Selection of Business Entity:
What form will your business take?

by Charles H. Van Gorder

Now that you have decided to start your own business and have determined the catchy name that will become the beacon attracting customers from all points of the compass, what's next? One of the most important decisions you will have to make is what form of entity should you select for your new business? This decision will be affected by many variables that will be unique for each individual situation. Your selection will depend upon numerous considerations including the following: 1) Who will "own" the business and how will the start-up costs be financed? 2) Who will control the business and how will decisions be made? 3) How will the day-to-day operation of the business be managed? 4) Is the a need to protect personal assets of the owners? 5) How can potential tax liabilities be minimized? 6) How long is the business expected to endure and is transferability important? 7) How difficult is it to meet the legal requirements necessary to effectuate the selected entity?

This article is intended to present the most common forms of business organization and the principal advantages and disadvantages of each alternative. In making your decision, it is important that you seek the advice of a competent tax advisor and legal counsel. The rules for each form of business entity may change from state to state, and you should obtain assistance from professionals who can help you decide upon the best choice for your business. The money you spend for such advice at the outset can save you major expenditures at a later date!

Sole Proprietorship
The sole proprietorship is the simplest, and perhaps the most common form of doing business. In many states, all you need to do is register the business name and obtain the necessary state and local business licenses. There is no establishment of a separate business entity; you will simply be known as J. P. Businessperson doing business as (d/b/a) Outdoor Recreation. All business income will be attributed (and taxed) directly to the owner, and all business liabilities will be personal liabilities of the owner.

The beauty and attraction of the sole proprietorship is its simplicity. There is typically only a single owner, so shared finances and control is not an issue. Governmental red tape is minimal, and it is easy to open the business and to shut it down. One principal disadvantage is that the owner's personal assets will be at risk if there is a business-related liability. This may be particularly important where the owner has (or anticipates having in the next 10-20 years) significant personal assets, and the business has employees or manufactures a product.
 
Partnership
A partnership is basically an association of individuals for the purpose of doing business together. A partnership is recognized as a separate business entity. Unlike a corporation, discussed below, a partnership can be expressly created by the drafting of a partnership agreement, or it can be implied from the actions of the partners, such as by sharing business profits or joint ownership of property.
Where a partnership is expressly created, a partnership agreement is drafted to define the relationship of the partners to each other, and to address issues such as financing, management, new partners and profit sharing. All partners of a general partnership are entitled to participate in the management of the business. An agreement can also address the duration of the partnership. When a partnership is dissolved, that are certain procedures that must be followed. State law may impose conditions and obligations in the absence of provisions otherwise in the partnership agreement.

The advantage of a partnership is that it provides a framework for two or more individuals to work together in a business. Once a partnership is up and running, there are few formalities that must be complied with to keep in partnership in force. Partnership income is attributed and taxed to the individual partners. The principal disadvantages are that the actions of a partner may bind the partnership, and partners may be jointly and severally liable, individually, for certain obligations of the partnership, including claims for damages suffered by clients or customers of the partnership. Partners may also be jointly liable for all of the debts of the partnership. Thus, a general partnership provides little protection for the personal assets of its partners.

Limited partnerships are a specific type of partnership, but must be formed through the filing of appropriate documents with the state. Limited partnerships include both general partners and limited partners. One benefit of a limited partnership is that limited partners may contribute to the financing of a partnership and share in its profits, thereby easing the struggle for sufficient financing. The principal advantage for limited partners is that he or she is usually not personally liable for any of the liabilities or debts of the partnership; such liability may be limited to the amount of capital investment. The disadvantages include obligations for record-keeping and other procedural requirements that may be required by state law. For the limited partners, a major disadvantage is that they may have virtually no role in the actual management or control of the partnership. Limited partnerships must include at least one general partner who is responsible for managing the partnership and may be personally liable for the partnership's debts and liabilities.

