A General Overview of Different Business Entities and their Pros and Cons.
As you’re deciding on the perfect name and location for your business, you might also be considering the different types of business entities and which one might be best for your venture. Each entity has its own unique set of properties and attributes, which can create advantages and disadvantages in different scenarios. The information below is intended to provide a brief overview of the most common entity structures. However, before you pull the trigger and move forward, you should consult with a business formation lawyer to ensure your business strategy is appropriate.
A sole proprietorship is simply a single individual conducting some type of business. There is no formal registration required, and there is no distinction between the owner and the business… the owner is the business. Some advantages of a sole proprietorship are that they are easy to set up and maintain (no registration requirements), there are no formation fees, all finances pass through to you personally so you can deduct a net business loss from your personal income taxes. Some downsides to having a sole proprietorship are that the owner has to pay personal income taxes for all of the earned business profits, and even more importantly, the owners are held personally liable and responsible for all of the business’s judgments, debts, lawsuits, claims and other liabilities.
General & Limited Partnerships
General partnerships are similar to sole proprietorships, except that the business is run by more than one person. Therefore, they have many of the same benefits and downsides of a sole proprietorship. However, partnerships also come with additional issues and considerations. Not only are the owners personally liable for the debts and liabilities of the business, but they are also liable for the debts and liabilities of the owner partners in the business. This creates an additional risk to the general partners. Like sole proprietorships, there are no registration requirements. However, owners can choose to register their partnership with the Secretary of State, to formally establish the entity. In addition, because there are numerous owners, it is typically a best practice to implement a partnership agreement outlining all of the owners’ roles and responsibilities.
A slightly different version of the general partnership, is the limited partnership. With a limited partnership, the general partners are still equally liable as under a general partnership, and are personally liable for the business’s debts, liabilities and judgments. However, additional parties and investors may come into the business as limited partners who are not liable for the debts and liabilities of the business and its other owners. Generally speaking, the general partners run the business, and the limited partners simply invest and do not have any control over the business itself. As a limited partner, investors are only liable for the amount they invest in the business.
Limited Liability Companies
The limited liability company (LLC) is one of the fastest growing entity types due to the great benefits it allows for. It is essentially a hybrid entity that provides the liability protection of a corporation, with the flexibility in management of a partnership or sole proprietorship. With an LLC, as long as the business is properly formed, maintained, and so long as all legal formalities are adhered to, the owners (called “members”) are not generally held personally liable for the debts and liabilities of the company or its other owners.
An LLC may be created by filing registration articles with the Secretary of State. There are additional requirements to file a statement of information, as well as annual minimum payments to the franchise tax board. The annual franchise tax payments for LLCs in California is approximately $800, which can be burdensome for smaller businesses. However, there are significantly less documents required than a corporation. An LLC can be owned by one or more individuals or other entities. Though it is not always mandatory, it is generally a best practice to implement an operating agreement, outlining the ownership structure, management, equity splits, profit distributions and more.
Like LLCs, corporations are distinct legal entities that exist separate and apart from its owners, and the owners (called “shareholders”) are not generally held personally liable for the debts and liabilities of the company or its other owners. Unlike most other types of business entities, corporations have very rigid management structures and formalities to adhere to. Corporations are required to have a board of directors, certain key officers, shareholders with properly issued shares, and must conduct annual board and shareholder meetings. The internal documents of a corporation can include bylaws, written consents and resolutions, minutes, shareholder agreements, stock ledgers, and more.
Positive aspects of a corporation are the limited liability protection, consistent management structure, options for combining salaries and profit distributions, and they are generally preferred by investors. Some downsides of a corporation are that they tend to have a larger paper trail, so are more costly to form and maintain, and are also subject to taxation on both the corporate and the individual level (ie. double taxation).
Technically an s-corporation is still a corporation. However, if the corporation meets and maintains certain requirements, it may request to be filed under subchapter-S with the IRS for certain tax benefits. This requires that the corporation have 100 or less shareholders, who are all actual people and US residents, and issues only one class of stock. If these requirements are met, and the proper s-election forms are filed with the IRS, the tax status shifts to “pass through” and the company avoids the double taxation that is incurred by standard c-corporations.
With all of the different properties, attributes, pros and cons of the different business entities, it is very important to choose the right entity for your particular goals and preferences. Starting and operating a business under an entity that does not suit the business, can potentially expose the business and owners to unnecessary liability and risk.
The information presented here is merely an overview of the different types of business entities, to allow individuals to start asking the right questions with regards to forming a business. For a more detailed explanation of the different characteristics of each entity type, and to decide which one is right for you, you should consult with a business formation attorney and discuss the best options available to you.