WHICH TYPE OF BUSINESS ENTITY IS RIGHT FOR YOU?
So you have an idea for a new business. One of the most important and frequently overlooked decisions that must be made before you even begin putting your idea into reality is how to structure your new business . Most people assume a new business should be formed as a corporation because structuring a business in that fashion will limit the personal liability of the "owners" for the obligations of the corporation.
Even though a properly maintained corporation will generally insulate its shareholders from personal liability, organizing your new business as a corporation may not necessarily be your best choice. As will be explained below, other business organizations, such as a limited liability company, in addition to providing limited liability, also offer a number of distinct advantages not available to corporations.
That is why it is essential the owners ask themselves what the objectives of the business are before forming their business entity. Typically, the major factors that should be considered are:
- the ease of formation;
- the number of owners;
- the style of management and control of the entity;
- the authority of owners and management to bind the entity;
- liability of the owners for the obligations of the business;
- transferability of the owners' interest in the business;
- the ability to raise capital;
- tax considerations; and
- dissolution of the business.
Similarly situated businesses may very well have different objectives. For example, while one business entity may wish to avoid personal liability for the liabilities of the company, another business may be more concerned with its treatment for taxation purposes. In short, the goals of the prospective entity should dictate the organization of that business.
Most business entities are structured as sole proprietorships, corporations, general partnerships, limited partnerships, limited liability partnerships (only available for attorneys and accountants in California), or limited liability companies. As explained in detail below, each of these organizations has its advantages and disadvantages.
SOLE PROPRIETORSHIP
A sole proprietorship is a business where the individual engages in business personally, rather than by means of a separate business entity, such as a corporation. The benefit to the formation of the sole proprietorship is the avoidance of the formalities and reporting requirements associated with the formation of other business entities.
If you are the only owner, and your business is of a sort where there is little likelihood that any obligation of the business would surpass its net worth, a sole proprietorship may be right for you. However, because the major drawback to formation as a sole proprietorship is the personal liability of the owner of the business for each and every business liability, the sole proprietorship is not a practical choice for the vast majority of businesses.
CORPORATION
A corporation is a limited liability entity. What this means is that generally, none of the owners can be held liable for the obligations of the corporation solely because they are shareholders.
There are always exceptions. For example, controlling shareholders owe a fiduciary duty to minority shareholders and may be held personally liable for a breach of that fiduciary duty.
Unlike most other business entities, only one member is required to form a corporation. One principal advantage of setting up a corporation is ease of formation. The Articles of Incorporation, which set forth general information about your new company, is filed with the Secretary of State for a fee of $115.00. While formation of the corporation is easy, there are still a number of formal requirements that must be adhered to at the infancy of the corporation, such as the election of directors, appointment of officers, and the adoption and preparation of by-laws. Notwithstanding these formalities, the parties may rely upon a very detailed General Corporation Law (GCL) for the day to day rules and regulations governing the operation of the business. Because the GCL is so comprehensive, the parties need not negotiate a detailed agreement covering the structure and operation of the organization.
The corporation is managed through the Board of Directors who appoint officers to run the day to day operations. Shareholders have no right to participate in the day to day management of the corporation. The officers are considered the agents of the corporation, and neither the shareholders nor the directors have the authority to bind the corporation. Ownership of the corporation is transferred more easily than with other business entities through the transfer of shares of stock. A major advantage of the corporation is continuity of life. What that means is that a corporation is not terminated upon the withdrawal, death, or termination of the shareholders, officers, or directors. Generally, capital is raised through equity contributions by shareholders, loans from shareholders, and secured and unsecured loans from third parties.
Unless the corporation is structured as an "S" corporation, the corporation and its shareholders are subject to double taxation. First, the corporation pays federal and state taxes on its income at the corporate tax rate and is not allowed to deduct the dividends issued to its shareholders. Second, the shareholders then pay tax on the dividends they receive from the corporation.
There are however certain ways to avoid minimize the double taxation such as paying salaries to shareholders and implementing shareholder loans. However if the entity will retain most of its income, it may benefit by being organized as a corporation since the marginal rates available to corporations are usually lower than the marginal rates available to individuals.
Qualifying corporations organized as a "S" corporation, can avoid double federal taxation by having its profits, losses and tax credits skip taxation at the corporate level and pass directly through to the shareholders.
GENERAL PARTNERSHIP
A general partnership is defined as an association of two or persons to carry on as co-owners a business for a profit. While no filing of papers with the state is required for formation, the partners must enter into a partnership agreement, which should be in writing. Because the agreement must cover all of the terms of the parties' relationships, it is normally expensive and time consuming to draft an agreement to the satisfaction of all parties. Unfortunately, unlike a corporation, a partnership does not have the advantage of a comprehensive set of laws such as the GCL. For this reason, the partnership agreement should be as detailed as possible.
