Choice of entity — a few basic considerations
July 14, 2014
From a legal perspective, business owners have several options for organizing and operating their business. Selecting the best option usually depends on three concerns — allocating management of the business among multiple owners, limiting liability and promoting tax efficiency. I generally try to avoid sounding like an ad for a law firm in this column, but I believe that getting legal and tax counsel when forming a business is a good investment, especially the more people, property and money are involved. In any event, business owners will need to at some point decide whether to proceed with running their business informally or to organize a business entity. And if they organize, which form is best?
When the proverbial widget maker hangs out a shingle, and does nothing more to organize her business, she is a sole proprietor. A sole proprietorship can be registered with the state, which may be beneficial for trademark, licensing or other administrative purposes. But in terms of liability protection or taxes, a sole proprietorship is indistinguishable from the owner. They are one and the same. A single-owner business can enjoy certain benefits from operating under another form of business, which I will address below, but for some, a sole proprietorship is a simple and effective manner in which to operate.
A general partnership is the default form of business when multiple business owners team up informally. Like a common law marriage, it’s possible for the “partners” to unintentionally enter into a general partnership, simply by holding themselves out as co-owners of a business for profit, and to proceed in business together without a full understanding of the consequences. The consequences can be significant.
In a general partnership, each partner can independently operate the business on behalf of the partnership. This is efficient, but there are no checks-and-balances. All general partners are jointly, severally and personally liable for the acts of the other partners, and the knowledge of one partner is imputed to the others. This means that when one partner creates a liability of some kind, say, committing the partnership to a large and unnecessary purchase order, the other partners can be caught holding the bag, even though they didn’t cause the liability in question and even if they knew nothing about their partner’s actions.
As a result, it’s often best for a multi-owner business to organize and operate under a formal business entity to potentially limit their liability and to create a mechanism for allocating the responsibilities, authorities, benefits and obligations of teaming up to run a business. Tax considerations are also very important, because the various forms of business are taxed differently, and the differences can be significant. There are many options available, including corporations, LLCs, limited partnerships, limited liability partnerships and limited liability limited partnerships.
Most business owners form a corporation or another limited liability entity, such as an LLC or a LLP, to avail themselves to liability protection. In theory, the owner(s) of a limited liability entity won’t be held personally liable for the liabilities of the company. However, running a business through a limited liability entity isn’t an absolute protection against personal liability. If the business is a shell company with no assets or if the owners disregard the business entity by comingling personal and business assets or by disregarding business formalities, then it’s possible for creditors of the business to reach the assets of the owners. As a result, it is important for business owners to adequately capitalize, insure and manage their corporation or LLC, especially if liability protection is an issue.
LLCs are by far the most popular and flexible business entity, in part because the members of an LLC have broad discretion under law in crafting, by contract, how the business will be run. Control of an LLC can be consolidated in one or more managers or officers, or an LLC can operate more like a general partnership where each member is authorized to steer the ship. Majority rule is also a common mode of operation for an LLC.
Corporations on the other hand, are somewhat rigid in the manner in which they’re managed, and certain formalities are required under law. That being said, corporations can still be an excellent, if not ideal platform to structure the management and operation of a business, depending on the circumstances.
Finally, from a tax perspective, a single-member LLC will generally be ignored by the taxing authorities, simplifying tax reporting for the owner. The registered partnership forms of organization and most multi-member LLCs are taxed as a partnership. A corporation and an LLC can elect to be taxed as a C or S corporation. Partnerships and corporations involve an additional level of tax reporting, and each type is taxed differently. Taxes are a central consideration when choosing a form of business, but the subject is way too broad and consequential to discuss here. Suffice it to say that the issues pertaining to a corporation from a tax perspective are particularly technical. Many hard-to-fix pitfalls exist in the corporate context, so I would strongly advise that business owners who determine that a corporation is for them work with a CPA and a qualified business lawyer.
Matthew Trinidad is a transactional attorney with Karp Neu Hanlon PC. He focuses on business law, lending and estate planning. He can be reached at firstname.lastname@example.org or 970-945-2261.