Entity Formation: Corporations, LLCs, Partnerships & Sole Proprietorships

So you want to start or are already running a business? You have a product or service to sell, a farm to run, or some other entrepreneurial venture.  You need some money and probably a location and possibly some tools or equipment. Add a few more ingredients and you're set, right?

This is how most people go into business, and very few of them think about what kind of legal ‘entity" they should form.  For many, that's a big mistake.

Sole Proprietorship or Partnership

If you just open your doors without signing any papers creating an entity, by law you have a sole proprietorship if you're alone, and if you do it with others it's a general partnership.

When partnering with others in business, even your closest friends, a written Partnership Agreement is essential because it sets forth a partner's rights, responsibilities and limitations.  There are many different kinds of partnerships.

In a general partnership, unless spelled out in a Partnership Agreement, each partner can bind the other partners to agreements, obligations, bank loans and other debts. An agreement can be used to restrict this ability to fly solo. For example, an agreement can require that spending more than $1,000, borrowing money, selling assets, or entering into agreements by a partner must be approved in advance by other partners. An important aspect of a general partnership is that all partners are liable for all the debts of the business.

This is not so in a limited partnership where the Partnership Agreement establishes that "limited partners" can join with the understanding that their liability for debt is limited to the extent of their investment only, while general partners remain liable for all the debt.

A limited liability partnership can be formed to protect the personal - non-business - assets of partners. Some businesses even form limited limited liability partnerships (this is not a misprint) in which even the general partners are afforded limited liability for the debts and obligations of the limited partnership.

One nice aspect of a sole proprietorship or partnership is that neither entity must file a tax return. Instead, the taxable income of these entities is reported on the owners' individual tax return.

Corporation

Generally speaking, most business owners form corporations to protect themselves from personal liability, as well as other reasons.

Many businesses organize as a C corporation, especially if they have extensive benefit programs to write off.  Articles of Incorporation and Bylaws set forth the rules of operation, and a Buy-Sell Agreement is common place. Forming a C Corporation doesn't mean that protection from liability is absolute. If the corporation is used simply as the "alter ego" of the owner or proper meetings and records requirements are ignored, creditors and others may be permitted to "pierce the corporate veil" to get at the personal assets of the owners. Another down side is that profits are taxed twice, once at the corporate level and again when distributions are made to the shareholders.

Double taxation is often avoided by electing (under the tax code) to be taxed as an S corporation, which still affords owners the liability protection of a C corp but taxes are paid only at the shareholder level, like a partnership. An S corp is best used for business that are "active" or operational and not "passive" which are formed to simply own real estate.  Many S corp owners pay themselves a salary (which must be reasonable in the industry) upon which self-employment tax is paid, and profits are made over and above this salary they are not subject to this tax. Deduction of employee benefits is more restrictive for an S corp.

Another popular corporate entity is the Limited Liability Company (LLC). Its best attributes include liability protection and taxation only at the Member (akin to shareholder) level. An LLC frequently used for real estate ownership, although many active business form LLCs too.  Articles of Organization and an Operating Agreement are required and a Buy-Sell Agreement is highly recommended.  On the tax front, up to the first $102,000 paid to owners is subject to self-employment tax. Another downside is that a separate tax return is required for the LLC.

Choosing between forming an S corp or an LLC often times presents a dilemma. This decision should only be made in consultation with your accountant and attorney.

Whether you are starting a business or are already up and running, like salt is to most dishes, the entity you chose to form is an essential ingredient to your success.