Entity Basics
One of the most common topics I am asked to explain to my clients and speak on to new businesses is all the different types of entities that are available and which one should you select for your business. In this article I will discuss the differences between the main entity types sole proprietorships, general partnerships, limited liability companies and corporations.
Sole Proprietorship
Probably the most common and simplest way to operate as business is as a sole proprietorship. If you start up a business that has only one owner and you do not pick any other type of entity then you are deemed to be a sole proprietor. That is because there are no formal filing requirements or fees to pay if you want to be a sole proprietor. You don’t have to draft up any written agreements to become one you just start up your business, and it is deemed a sole proprietorship.
However, since you pay nothing to become one, there are not many benefits to being a sole proprietor. You as the owner are 100% liable for all the debts and obligations of the business. The business is taxed simply as part of your personal tax returns and management is vested in the sole owner of the company.
General Partnership
A general partnership at its simplest can be seen as a sole proprietorship that just has more then one owner. So in that respect is it the same in that there is no formal fling requirements and no written agreement required to become one. Like a sole proprietorship, the owners are all liable for the debts and obligations of the company. The twist is that each partner is jointly and severably liable for all the obligations of the partnership. That means a person suing the partnership can choose to collect from any partner and does not have to collect an equal amount from each partner.
A general partnership is different from a sole proprietorship however in that there is a more formal management structure. Each partner has an equal vote unless they agree otherwise. Each partner can also bind the partnership, even if the other partners do not approve of a transaction. Since a single partner can bind the partnership, picking the right partner to work with becomes critical. Also a partner cannot sell his or her interest without the consent of the other partners.
As to tax matters, the partnership is not seen as a separate entity. For that reason the profits and losses flow equally to the partners.
By default, there is an oral partnership agreement consisting of all the agreed upon terms and conditions unless the partners enter into a written agreement. However, I always try to encourage my clients to enter into a written partnership agreement. Many times you may think you and your partner are in agreement as to the main points of the partnership. However, when partners try and reduce their agreement to writing they find out that the other side may not have the same understanding as to how the business is to operate.
Corporations:
This is the first of our entities that is recognized as a separate entity in the eyes of the law distinct from its owners. The corporation is recognized as perpetual in that it continues to exist in spite of the death of an owner or the fact that the ownership in the corporation is bought and sold.
There are specific filing requirements for creating a corporation. The corporation must file articles of incorporation in the state of incorporation with the Secretary of State and pay fees in order to have the right to call itself a corporation. The main benefit to the owners is that the corporation, and not the owners, is liable for the debts and obligations of the business (putting aside the issue of personal guarantees).
The corporation has a much more formal structure and set of procedures. The owners of the corporation elect a board of directors that control policy and major decisions for the corporation. Officers elected by the board of directors handle day to day operations for the corporation. There are specific formalities that must be observed such as properly forming the corporation with bylaws and corporate minutes. In addition, the preparation of annual minutes and other formalities must be observed.
There are two types of corporations, the “C” and “S” types. By default all corporations start out as a “C” corporation. This means that the corporate profits are taxed at the corporate level and then profits are taxable to the owners if paid out as dividends. The old “double taxation” conundrum.
However, if you properly file form 2553 with the IRS, you can elect to be taxed as an “S” corporation. The benefit of being an “S” corporation is that the profits of the entity are not taxed at the corporate level, but are taxed as a pass-through to the owners as if they were in a general partnership. This gets rid of the double taxation issue and explains why most small businesses choose to make an “S” election.
Limited Liability Company:
Limited Liability Companies (“LLCs”) were adopted in the mid-1990s in order to allow for a type of hybrid entity. There was a need for businesses to be taxed on a pass through basis without having to go through all the formalities of being a corporation. So the LLC was developed as kind of merger of a partnership and corporation. I say that because the LLC provides the same type of protections for the owners like corporations in that they are not liable for the debts and obligations of the business. But, the LLC is generally taxed like a partnership and does not have all the same formal requirements of a corporation.
To create an LLC you do have the formal requirement of having to file articles of organization with the Secretary of State and also to pay a fee for the right to have an LLC. But, you don’t need to draft bylaws, initial organization minutes, stock certificates or annual corporate minutes. Most LLCs are governed by a written operating agreement that sets forth all the duties of the members (the name for the owners) of the LLC and no other documentation is required. Many states do not even require there to be any written document other than the articles of organization and annual information filings.
Given its flexibility, LLCs generally are the entity of choice. The only time I see people choosing a corporation instead is when they are under the mistaken belief that a corporation provides some higher level of protection to the owners from the business’ debts, which is untrue. There are however, some states such as California in which there may be tax benefits to operating as an “S” corporation as opposed to an LLC. Make sure you consult with a tax professional in your state to determine which one is better for you.
The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.
