Selecting the proper legal form to organize your business has become increasingly complicated, but the choices today are more flexible and numerous than in the past. Until a few years ago, the choices available were fairly limited. If an entrepreneur feared liability from creditors or had partners/investors, the company was incorporated; otherwise, the simplicity of a proprietorship or partnership was often chosen. Today, the choices are much more complex but offer small business owners greater flexibility and protection.
Four Classes of Organization
Let's start with the basics. There are essentially four classes of business organization: Proprietorships, Partnerships, Corporations, and most recently, Limited Liability Entities.
Proprietorships
Proprietorships are owned by one person or a married couple and are among the simplest ways of starting a business. The advantages of a sole proprietorship are exclusive control over the management and development of your business. They are easy to form, inexpensive, and often have favorable tax status when compared to other business forms.
However, proprietorships involve high personal liability, since the business is not a separate legal entity and all business debts and liabilities are your personal obligations. Another downside is that the company's potential financing options may be limited by the credit profile of the individual entrepreneur.
Partnerships
A partnership can be a general partnership or a limited partnership. A general partnership is viewed by the IRS essentially as two or more sole proprietors who are equally responsible for the business. The terms of sole proprietorship apply fully to each partner. Limited partnerships include one or more general partners and one or more limited partners. Limited partners are liable for activities of the business to the extent of their investment.
Partnerships can be relatively cheap and easy to form and maintain. All partnerships should adopt a written partnership agreement, but there is no legal requirement for a contract. No statutory formalities are required nor are there any fees. However, if you choose to do business under an assumed name, registration with state authorities may be required.
Partnerships are often formed to take advantage of the different skills and expertise of the parties involved. In addition, the partners also agree to share the financial and legal risks of the business, thereby spreading the cost of possible losses. Partnerships can offer favorable tax treatment since partners are taxed as individuals, but the partnership itself is not taxed. Each individual partner shares the income and deductions of the business according to the agreed-upon allocation of partnership interests. Because new small businesses frequently experience temporary losses, the pass-through tax treatment of a partnership can benefit a partner by allowing the partner to immediately apply any losses from the business to offset income from other sources.
There are disadvantages to organizing as a partnership. A general partner has unlimited personal liability for business liabilities. Each partner bears personal financial liability for the contracted debts of the business. This financial exposure can be minimized to some extent by purchasing liability insurance. Also, most partnership arrangements restrict a partner's rights to withdraw from the partnership or to transfer the ownership interests.
Obtaining financing, especially long-term financing, is often more difficult for smaller partnerships. New equity financing is generally limited to increased contributions from existing partners, or by adding a new partner. Debt financing is somewhat easier than in a sole proprietorship but may still be difficult because the business's credit is no better than the credit of each individual partner.
Corporations
A corporation is formed as its own legal entity, apart from the individuals who own or formed the organization. The corporation can be either for-profit or nonprofit. The principals of a for-profit business choose this form primarily to shield themselves from personal liability for activities of the business and/or to sell stock in the business. Nonprofit corporations are usually formed this way for certain tax advantages. Whether the company is for-profit or nonprofit, a Board of Directors oversees policy and strategy
for corporations. Principals and board members of for-profit corporations typically have little or no liability for operations of the corporation, unless the owners or board members broke federal or state laws in running the corporation.
There are several tax categories for corporations available, including S-corporations, C-Corporations and Close corporations. These categories are often mistaken for types of corporations, but they are not. These categories affect how the government taxes a corporation, and are not forms of business organizations. Each of these tax categories have different requirements but they all permit equity financing through the sale of stock in exchange for money or property.
Limited Liability Entities
Limited Liability Entities are a hybrid of corporations and partnerships that offer characteristics of both. They come in forms such as Limited Liability Corporations (LLC), Limited Liability Partnerships (LLP) and Professional Limited Liability Corporations or Partnerships (PLLC and PLLP). As with a corporation, the entity can only be created by complying with state law. Limited liability entities are a relatively new form of business organization and are now permitted in all states.
A limited liability partnership permits limited liability for partners and partnership tax treatment; however, unlike an LLC, the LLP is often available only for certain occupations, such as attorneys or physicians. An LLP is formed by a simple registration that indicates that the partnership elects to be treated as an LLP. General partnership law governs the entity, except as to partner's personal liability for the business's liabilities.