Usually, the partners will have equal rights of management. Through the partnership agreement, however, a partner's right to manage the company may be limited. The partners may also designate specific partners to manage the company. Thus, the general partnership offers a great deal of flexibility in structuring the management of the company.
The major drawback to setting up your company as a general partnership is that each partner is jointly and severally liable for the obligations of the partnership. Because each partner is an agent of the partnership and can bind the partnership in the ordinary course of business, one partner will be held personally responsible for any action of the other partner if the act took place in the ordinary course of the company's business. Thus, if your partner commits a fraud upon third persons within the ordinary course of business, you may be held personally responsible even though you knew nothing of your partner's conduct. It is therefore imperative that you realistically anticipate a good working relationship with your partner before deciding to set up your business as a general partnership.
There is little continuity of life with a partnership. Without a written agreement to the contrary, the death, withdrawal, or bankruptcy of one partner will automatically dissolve the partnership. Moreover, any partner can have the partnership dissolved at any time. Joint ventures, or entities formed for a limited or temporary business purpose are treated as general partnerships.
It is difficult to transfer one's interest in a partnership. That is because unless otherwise provided by agreement, a partner cannot transfer her interest without the consent of the other partners. Although a partner may transfer her economic interest in the partnership to third parties, a partner generally cannot transfer her voting rights or rights to participate in the management of the partnership.
Typically, capital is raised from partners' capital contributions and secured and unsecured loans from third parties. Usually, there are no double taxation concerns with a partnership because the partnership does not pay any federal or state income tax. Instead, the partners are taxed directly based upon their receipt of income.
LIMITED PARTNERSHIP
Limited Partnerships are partnerships with:
- one or more "limited" partners who do not participate in the control of the business and are not personally liable for the obligations of the partnership; and
- one or more "general" partners who actively engage in the control of the business and are personally liable for the obligations of the corporation.
Unlike a general partnership, a Certificate of Limited Partnership must be filed with the secretary of state, together with a filing fee of $70.00. Like a general partnership agreement, the agreement of a limited partnership should be drafted to completely set forth the structure and business of the partnership.
Only the general partners manage the partnership. This structure lends itself to centralized management (complete management in the hand of few persons). If a limited partner engages in the management of the partnership, he risks the loss of his limited liability protection. The term "limited liability" means that the partner is liable only up to the amount of his capital contribution. General partners are agents of the partnership and can bind the company, while limited partners do not have the apparent authority to bind to the partnership. The assignment, death, bankruptcy or withdrawal of a limited partner will not cause the dissolution of a limited partner, although the same rules of continuity which apply to general partnership dissolution typically applies to the general partners of limited partnerships. In most other ways, limited partnerships are similar to general partnerships.
LIMITED LIABILITY COMPANY (LLC)
A Limited Liability Company, or LLC is an unincorporated business entity whose members do not have personal liability for the debts of the LLC. In that regard, it has the same advantage as a corporation.
In addition, it has the advantage of a partnership in that it is not subject to Federal or California income tax, as the members are taxed directly on their share of income. An LLC is formed by filing the Articles of Organization with the Secretary of State. Within 90 days after filing the Articles, the LLC must file with the Secretary of State, a statement of information which sets forth general information such as the name of the designated agent for acceptance of service of legal process. All members must enter into an operating agreement, which should be as comprehensive as possible. Thus, it is not as easy to form an LLC as it is to form a corporation.
There is however, a great flexibility in structuring the management of an LLC. The company many be managed by managers who are not members, or by members. The LLC may also appoint officers to run the day to day operations of the company. The right of members to remove managers may be limited by the operating agreement. The management style may be similarly structured to that of a corporation with highly centralized management, or to that of a general or limited partnership.
The agency authority of owners and managers in an LLC depends upon how the LLC is structured. For example, in a member managed LLC, every member is an agent of the LLC, and can bind the company. In a manager managed LLC, every manager is an agent of the LLC.
The Articles of Organization can further limit the liability of members and managers. However, the limitations will not be binding as against third parties having no actual knowledge of the restrictions.
While a member can transfer her economic interest without the consent of the other members, voting and management rights cannot be transferred without the consent of the other members. Capital is raised through capital contributions from members, loans from members, and secured and unsecured loans from third parties.
Normally, an LLC will dissolve upon the death, withdrawal, resignation, expulsion, or bankruptcy of a member, unless either all members vote to continue the business, or the articles of organization provide otherwise.
As stated above, the same limited liability afforded to the shareholders of a corporation typically applies to an LLC. However, because of the additional advantages available to LLC's which are not available to corporations, the LLC should be seriously considered as an alternative to the formation of a corporation and may very well be the best type of organization for your new business.