So you have an idea for a business, or perhaps you are already up and running. It’s time to select a business entity. But which of the types of business entities should you pick? A bewildering variety of such structures exists. They include sole proprietorships. general partnerships, limited partnership, corporations and limited liability companies (LLCs).
How are you to choose among them to find the best business ownership structure for you? There are three things to consider when facing this choice. First, and most important, does does the entity you choose protect you from individual liability in there is a lawsuit or the business fails? Second, what are the federal tax consequences for each entity? Finally, what filing fees, reports and taxes does the state where you organize the business impose?
Let’s take a look.
Sole Proprietorships
A sole proprietorship is simply a person doing business as his or her self. The sole proprietor has no partners. He or she might be using a trade name, but the business is still the individual. Unless the sole proprietor is a business that requires a license, the person is doesn’t have to register with the state. There is one exception to this rule. If the sole proprietorship uses a trade or assumed name, or “dba” (doing business as) that does not include the sole proprietor’s surname, the sole proprietorship must register that trade name. The sole proprietor typically files with the state. In some states, the sole proprietor files where the person is doing business.
This type of business ownership doesn’t give the sole proprietor any legal protection from any liabilities. A disappointed customer, or one who got hurt, can sue the sole proprietor. The lawsuit could be for breach of contract, negligence, and more. If that happens, the sole proprietor has only three choices. First, the person can either pay the debt or try to settle it. Second, if the person has few assets, bankruptcy might be an option. Finally, in each state, some items of property are exempt from being taken for debts.
The money the individual proprietor makes from the business is taxable as income for federal income tax purposes. The individual is also subject to self-employment taxes for Social Security and Medicare. If you are employed by someone else, your employer pays half these taxes. But a self-employed person pays both the employer’s and employee’s share. The tax rates for employees are 6.2% for Social Security and 1.45% for Medicare. The sole proprietor pays twice that, 12.4% for Social Security and 2.9% for Medicare.
General Partnerships – Worst of the Business Entities
A general partnership is a group of two or more people or businesses that join together to do business. You can be in a partnership simply by working together. A general partnership doesn’t have to have a written agreement to exist. However, from a legal perspective, it is better to put your agreement in writing. You don’t need to file anything with the state to form a general partnership.
Like a sole proprietorship, a general partnership has no shield from legal liabilities in the event that it becomes a defendant in court. But the situation is even worse for the general partner than it is for the sole proprietor. Every general partner liable for the business activities of each of the other general partners. That liability is “joint and several.” What this means is that a creditor can sue every partner for the acts of every other partner (“joint” liability). Moreover, every partner is liable for the full amount of any judgment against the partnership (“several” liability). For this reason, investors are very unlikely to become general partners in a startup. General partnerships are usually not the best choice for business ownership.
Under the Uniform Partnership Act, a general partnership is a distinct legal entity. It is separate and apart from its partners. But federal law disregards the partnership tax purposes. In other words, any income from a general partnership “passes through” to the partners. The general partners then report that income on their individual income tax returns. General partners who receive partnership distributions are taxed as though they were self-employed. They must pay both the employer’s and the employee’s share of Social Security and Medicare.
Limited Partnerships
A limited partnership has at least one general partner and at least one limited partner. A general partner may be an individual or another business entity; so may a limited partner. The general partner is in charge of running the business of the partnership. The limited partner invests in the partnership. But the limited partner may not help manage the business.
If the limited partner is just an investor, then the limited partner is not liable to anyone who sues the limited partnership. The limited partner could lose what the limited partner invested in the partnership, but any losses stop there. If the limited partner does help manage the business, then the limited partner loses this shield from liability. The limited partner is liable to the same extent as a general partner would be.
To make sure that people know they are dealing with a limited partnership, the name usually must contain the phrase “limited partnership” or “limited,” It can also abbreviate either term. To form a limited partnership, each general partner signs a partnership agreement. Then, the partners file a notice with the state. The notice can be called Certificate of Formation or Articles of Partnership, or something else depending on the state. The filing usually lists each general partner. It also identifies the registered agent for the partnership and lists the business’ address.
A limited partnership, like a general partnership, is subject to “pass through” taxation. In other words, the partnership is ignored for federal income tax purposes. The individual partners must report any money distributed as income to them. Any losses also pass through to the individual partners. Limited partners do not pay Social Security or Medicare taxes on partnership income because it is unearned, or passive, income.