The limited liability corporation offers the best of both worlds for some businesses. As with a corporation, the entity can only be created through compliance with state law. The members enjoy limited personal liability for the entity's liabilities. As with a partnership, the members benefit from pass-through (individual) tax treatment -- that is, there's no taxation of the business itself, but all income, deductions, and credits "pass through" to the individual members and are reported by them on their individual tax returns.
The features of limited personal liability and partnership tax treatment have made LLCs a very popular form of business entity. The disadvantages of an LLC are the statutory formalities that must be followed and the expenses that accompany compliance with those formalities. For financing purposes, the limited liability feature of LLCs and LLPs is attractive to investors who might balk at investing in a risky general partnership. Unlike a limited partnership, the participants in an LLC and LLP can be actively involved in management of the business.
Other forms of business organization, including 'benefit corporations' and 'flexible purpose companies' are on the horizon. These are different ways of allowing for-profit companies to engage in activities with primarily 'social benefit'. More information is available at www.bcorporation.net.
What to Consider When Choosing Your Organizational Form
When choosing your company's form of business organization, you should carefully evaluate your business plan, financing needs, and personal risk profile. The key organization issues are liability risk, tax treatment, financing, control, and transferability.
Liability Risk - The major consideration in choosing the form of business is often personal limitation of liability -- that is, to protect your assets from the claims of business creditors. This factor has historically been the driving force in choosing how to organize the business. Certain forms of organization, such as corporations, limited liability entities and certain partnerships have a separate and distinct existence under business law, and provide a shield to the owners from liability to a great extent.
Proprietorships and certain partnerships do not have this advantage because the business entity is not separate and distinct from its owners.
Tax Treatment - After evaluating your liability risk, the tax treatment of the business is the second most important factor to consider. There are basically two federal tax treatments for businesses. The system of taxation of the entity itself and the owners, often referred to as C-corps, applies to business corporations. Alternatively, some business forms may have pass-through taxation, referred to as an S-corp or a "flow-through" entity like an LLC or partnership. Almost any form of organization may be able to take advantage of pass-through taxation. The only form that can not is a publicly traded entity which must be taxed unto itself. This means a C-corp's profits are taxed twice: once when earned and again when distributed to the owners.
Financing - To some investors, a more formal organizational entity may add to the intangible appeal of your business. A corporate name may create an image of credibility and business sophistication for some investors. Securing capital in the form of debt or equity from either partners or investors oftentimes will require the entity to form as a corporation. Alternatives of LLPs and LLCs may make sense if the financing requirements are expected to be narrow in scope.
Control - Any entity that has more than one owner compromises your exclusive control over the business. Your willingness to dilute your ownership control and the need to obtain outside equity financing will govern this factor.
Transferability and Marketability - All organizational forms, other than sole proprietorships and C-corporations, have restrictions on the transfer of ownership interests. Although these restrictions allow the owners a greater degree of ownership control, the constraints are also likely to limit the marketability and liquidity of the equity interests.
Conclusions
There is no set formula for making the determination of which organization form is best for your business; however, certain general principles can help guide your selection of an organizational form that will serve you best. For example, many startup businesses follow a progression of organizational forms, evolving from a sole proprietorship into some form of corporate entity as the business's financing needs and options become more complicated. The sole proprietorship is popular for startups because it requires virtually no formalities and no cost to create and maintain, and tax treatment is favorable and simple.
On the other hand, if your business will have employees, poses relatively high risks, or needs to attract equity financing, the business may benefit from beginning as a corporation. The LLC entity may also be worth considering for a startup business if you want the pass-through tax benefits of a partnership but also want to limit your personal liability.
After carefully evaluating your business and personal goals, consult with your attorney and tax specialist to help you select the best match for organizing your company.
Tom is the Founder and Managing Partner of CFO Selections. He has 20+ years of experience in finance and other executive positions at a variety of companies. Tom enjoys seeing business owners overcome challenges and take their companies to the next level. If he ever had spare time, he would spend it hiking, climbing, and teaching mountaineering.
