Types of Business Entities
Deciding which entity to choose for your business relies on your situation. There are four primary types of business entities;
1) sole proprietorship,
3) limited liability company and
4) a corporation.
A sole proprietorship is the easiest business entity to establish. It is so easy that it can happen by accident! If a child sets out to mow lawns for the summer, that child, by default, has established a sole proprietorship. A sole proprietorship is a business that is owned and run by one individual, and therefore the individual is taxed on earnings. This may be an appealing route to take if you are just getting started and lack the necessary funds to set up an LLC or a Corporation, or if you are just testing out the waters to see if entrepreneurship is for you. The benefits of this entity are; it is easy to establish, it doesn't have any set-up fees, and there is less paperwork (if there is such thing). The downside to this form of entity is that there is no legal separation between the individual and the business. If legal action is taken against the business, because there is nothing to distinguish between the two, the individual’s assets (personal and company equipment, property, finances, etc.) are at risk and exposed to any lawsuits that may occur.
The next entity is a partnership. There are three types of partnerships; 1) general, 2) limited partnership and 3) limited liability partnership. A general partnership is very similar to a sole proprietorship, in that it is easy to set up, there are no set up fees involved and when it comes to legal liabilities, the individuals are responsible and equally exposed to credit obligations and lawsuit risk. This type of partnership can be established on a handshake between two (or more) individuals who decide to pursue a business venture together. However, with the ease of this business formation there are a few areas to consider, such as; distribution of daily duties and responsibilities and in particular, there should be an exit strategy in place and written out. If one partner decides to exit, you do not want disruption in the flow of daily operations due to a disagreement and by having discussed and established an outline of how an exit will be carried out you will avoid potential conflict and further hardship (if applicable).
A limited partnership (LP) and a limited liability partnership (LLP) are a little more complicated to set up and will require formal legal paperwork to be drawn, which will add cost to your start up and, of course, create more paperwork. These two should definitely be considered over a general partnership because it separates the individuals and offers liability protection to all limited partners. It should be noted that while a limited partnership offers personal liability protection to limited partners, the general partner is personally liable for all aspects of the business. Because of this, an LLC or corporation is named as the general partner in a limited partnership. Additionally, the general partner is responsible for running the day to day operations of the business, controls all aspects of the business and is responsible for handling any liability claims that may occur. Limited partnerships are common in real estate ventures. LLP’s are common for accounting firms, attorney’s and other professional partnerships that consist of individuals conducting the same specific service under one entity.
Limited Liability Company
A limited liability company (LLC) a combination of a general partnership and a corporation offering the benefits of both while avoiding some of the drawbacks of a corporation. It is fairly easy to set up and while it does cost a little bit of money (as determined by the state you become established in), it helps to protect the individual(s) from having their personal assets exposed to the business risk. For this entity you file articles of organization with the state you organize in and owners are considered members; there can be one member (in most states) and include as many additional members as you wish. It is recommended that you have an attorney draw up an operating agreement, but this is not necessary if you are operating as an individual. The primary benefit of this entity is personal limited liability and pass-through taxation. A downside to this form of business is finding investors, as investors generally prefer to put their money into corporations.
A corporation is more complicated to establish and are considered separate legal entities that can live forever! There are two types of corporations, C and S. Similar to an LLC, a corporation files to incorporate within the state it is established. This will require research as some states are friendlier, with taxation a primary consideration. While it is more complicated and more expensive to establish, the primary advantage is complete liability protection for the owners from any and all business debts. Additionally, the owners cannot lose more than they have invested in the corporation, which is why equity investors prefer this entity over an LLC. A corporation requires a number of technical and governmental formalities, such as; establishing a board of directors, maintaining meeting minutes and yearly shareholder meetings and of course other governmental compliance regulations (i.e. Sarbanse-Oxley). Because these are part of your corporate obligation, failure to comply with these requirements can nullify your protection from personal liability.
All corporations are classified as a C Corp.’s unless they file for S classification. The primary distinction between the two variations is a result of tax treatment. For a C Corporation, the corporation pays taxes while S Corp. taxation is passed to the owner’s personal tax returns. A drawback for the S Corp is that there can only be one class of stock issued, there are restrictions on who can be a shareholder and there are limitations on the number of permitted shareholders. Finally, many states have established what is called a close corporation, which has been created for smaller corporations to help them maintain compliance and to protect them from some of the formalities of larger corporations.