Corporations for Business Ownership
The best known business entity is the for-profit corporation. In some ways, a for-profit corporation is like a limited partnership. In both entities, there are investors and management. Investors in a corporation are the shareholders. They are not liable for the acts of the corporation even if the shareholder participates in running the business.
A corporation has one or more shareholders. The shareholders elect one or more members of the Board of Directors. The corporate bylaws establish how many directors there are. The Board of Directors is responsible for running the business. The Board appoints officers to run the business on a day-to-day basis. Shareholders may serve on the Board of Directors. In corporations with only a few shareholders, they often do. If there are many shareholders, the shareholders with the largest holdings often serve on the Board.
Do You Want Investors?
Investors tend to favor the corporate format for business ownership. Corporations have existed for many years. There is a substantial body of statutory law governing them. There are many court decisions that settle some of the finer points of corporate law. An investor will be familiar with corporations. The investor will understand that when the investor buys stock, the law spells out the investor’s rights. For that reason, the investor’s money is better protected than in some other types of business ownership such as the limited liability company. Further, if the investor is a member of the Board of Directors, the investor can help to manage the business.
The first step in forming a corporation is making a filing with the Secretary of State. The organizer of the corporation files the document. The filing lists the registered agent for the business. Depending on the state, the filing might name one or more members of the initial Board of Directors. The organizer can be the same person as the registered agent and the initial Board member. The corporation’s name usually must contain the word “company,” “corporation” or “incorporated” or an abbreviation of one of those words.
A corporation may be either a “C” or an “S” corporation. The “C” corporation is the default: The business pays federal income taxes on its profits. When it distributes dividends to its shareholders, the shareholders pay tax on those dividends. The corporation, if it meets certain requirements, may eliminate taxation at the corporate level by electing Subchapter S status. When a corporation makes that election, corporate profits “pass through” to the shareholders rather than being taxed at the corporate level. The shareholders pay tax on these distributions.
Limited Liability Companies
Finally, there is the limited liability company (LLC). LLCs are like corporations except that there are members instead of shareholders. The members may appoint managers to run the business, but they don’t have to. They can run the LLC themselves. Only the LLC is liable for company debts. LLCs are much more flexible in how they work and there is minimal legal regulation.
The limited liability company (the “LLC”) is a popular alternative to corporations for business ownership . Wyoming was the first state to pass limited liability company legislation, in 1977. Passage by other states was slow because a question existed whether the IRS would tax an LLC as a corporation or as a partnership. If taxed as a partnership, then tax consequences would flow through to the owners. The IRS clarified this issue to allow pass-through taxation in 1988. Each state now allows some form of LLC.
Like corporations, each LLC must have at least one member. The members own the LLC in the same was that a shareholder owns a corporation. An LLC also may have managers. Managers need not be members although often managers also are members. When the LLC filing with the state says that the LLC will have managers, then the managers run the LLC. If the filing says that the LLC will not have any managers, then the members run the LLC.
When there are managers, the structure of an LLC closely resembles that of a corporation. When there are no managers, an LLC is very much like a partnership except that there is no individual liability.
LLCs did not take off in popularity until the IRS declared that they were pass-through entities for federal income tax purposes. But then, and now, the law allows a corporation to elect pass-through, or “S” status, if eligible. This means that the corporation is a pass-through entity, too.
Why, then, did the LLC prove so popular? LLCs are much more flexible in how they operate. There are many more legal restrictions on how a business operates if it is a corporation rather than an LLC.
So Which Type of Business Ownership?
I suggest that sole proprietorship and partnership are out. There is significant liability risk if things don’t work out. Limited partnerships are OK, so long as the limited partners stay out of the management of the business.
So, we are left with the corporation and the LLC. The short answer is that the corporation is best if you will be looking for outside investors. The Delaware corporation is the gold standard. If there are only a few of you, and you don’t plan on outside investors, then the LLC is better. There’s less paperwork and more flexibility about how you run the business.
What happens if you start as an LLC but might want investors down the road? You can always organize as an LLC, then convert to a corporation later if need be.
So there you have it. For more information and discussion, download a copy of my free ebook from the window on this page.