CHOOSING A BUSINESS ENTITY
Each business entity has unique characteristics which provide varying degrees of flexibility, liability protection, and tax consequences. Deciding which type best meshes with your business’s goals depends on a number of factors. Our small business and startup attorneys will help you evaluate each of these factors to determine which type is best for you and your business endeavor.
If you have started a business yourself but have not formed a formal business entity, your business is likely operating as a sole proprietorship. In fact, most states will classify a business operated by a single owner as a sole proprietorship, even if the owner has not filed a single document with the Secretary of State or has not designated the business as such.
A sole proprietorship is owned and operated by one person in which there is no distinction between the owner of the business and the business itself. That is, the owner of a sole proprietorship is in direct control of all aspects of the business and is legally accountable for all finances. Although the owner of a sole proprietorship receives all profits of the business, he or she also bears unlimited personal responsibility for all business debts, loans, and losses.
For tax purposes, a sole proprietor is responsible for reporting all business profits as personal income and for paying self-employment tax on those profits. Because a sole proprietorship has no partners, membership interests, or shares of stock, it can sometimes be difficult to attract outside investors without changing the structure of the business entity.
Thus, due to the fact that the owner of a sole proprietorship bears unlimited personal liability and that it is difficult to raise venture capital for a sole proprietorship, The Atlanta Lawyer often recommend that our clients consider converting their sole proprietorship to another form of business such as a limited liability company (LLC), limited partnership (LP), or a corporation (C-Corp or S-Corp).
A general partnership is formed when two or more people agree to go into business together. A written contract, however, is not required to form a general partnership, and a general partnership can be formed without the partners intending for the business to be recognized as a general partnership. In fact, a general partnership can be formed without any of the partners even having knowledge that a legal partnership exists.
Similar to a sole proprietorship, a general partnership is formed without filing any documents with the Secretary of State. In a general partnership, all partners are personally liable for all business debts and obligations, including those business debts or obligations incurred solely by another partner. In addition, all partners share joint authority to bind the business in a general partnership, which means that any individual partner can usually bind the entire business to a contract or other business deal.
Thus, when forming a general partnership, it is imperative that the partners completely trust one another. Another potential disadvantage of a general partnership is that when one partner wishes to leave the business, the partnership generally dissolves. However, this scenario may be avoided though a well-drafted partnership agreement.
For tax purposes, a general partnership is not recognized as a separate tax entity from its owners, and the partnership itself does not pay income taxes on profits. Instead, the partners report their share of profits or losses on their individual income tax returns. Because a general partnership does not shield its partners from personal liability, it is often difficult for a general partnership to raise attract venture capital from outside investors.
Thus, we often recommend that clients who are currently operating a general partnership consider concerting their business to an alternative business entity such as a limited liability company (LLC), limited partnership (LP), or a corporation (C-Corp or S-Corp).
A limited partnership (LP) is a business entity formed by two more partners, consisting of at least one general partner and one limited partner. The general partner in a limited partnership is responsible for controlling the day-to-day operations of the business and is also personally liable for all business debts, loans, and losses. Limited partners, in contrast, do not play an active role in the operations of the business but contribute financially to the business.
Because limited partners give up management power, limited partners are protected from personal liability of business debts, loans, and losses. The characteristic of limited liability for limited partners makes limited partnerships particularly attractive to investors. However, a limited partner can lose his or her financial investment in the business. For tax purposes, general partners and limited partners are taxed in slightly different ways.
Although all partners, general and limited, pay taxes on their share of the business profits every year, limited partners generally do not have to pay self-employment taxes due to their passive role in the business. It is also important to consider that a limited partner can become personally liable for business losses if he or she begins taking an active role in the business. Unlike a sole proprietorship or general partnership, a limited partnership is formed at the state level. To form a limited partnership, you must pay a fee and file a “Certificate of Limited Partnership” with the Secretary of State.
A limited liability partnership (LLP) is a type of partnership that provides all of its owners with limited personal liability. Limited liability partnerships are particularly well-suited for licensed professions such as lawyers, architects, and accountants because they shield a limited partner from personal liability arising from the negligence or misconduct of another partner.
