When deciding to open a business, there are a number of different entities from which to choose from. There are advantages and disadvantages to certain entities and this document will provide a brief overview of the different entities and other things that a new business owner should be aware of.
A Sole Proprietorship is the simplest form of a business entity. With this type of entity the owner is the business and all business income are reported in her personal income tax return. The advantage to this entity is that it is typically easier and cheaper to start up. The disadvantage is that the owner opens herself up to several risks and liabilities personally. Additionally, there is a lack of continuity if the owner dies or is unable to work.
A General Partnership is where two or more persons carry on a business for profit as co-owners. The partners typically share the profits and losses and have an equal right to be involved in the management of the business. The Partners should set up a written agreement detailing the rights and responsibilities of the parties. Unfortunately, most partners tend to avoid doing this and when things go south (as they typically do) it gets very expensive as the courts typically need to determine how things should be wound down. One significant disadvantage of a general partnership is that partners are personally liable for the debts of the partnership and partners may be jointly or severally liable.
Limited Liability Partnerships
A Limited Liability Partnership (LLP) is designed for people who normally do business as partners and the state in which they do business has adopted a LLP statute. It helps avoid personal liability for the malpractice of other partners. A partner in an LLP is still liable for her own wrongful acts and a partner who supervised the individual who committed the wrongful act may also be liable.
A Corporation is the more traditional and commonly known form of business entity. The owners of the Corporation are its shareholders and the Corporation substitutes itself for its shareholders when conducting business and incurring liability. In order for the shareholders to have their personal assets protected from liabilities arising out of Corporate transactions the Corporation cannot co-mingle assets with the shareholder and it needs to act as its own distinct entity. If a court determines that the corporate privilege was abused for personal benefit or fraud, then a court could decide to “pierce the corporate veil” and go after the shareholders personally. Additionally, courts will look at the Corporate Record (or “Books of the Corporation) of the shareholders to see if the they maintained all the formal requirements of the corporation, and if the Corporate Record is not kept up to date then some courts could find that the corporate veil may in fact be pierced. These strict record retention policies are one of the biggest drawbacks to Corporations and why people favor LLCs instead.
Limited Liability Companies
A Limited Liability Company (LLC) is the most commonly formed business entity. It provides several different tax treatments (including S-Corp status) and allows the Members to choose how profits and losses should be allocated. It also limits the liability of the Members so that their personal assets are not subject to a law suit, rather only the assets of the LLC are recoverable. The LLC is governed by a State statute. There should also be an Operating Agreement signed by the Members indicating their rights and responsibilities. A LLC can also include business continuity when a Member dies. Many attorneys find an LLC to be the most flexibly and tax advantageous business entity.
Considerations When Forming a LLC:
- What State should the LLC be formed in?
- What is the purpose of the LLC? What kind of business will it be conducting?
- Where is the principal place of business?
- Should the LLC be managed by its Members or should the LLC have a Manager? If it is Manager Managed then who should be the Manager?
- Who should act as the LLC’s Registered Agent for service of process?
- What kind of dispute resolution should be implemented?
- Should the LLC be taxed as a Partnership, S-Corp or in another manner?
- Should there be a holding company in place as a Member of the LLC?
- What happens when a Member dies?
- How should a buy out of a Member’s interest be structured?
- How should the addition of a new Member be handled?
- What does the initial budget and business plan look like?
- What contributions should the Members initially make?
- How should profits and losses be allocated?
- What matters should only be decided by Members and what authority does the Manager have?
- What should the voting requirements be?
- What duties should the Members have to one another?
- Should Members or the Manager be able to compete against the LLC?