Owning and operating a small business is a tremendous accomplishment. After all, small businesses keep this country going in more ways than one.
But, far too often, small-business owners are not aware of the legal availabilities and consequences that come with owning small businesses. Choosing the right business form, for example, comes with its own set of implications.
Various forms are available to small businesses, and various issues can arise for businesses, such as ease of formation, liability, ownership, capital structure, tax implications, transferability of interests, and continuity of existence. This introduction to the world of business forms will allow you, the small-business owner, to ensure the survival and profitability of your business.
The first type of business entity is the sole proprietorship, the simplest form available.
Essentially, sole proprietors are in business for themselves, because no formalities exist in the creation of these types of businesses. Sole proprietors are allowed to have employees; however, the liabilities attached to the businesses are unlimited. In other words, a sole proprietor is personally liable for his actions or those of his employees, barring a few specific employer-employee rules.
Furthermore, the sole proprietorship is a pass-through entity in relation to taxes—meaning, the sole proprietor is taxed individually with regard to the business.
Finally, transferability of the sole proprietorship is simple. It can’t happen. Transferability can’t happen because the sole proprietorship is not its own entity. You can’t sell you. With that said, continuity of existence can go as far as the sole proprietor wishes.
The second type of business entity available to small-business owners is the partnership.
Generally speaking, a partnership is an association shared by two or more people. Two or more people get together and form a business with the goal of generating profits. A partnership can arise either formally or informally, depending on the explicit agreement between the partners.
Typically, partners enter into a partnership agreement that lays out all of the details of the business. For example, the agreement will set out capital contributions, distribution of profits and losses, dissolution procedures, and anything else that may be relevant to the business. If no formal agreement is reached, the state’s partnership statute will control the business, because it sets forth default rules for various situations that may occur during the course of a partnership.
Similar to a sole proprietorship, a partnership typically entails pass-through tax treatment to the individual partners. Also, the partners share “joint and several liability,” meaning one or all of the partners may be personally held liable for obligations arising out of the partnership.
In addition to the typical partnership described above, commonly referred to as a general partnership, there is also a limited partnership. This type of partnership allows contributing members to take advantage of a liability shield. The general partners share “joint and several liability” as in a general partnership. However, the limited partners are only liable for partnership obligations up to the amount of their investment, meaning that they are not additionally personally liable for other obligations of the partnership. Although it shares essentially the same characteristics as a general partnership, the limited partnership requires at least one general partner to remain fully liable for any obligations. State statutes also contain rules for limited partnerships.
Limited Liability Company (LLC)
The third type of business entity available to small-business owners is the limited liability company, also known as an LLC. An LLC is commonly known as an “unincorporated corporation,” meaning there is centralized management, as with a corporation, but there is limited liability attached. In other words, the LLC allows for partnership-like business behaviors.
To properly form LLCs, small-business owners must file with the Secretary of State’s office or equivalent governing body in their states. Many states have statutes regarding LLCs, as they do for partnership business entities. Another trait that LLCs share with partnerships is that they can encompass operating agreements that stipulate how the parties intend to run the businesses in terms of contributions, distributions, dissolution, and any other relevant business needs.
Most business owners choose LLC entities because of their limited liability, which means that the members of the LLC are not personally liable for the obligations of the business. Furthermore, LLCs are also pass-through entities, meaning that the members are individually taxed, and the LLCs are not taxed.
The fourth type of business entity available to small businesses is the corporation. Forming a corporation includes the articles of incorporation, or equivalent, with the Secretary of State’s office or equivalent body. The articles of incorporation contain the name of the corporation, purpose of the corporation, number of shares to be issued, stock restrictions, address, and other information about the business.
Once the corporation is approved by the state, it begins its existence and requires various “housekeeping” requirements to maintain corporate status. The state’s statutes will dictate the various formalities and requirements for a corporation, as they do for partnerships and LLCs. Also, once created, a corporation remains in existence indefinitely, unlike a partnership or an LLC. With regard to taxes, the corporation is taxed as a separate entity, and the members of the corporation are not individually taxed. Finally, liability is limited in a corporation. Members of the corporation are not personally liable for obligations of the corporation, unlike members of a partnership.
Which form is right for you?
It’s important to understand which type of business you are running and where you want your business to go in the future. Certain entities described above are more or less appropriate for specific types of business. Similarly, certain entities are more or less appropriate depending on future plans of the business.
Simply put, the sole proprietorship is the cheapest entity to create because it requires nothing. Of the “filing” entities, the LLC and the corporation, the corporation is known to be the cheapest. However, various tax details, filing fees, and other costs may raise the price.
The bottom line is that the goal of business is to generate profits while promoting and selling products. The small-business owner should choose an entity form that will protect the owners, investors, and employees, as well as provide the best cost-savings processes.
The above analysis is a simple overview. The analysis is not intended to serve as legal advice. It is strongly recommended that a small-business owner consult an attorney before making business decisions that would affect the business form or everyday business operations, because different rules apply to different businesses and circumstances.
This article is from The Small Business Authority’s archives.