Limited liability partnerships ("LLP") are a relatively new form of partnership wherein the general partners may be protected from personal liability for the negligent or wrongful acts of the partnership or another partner. An LLP must specifically register as such with the state, and comply with whatever statutory procedures are set forth within the state.
 
Corporation
A corporation is a distinct legal entity separate from the owners, and must be created in accordance with applicable state laws. Usually, in addition to obtaining state and local business licenses, one must file Articles of Incorporation to form a corporation. Once formed, the corporation must adopt bylaws governing its operation, and must elect the necessary corporate officers and directors. State law will impose many conditions and duties on a corporation unless its articles of incorporation or bylaws provide otherwise; and some state law requirements are mandatory and cannot be avoided. A corporation's existence is usually indefinite, and appropriate legal procedures must be followed in order to "dissolve" the corporation.

Financing is accomplished through the issuance of shares, and there must be a sufficient initial capital contribution. In the case of multiple shareholders, consideration must be given to the percentage of ownership for each shareholder and the issuance of more than one class of stock, methods of resolving shareholder disputes regarding the operation of the corporation, and to adopting a shareholders' agreement limiting options for selling shares to other persons.

Unless specially designated otherwise, corporations are considered as "C" corporations, and corporate income is taxed on the corporation at applicable corporate tax rates. Shareholders are compensated through the payment of dividends on corporate stock, and they must pay their own personal taxes on that income. Corporations that select "Subchapter S" status pursuant to IRS regulations have their income taxed directly to the shareholders, thereby avoiding "double" taxation of income. Generally speaking, Subchapter S corporations cannot have more that 35 shareholders, shareholders must be individuals and cannot be non-resident aliens, and there cannot be more than one class of stock. The election of Subchapter S status is accomplished through filing the necessary forms with the IRS, and must be accomplished within specific time frames. 
  
The principal advantage of the corporation is protecting the personal assets of the shareholders from the liability incurred by the corporation. Generally, the extent of the shareholder's personal liability is limited to the amount of the shareholder's capital investment in the corporation. The major disadvantage is the somewhat tedious management and record-keeping required to maintain the corporate status. There must be annual shareholders' and directors' meetings with minutes, there must be a registered agent for the corporation, and most states require the filing of an annual corporate report and payment of the appropriate filing fee. A failure to meet such requirements may result in a creditor's ability to "pierce the corporate veil" and go after the personal assets of the shareholders.

Limited Liability Company
Limited liability companies ("LLC") are another relatively recent invention of state law, and attempt to combine the advantages of a partnership with those of a corporation. As with a partnership or S corporation, the income of an LLC is taxed directly to its members, thereby avoiding double taxation. Like a corporation, the LLC protects in members from personal liability for most of the debts and liabilities of the business; liability may limited to the amount of the members' financial or other contributions.

As with a corporation, an LLC is an entity created under state law, and numerous formalities must be met for an LLC to exist. A certificate of formation must be filed with the state and a company agreement must be adopted. The company agreement establishes the nature of the LLC and addresses issues such as duration, membership, management, financing and transferability of ownership interests. LLC are often run by elected managers rather than by the members themselves. While state statutes impose certain record-keeping requirements, many of the requirements of a corporation are not imposed upon an LLC. This simplicity may make an LLC a more attractive choice of business entity that a corporation. One of the potential disadvantages of LLC is that as a relatively recent creation, there is a lack of case law on the interpretation of LLC provisions, and state laws may undergo fine-tuning as more and more LLC are formed. 

Remember - laws relating to the selection and formation of business entities vary from state to state. It is essential that you seek advice from legal counsel and a tax advisor who will help you to understand the advantages and disadvantages of each option as they relate to your specific situation. What may have been best for someone else may not necessarily be the best for you. Also, as your business changes, your needs may evolve such that a change of business entity may be advisable. For example, the business that initially began as a sole proprietorship may grow and require the financing options available through new partners or corporate investors. If the business is successful, the owner may acquire personal assets that will need protection from the liabilities of the business. This article is intended to help make you aware of the choices that are available, and to ask the questions that need to be answered to make the proper choice.