When you start a new business it’s always a good idea to start at the beginning. That means choosing the right form of legal entity to run your new enterprise. That choice depends on the type of business you envision running. For example,
- If you’re launching a technology start-up you’ll likely choose a c-corporation.
- If you’re starting a real estate investment company, you may choose a limited liability company.
- If you’re starting a venture fund you may choose a limited partnership.
- If you’re starting a professional service firm you would create a limited liability partnership or professional corporation.
In most states you have four basic types to choose from:
- Sole proprietorship,
- partnership,
- limited liability company and
- corporation.
While many states have other types of entities for specific business purposes, these four entities make up the vast majority of businesses operating in the United States today. Your decision should be driven by the type of business you want to start, and several important factors that impact just about every type of business: (1) taxation, (2) protecting against personal liability, (3) following formalities, (4) raising capital, and (5) easing succession.
1. The Factors
Taxation
Whether the company pays its own taxes or the profits and losses are taxed directly to the owners is a major consideration when selecting a business entity. When a business elects “pass-through” tax treatment – by checking a box on its tax return – the entity does not pay taxes on any of its revenue because it’s taxed as though it’s a partnership. The entity is considered disregarded. All profits and losses pass through to the owners, whether they’re partners, members or shareholders.
For example, suppose your business is a pass through entity that realized $300,000 in profit last year. You decided to distribute $100,000 to each of the two owners in the same year. In most jurisdictions, the entity would pay no tax on any of the $300,000. Each owner would report $100,000 on their individual tax returns and pay tax on that income. California imposes a minimum franchise tax on corporations, LLC and limited partnership so if you operate in California your business will have to pay a modest tax.
If your business is structured as a non-pass through entity the entity itself would pay tax on the profits it recognizes. The owners would also pay taxes on the dividends or distributions they receive personally. Taxing both the entity and owner is known as “double taxation.” In the example above, your business would pay tax on the $300,000 of revenue and the owners would pay taxes on their $100,000 distributions. In general, pass-through tax treatment is preferred because each dollar is only taxed once.
Protecting Against Personal Liability
As a general rule, if an entity protects its owners against personal liability the business’ creditors can only pursue the company’s assets to satisfy its debts. The owners’ personal assets are protected from collection by the company’s creditors. Conversely, if a business entity does not provide protection against personal liability – like a partnership – its creditors can pursue the owners’ personal assets to satisfy the business’ debts.
Following Formalities
The formalities a business entity must follow are the procedural and administrative tasks the law requires the entity to complete to create, operate and remain in good standing. These tasks include the type and frequency of owners’ meetings that must take place, the creation, preservation and availability of company records, and the preparation of organizational documents to create and manage the business. Complying with formalities have a cost in terms of the time spent and fees paid to advisors and to government authorities. Your failure to comply with certain formalities can cause the government to impose penalties on your entity and even revoke its ability to do business.
Raising Capital
Your business will need money to make money. Different entities have different options for raising capital. The most important distinction is that some entities can sell equity in their company to raise capital, while other entities cannot, and must rely solely on the personal assets of their owners, and the loans those owners can procure from lending institutions.
Easing Succession
Succession refers to passing the ownership interest and management responsibilities of the business to the next generation in a smooth, seamless and cost-effective manner. Usually, this means passing ownership rights and management responsibilities over time, rather than all at once. This is often a crucial consideration for family businesses, which tend to have a very strong interest in the longevity of the company.
2. Types of Entities You Can Choose From
Sole Proprietorships
A sole proprietorship is created when an individual commences a business without undertaking the necessary formalities for the creation of another type of entity. A sole proprietorship has one owner – as soon as it has two owners it’s a partnership – pass-through tax-treatment, no protection against personal liability, few on-going formalities, cannot sell equity, and cannot be passed on to the next generation in the same form in which it’s currently operated. This form of business entity is almost never recommended.
Partnerships
There are three types of partnerships: (1) general partnerships, (2) limited partnerships, and (3) limited liability partnerships. A partnership is an association of two or more people who carry on a business for profit as co-owners.
A general partnership (“GP”) is a sole proprietorship where multiple people start a business together without undertaking necessary formalities to create another type of entity. GPs have pass through tax treatment, no protection against personal liability, few on-going formalities, and can only raise capital by requesting the partners invest more money into the business or by borrowing. GPs have limited options for succession because the next generation can’t take over ownership without becoming subject to personal liability, and taking full responsibility for management.
Limited partnerships (“LP”) have two classes of partners: general and limited. The classes differ by their right to manage the business and protection against personal liability. Generals have complete authority to manage the business, but have no protection against personal liability. Limiteds have no authority to manage the business, but are protected against personal liability. LP are pass-through tax entities with varying degrees of formality depending on the partnership agreement. LP interests can be sold in exchange for capital, which means they can use debt to equity to raise money. Succession can be complicated. To bring a new generation into ownership, a partner must either be a limited not able to participate in management or a general subject to personal liability.
Limited Liability Partnership (LLP) are creations of state law so the specific legal requirements that govern them vary by state. As a general matter, all LLP partners can be involved in day-to-day management and still enjoy protection against personal liability. LLPs also enjoy pass-through tax treatment. They can raise capital by selling partnership interests or by borrowing from financial institutions. The combination of protection from personal liability and pass-through tax treatment makes LLPs an attractive choice in the states that allow them. LLPs are usually created for specific purposes – for professional services like law, accounting or architecture – and as a result impose limits and formalities that benefit only certain types of business ventures.
Limited Liability Companies
All owners of an LLC, regardless of how involved they are in day-to-day management, enjoy protection against personal liability. LLCs are generally pass-through entities. Depending on the state and complexity of the operating agreement, an LLC can require minimal formalities to properly operate. These advantages are unique to LLCs, and make them an attractive choice for family businesses. Ownership interests in LLCs may be appealing to investors because of the liability protections and management flexibility that accompanies them. Capital can be raised through both debt and equity offerings so long as investors have an appetite for the company’s business. LLCs provide great flexibility when it comes to succession planning. New generations can be brought into ownership over time with the full benefit of liability protection and involvement in management to the extent deemed appropriate for their skills by the older generation.
Corporations
Corporations are another popular entity choice for family businesses. There are many types of corporations, including c-corporations, s-corporations, non-profit corporations and benefit corporations. C-corporations tend to dominate the landscape of public and private corporations operating in the U.S. today. S-corporations may be quite useful for family businesses. Corporations provide protection against personal liability and allow for the creation of multiple classes of ownership – through different classes of stock with different rights – that offer different investors different types of investments. This gives corporations flexibility in how they raise capital. Corporations are able to take advantage of the same succession planning benefits as LLCs. C-corporations are not pass-through entities, and are subject to double taxation. S-corporations are pass-through entities and can avoid double taxation.
Conclusion
The descriptions of the various forms of business entities provided in this blog are general. The specific rules that cover each entity type vary from state to state, and can become quite complex. Selecting the entity type for your company is a big decision. One that hinges on the specifics of your business. Be sure to have a clear vision for your company, and please make sure you consult with a qualified attorney and accountant before selecting or changing your entity type. The consequences can be significant.
Contact Us.
Finkel Law Group, with offices in San Francisco and Oakland, has more than 25 years of experience advising the founders of new and existing business entities in all the forms and complexities discuss above. We have experience working with privately held corporations, limited liability companies, and partnerships across multiple industries to help them negotiate and properly document all forms of their business transactions.
When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist you with a business transaction or investment you may be contemplating for your privately owned business, please contact us at (415) 252-9600, (510) 344-6601, or info@finkellawgroup.com to speak with one of our attorneys about your matter.