Go Legal Yourself!. Kelly Bagla
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process. Your choice of structure can greatly affect the way you run your business, impacting everything from liability and taxes to control over the company. Choosing the right business entity allows an entrepreneur to reduce liability exposure, minimize taxes, and ensure that the business can be financed and run efficiently. It also provides business owners with a mechanism for ensuring that the business operations will continue, rather than be automatically terminated, upon the death of an owner.
When choosing a business entity, you should consider the following:
Are your personal assets at risk from liabilities arising from your business?
Are you able to offer ownership to key personnel?
What are the continued costs of operating and maintaining your business?
Here is a list of the most commonly used legal structures for business and the advantages and disadvantages of each one is explained in detail below.
Common Legal Entities:
Sole Proprietorship
Partnership
Limited Liability Company – including: Series LLC
Corporation – including:C CorporationS CorporationClose CorporationBenefit CorporationProfessional CorporationNonprofit Corporation
Sole Proprietorship
The most common and simplest form of business is a sole proprietorship. Many small business owners launch their companies as sole proprietorships, in which they and their business are essentially one and the same. An individual proprietor owns and manages the business and is responsible for all business transactions, including its debt. If you want to be your own boss and run a business from home without a physical storefront, a sole proprietorship allows you to be in complete control. Sole proprietorships do have some advantages. They are quick and easy to set up, as no paperwork is required to be filed with the state, they do not require large amounts of money, and accounting is relatively simple. However, sole proprietorships have many disadvantages as well.
The biggest disadvantage is that there is no separation between the assets of the business and the owner's personal assets. This means that anyone who sues the business for any reason can potentially receive a judgment for the business owner's personal assets, such as cash kept in personal checking or savings accounts, the family car, or even the business owner's home. Another big disadvantage occurs if the sole proprietorship wants to borrow money. Because there is no separation between business and personal assets, many sole proprietors have to use their personal assets, such as their home, as collateral for a loan. If the business fails and the owner does not have enough money to pay off the loan, the lender can take the owner's home and sell it to get its money back. Needless to say, this type of ownership is the riskiest and, to make things worse, the courts do not see any difference between a sole proprietorship and its owner. So, when the owner passes away, the business ends.
Partnership
Other forms of business ownership include forming a partnership. This entity is owned by two or more individuals. There are two types of partnerships: a general partnership, where all is shared equally including the assets, profits, liabilities, and management responsibilities between the partners; and a limited partnership, where only one partner has control of the operations while the other partner contributes to and receives part of the profits. A partnership is ideal for anyone who wants to go into business with a family member, friend, or business partner. This entity allows the partners to share profits and losses and make decisions together. Having a well-drafted partnership agreement by an attorney is advisable so all the partners can be held responsible for their contributions, or lack thereof.
While general partnerships provide a means of raising capital more quickly and allow several people to combine resources and expertise, several problems commonly occur, such as partners having different visions or goals for the business, an unequal commitment in terms of time and finances, and personal disputes. Some advantages of a general partnership are shared financial commitment, the ability to pool resources, and generally, limited startup costs. Some disadvantages of a general partnership include partners being personally liable for business debts and liabilities, and each partner may also be liable for debts incurred by decisions made and actions taken by the other partners.
Limited Liability Company
A limited liability company (LLC) is a unique business entity that allows the owners to limit their personal liability while enjoying the tax and flexibility benefits of a partnership. Under an LLC, the members (owners) are protected from personal liability for the debts of the business, as long as it cannot be proved that the members have acted in an illegal, unethical, or irresponsible manner in carrying out the activities of the business.
Limited liability companies were created to provide business owners with the liability protection that corporations enjoy while allowing earnings and losses to pass through to the owners as income on their personal tax returns, thus avoiding double taxation (which is covered in the corporation section below). LLCs can have one or more members and profits and losses do not have to be divided equally among the members. There is a state filing required to form an LLC and although not required by law, drafting an operating agreement is highly advised as it is a crucial document. The operating agreement customizes the terms of the LLC according to the specific needs of its owners, along with outlining the financial and functional decision-making among the members. Businesses that do not have a signed operating agreement fall under the default rules outlined by the individual states, which can sometimes work against the wishes of the owners. In such a case, the rules imposed by the state will be very general in nature and may not be right for every business. For example, in the absence of an operating agreement, some states may stipulate that all profits in an LLC are shared equally by each member regardless of each member's capital contribution. This may not be fair to the members who have contributed a lot more money as opposed to the members who only contributed a fraction of the money.
Many states do not offer this next structure but it's worth mentioning as it is part of an LLC structure – a Series LLC. A Series LLC is a unique form of a limited liability company in which the articles of formation specifically allow for unlimited segregation of membership interests, assets, and operations into independent series. Each series operates like a separate entity with a unique name, bank account, and separate books and records. A Series LLC may have different members and managers in each series. The rights and obligations of these members and managers differ from series to series. Each series may enter into contracts, sue or be sued, and hold title to real and personal property.
The most important characteristic of a Series LLC is the liability protection that is available to each series. Assets owned by one series are shielded from the risk of liability of other series within the same Series LLC. A Series LLC is similar in concept to a corporation with several subsidiaries. However, the Series LLC concept is designed to segregate risk within separate entities without the cost of setting up new entities. The Series LLC is a creation of the individual states and only in certain states are Series LLCs allowed to be formed. Delaware was the first state to enact legislation authorizing the creation of Series LLCs. Several states and one territory have followed suit, including Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah, and Puerto Rico. Some states, like California, do not allow the Series LLCs to be formed under state law but Series LLCs formed in other states can register with the state of California and do business in California.
Corporation
The law regards a corporation as a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, own and sell property, hire employees, own assets and pay taxes, and sell the rights of ownership in the form of stocks.
Corporations