This might be one of, if not the most, important choices you make after choosing to start your own business. The following is a breakdown of the most common forms.
A sole proprietroship (SP) is the easiest entity to form. There are no documents to fill out and turn in with the state, just hang up your sign and you are good to go. However, should you choose a sole proprietorship, the trade-off is that you accept personal responsibility and liability for any lawsuit filed against and/or debt undertaken by the company. This can get very dangerous because personal liability means creditors looking to satisfy debt or a judgment can go after just about anything you have.
As a sole proprietor, all business profits and losses are reported directly on your tax return. Some may consider this good, others a nuisance; that much will depend on your preference. You can have employees in an SP, but the moment someone decides to join you and your business as an equal to you, it becomes, by default, a general partnership.
This is the default corporate entity if no corporate entity structure is otherwise declared. In a GP, all partners are jointly and separately liable for the company; this includes lawsuit judgments and debts.
Similar to the sole proprietorship—and because it is the default entity structure—all that is required to establish a GP is for at least two people to jointly engage in an endeavor toward making a profit. The unlimited liability is probably the biggest drawback, but did you know partnerships can also have limited liability?
An LP is a partnership where one partner has full/unlimited liability. This partner does not have to be an actual human, it is common for an LP to establish the “partner” of unlimited liability as a GP. All other partners can (and usually are) humans; they have limited liability. This limited liability is a major step-up because they are not personally liable for the partnership’s debts or judgments.
However, the trade-off here is that these limited partners usually do not have the authority to actively manage the entity; they take a more passive position. Traditionally, partnerships are naturally limited to an arbitrary amount of people. Should you desire to take your business to the next level, a corporation offers you something entirely different.
These are your name-brand companies. A corporation is a separate legal entity altogether. This means a corporation has its very own legal, tax and management set-up. Additionally, shareholders (to which there is no limit) are the “owners” of the company. Shareholders operate in a similar manner to limited partners in that they take a passive approach to management, but still pledge their investment to the company. There are many types of shareholders (common and preferred are the most popular) and some have the right to vote, but others do not.
The biggest drawback to a corporation is double-taxation. Not only is the corporation taxed on its revenue, but shareholders are also taxed upon receiving their dividends (not all shareholders receive dividends). Finally, there are “housekeeping rules” a corporation must keep track of. This includes hosting annual meetings and keeping track of meeting minutes. If you are looking to avoid double taxation, read on!
This type of company is very similar to the C Corporation, but might be considered the upgraded version. An S Corporation also is its own legal entity, owning its own legal, tax and management structure. However, unlike a C Corporation, an S Corporation is not subject to double taxation.
Instead, the owners of an S Corporation operate similarly to a Sole Proprietorship; they report their share of profits/losses in the S Corporation on their own tax return. Unlike a C Corporation, there is a limit to the number of shareholders: 100. Additionally, every shareholder must be a United States Citizen. Finally, because it’s a corporation, it must follow the same housekeeping rules as a C Corporation.
Limited Liability Company (LLC)
The LLC is arguably the best form of corporate structure. Every owner has limited liability; no one is required to serve as the “unlimited liability” party. An LLC is not treated as a corporation, but it still has its own legal structure. One person can form an LLC; a million people can form an LLC; it does not matter. However, if there is only one person, it is taxed similarly to a sole proprietorship. If there are multiple owners, it is taxed similarly to a partnership.
An LLC is not required to host annual meetings or record minutes, but an LLC still needs to formulate and follow what are called Operating Agreements. The details of these Operating Agreements become that much more important in the multi-owner context, as everyone needs to map out some critical questions about control, how profits can be distributed, how outside buyout offers are to be treated, and how to deal with business succession and wind up.
Good counsel at this stage of company formation is critical. If you need help choosing the right entity for your business, or even change business entities, you should consult an experienced corporate lawyer in your state.