more complex and mismanagement can get a group of owners in trouble. This is why more and more entrepreneurs are turning towards the LLC or an LLC that elects to be taxed as a corporation or s-corporation for “pass-through” tax benefits.
If you have any questions or legal needs regarding business structures and formal business formation, don’t hesitate to contact us for assistance.
This document/post/article is not to be considered as legal advice. Content and information contained herein is subject to changes, modifications, and may contain inaccuracies or out-of-date information. As with any legal matter or other matters of importance, consultation with an attorney or professional is the best course of action.