When you are thinking of starting a new business, the options for entity structures can seem endless and confusing. The following guide can be used to help you understand the basics and begin to narrow down the options in preparation for a consultation with your lawyer.
In a sole proprietorship, there is only one individual running the business and that individual takes on all of the risks of the business personally. There is no distinction between the individual and the business, meaning the liabilities and debts of the business can be satisfied with personal assets. Picture it this way – if you default on a business loan, lenders can come after your personal cars, real estate, and much more. Sole proprietorships also are subject to pass through taxation, meaning all business profits and losses are reported on the business owner’s personal tax returns. This type of entity does not survive the death of its owner, meaning that all the business assets upon death are liquidated and distributed to the estate. If you are an individual with a business and have not taken formal action to set up your business, this is the default structure.1 This business structure is not recommended.
This is a formalized legal relationship between two or more parties that have agreed to share in the profits and the losses of a business. There are a few types of partnerships that provide more information regarding legal implications of forming this type of entity.
This is the default entity structure for two or more people who have started a business together. There is no formal filing needed for this structure, and it is similar to a sole proprietorship in that all of the debts and liabilities of the partnership can be satisfied with personal assets. In other words, each general partner is responsible for the actions of the partnership and of the other general partners and such liability extends to each partner’s entire net worth. This business structure is not recommended.
A limited partnership has two different classes of partners: general partners and limited partners. In most cases, there are only one or two general partners who manage the day-to-day operations of the business. These individuals take on the liability of the partnership, offering their personal assets to satisfy debts and liabilities, if needed. The limited partner role is typically that of a passive investor who does not take part in managing the business. The investment provides a limit to a limited partner’s personal liability.2 This structure is a common one in certain types of investment vehicles like hedge funds and venture capital firms.
Limited Liability Partnership
In a limited liability partnership, all of the partners have limited liability and there is no general partner. Each partner is able to act on behalf of the partnership and enter into binding contracts for the partnership itself. This entity type is popular among professionals that do not want to take on potential personal liability for another partner’s actions within the partnership.
Limited Liability Limited Partnership
It is important to note that this partnership type is a relatively new corporate form and is not recognized in all states, causing potential issues if business will be conducted across multiple states. This structure is the same as a limited partnership, but it includes limited liability for the general partner(s). LLLPs are most often used as investment structures, and largely in the real estate industry. For example, a group of investors form a LLLP to build an apartment community or hotel, and the investors enjoy the fact that they are not personally liable for the debt of the partnership and can only lose what they invested.
Limited Liability Company
LLCs provide the most simple and flexible entity structure for establishing a corporate form and limiting the liability of the business’s owners. The owners’ liability is limited to the value of the assets contributed to the LLC. It is the most common entity selection for small businesses in the U.S. This type of entity can be owned by one or more people (including other entities) and is created by filing formal documents with the state. One drawback to forming an LLC is that there are limits to the liability. If you find yourself in court, a judge can rule that the LLC structure does not completely protect your personal assets.
A corporation is an organization authorized by a state to act as a stand-alone legal entity that is owned by its shareholders. When a corporation is created it must go through the process of incorporation in order to establish the business entity a distinct identity. This identity creates a liability shield for the owners in the event of a lawsuit or legal claim.3
This is the default corporate structure. It provides unmatched flexibility when it comes to raising capital because the directors can issue as many classes of shares as is needed and can attach different rights to each class. Additionally, C-corporations are generally easy to value, something that is essential if you plan on conducting more than one round of financing. C-corporations are subject to double taxation, meaning the company is taxed on its income at the corporate level and individual shareholders are also subject to personal income taxes on the dividends they receive.
S-corporations are a legal fiction that only exists at the federal level. An S-corp. election modifies the taxation status of the underlying entity to cause it to be a flow through entity for tax purposes, which means that shareholders are taxed on corporate profits at a personal level, thereby avoiding double taxation. Such an election can be made at time of incorporation or within 75 days of the date of formation. S-corporations predate the creation of LLCs, and in some ways, they are very similar. In fact, the rise in the popularity of LLCs has caused a significant decrease in the use of S-corporations, however they do still have utility in the right circumstances. The S-corporation designation does come with some significant restrictions though, as companies that take the election are limited to 100 shareholders, cannot issue more than one class of stock, cannot have foreign shareholders, or be owned by another entity.4 Additionally, owners and employees opt for a smaller reasonable salary, pay income taxes on that salary and then take any remaining profit as a distribution, which are almost always taxed at a lower level. In choosing to operate in such a manner it is vital that shareholders work with a CPA to determine a defensible salary to avoid a run-in with the IRS.
This type of corporation is not to be confused with the B-Corp certification that any type of business can apply to receive. A benefit corporation is a traditional C-corporation or S-corporation that commits to creating a public benefit and adding sustainable value in addition to generating profit. The leaders of the company must make decisions with this social justice lens, rather than the traditional view of maximizing profit. There is also a higher reporting standard for benefit corporations. They are expected to show progress toward achieving social and environmental goals for the public.5
The main difference between non-profit corporations and traditional corporations is the way that profits are distributed. Instead of making profits for shareholders, non-profits focus on making money to put back into the corporation. These types of corporations are also eligible to qualify for a tax-exempt status, which is helpful for maximizing profit to cycle back into the business.
The Rodman Law Group has extensive experience in helping business owners of all kinds make the optimal entity selection for their needs and in helping them select a jurisdiction in which to incorporate. Please give us a call or send us an email if you would like assistance with what will be one of the most important decisions you make for your new business.
1 “Sole Proprietorship”. U.S. Small Business Administration. Feb. 21, 2020. https://www.sba.gov/content/sole-proprietorship.
2 Murray, Jean. “Selecting a Business Partnership Type”. The Balance. Jun. 25, 2019. https://www.thebalancesmb.com/selecting-a-business-partnership-398880.
3 “Corporation”. Corporate Finance Institute. Feb. 25, 2020. https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-corporation-overview/
4 Haman, Edward. “What is the difference between S Corp and C Corp?”Legal Zoom. Feb. 25, 2020. https://www.legalzoom.com/articles/what-is-the-difference-between-s-corp-and-c-corp
5 “What is a Benefit Corporation?” Benefit Corp. Feb. 25, 2020. https://benefitcorp.net/what-is-a-benefit-corporation.
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