A limited liability partnership is relatively flexible legal entity, allowing for new partners to join the partnership and existing partners to leave. An LLP is formed by drafting and filing a “Limited Liability Partnership Election” with the Secretary of State and paying a fee.
Like the limited liability company and general partnership, the limited liability partnership is recognized as a pass-through entity for tax purposes, meaning that the LLP itself does not pay income taxes on profits. Instead, the partners report their share of profits or losses on their individual income tax returns.
A limited liability company (LLC) is of a type of hybrid business entity that combines the pass-through taxation benefits of a partnership or sole proprietorship with the limited liability of a corporation. Although it is a business entity, an LLC is classified as an unincorporated association and is not a corporation. In an LLC, all LLC owners, known as members, are protected from personal liability for debts and claims arising from the business.
Thus, owners generally stand only to lose the money they have invested in the LLC, however, there are certain exceptions to this rule. The most important exception to shielding members from personal liability occurs when a member treats the LLC as an extension of his or her personal affairs, rather than a separate legal entity.
A limited liability company is recognized as a pass-through entity for tax purposes, meaning that the LLC itself does not pay income taxes on profits. Instead, the members report their share of profits or losses on their individual income tax returns.
An LLC is formed by drafting and filing the “Articles of Organization” with the Secretary of State and paying a fee. There are two primary management structures for an LLC – member-managed and manager-managed. In a member-managed LLC, the owners participate equally in the management of the LLC. Alternatively, in an manager-managed LLC, one or more specific members, over even a non-owner, are designated to manage the company.
The primary difference between an LLC and a Corporation is an LLC is easier to set up and has fewer business formalities and legal requirements than a corporation. However, outside investors and venture capitalists are generally less likely to invest in an LLC as compared to a corporation due to the reduced formalities and predictability of an LLC.
A corporation is a business entity that provides limited liability to its owners. The owners of a corporation, known as shareholders, are protected from personal liability for debts and claims arising from the business. Thus, shareholders generally stand only to lose the money they have invested in the corporation, however, there are certain exceptions to this rule.
The most important exception to shielding shareholders from limited liability occurs when a shareholder treats the corporation as an extension of his or her personal affairs, rather than a separate legal entity. Unlike a partnership or limited liability company, a corporation generally pays taxes on corporate profits, and its shareholder employees also pay taxes on their personal income paid from the corporation. This tax structure exists in the traditional C-Corporation. However, if certain requirements are met corporate shareholders can elect S-Corporation status by filing Form 2553 with the IRS.
By electing S-Corporation status, the corporation will be treated like a partnership or LLC for tax purposes, with business profits and losses “passing through” the corporation to be reported only once on the owners’ individual tax returns.
A corporation is formed by drafting and filing “Articles of Incorporation” with the Secretary of State and paying a fee. In addition to filing the “Articles of Incorporation,” bylaws must also be drafted for the corporation. The corporation’s bylaws set out the corporate formalities and basic rules that govern how the corporation is operated. Finally, stock certificates must be issued to the initial owners and recorded to show the respective ownership interests of the shareholders of the business.
Corporations and their shareholders must also observe certain corporate formalities to retain the corporation’s status as a separate legal entity. Some examples of required corporate formalities include, holding annual shareholders’ meetings, maintaining separate bank accounts, and filing a separate corporate income tax return.
HOW OUR SMALL BUSINESS & STARTUP ATTORNEYS CAN HELP YOU
- We will advise you on the advantages and disadvantages of forming a particular entity in light of your long term goals and the nature of your business;
- We will draft the necessary governing documents and register your business with the appropriate state and federal agencies;
- We will prepare other important agreements which spell out additional details relating to your business operations and the authority of its members/owners, including ownership interest, duties and responsibilities, profit and loss distributions, etc.
- To legally operate your business, you may also be required to obtain state or local business licenses and/or permits. The Atlanta Lawyer can help you determine which permits are required for your business and assist you in obtaining them.
And so much more!