Forming a business entity is critical to creating a shield between the debts and liabilities of the company and the personal assets of the owners. Let’s take a look at the different types of business entities available to the average business as well as what works when.
We need to start with the corporation when discussing the different types of business entities that exist under law. It was the first type of company designed to protect owners. Google, Facebook, and Twitter are examples of corporate entities.
When run correctly, the corporation protects its owners from the liabilities of the business. Having said this, the company must follow corporate formalities to maintain the protection. The formalities can be annoying. Annual shareholder meetings are a requirement, for example. Still, the corporation is the rock solid choice. For tax purposes, many CPAs will advise classifying the entity as an “S” with the IRS.
Limited Liability Company
The limited liability company, “LLC”, is the new entity on the block. Well, new is a relative term. While the corporation has been around for hundreds of years, Wyoming first established the LLC in the United States in the late 1970s. It didn’t gain in popularity in other states until the 1990s. Now, every state allows for its formation for better or worse.
The biggest positive associated with an LLC is they are easy to run. Most of the corporate formalities you have with a traditional corporation do not exist, yet you still get the shield between the debts and liabilities of a business and your personal assets. However, many entrepreneurs run into trouble by failing to realize there are still certain formalities that must be met. For example, Multi-member and manager-managed California LLC operating agreements differ significantly. You can also choose to have the LLC designated as a partnership or corporation for tax purposes, which gives you a certain amount of flexibility.
The biggest negative associated with the LLC is it is a fee and tax trap. The California LLC, for instance, must pay a revenue tax once it starts bringing in more than $250,000 a year. Mind you – this is a gross revenue figure. You must pay the increased tax whether you are profitable or not. The tax starts at $900 at $250,000 and goes up from there. While the amount of the tax is not crippling, it is annoying if you must pay the tax without turning a profit in a particular year.
Can we include the sole proprietor designation as one of the different types of business entities available to entrepreneurs? Not really. The sole proprietorship isn’t an entity. Instead, a sole proprietorship is the default designation for anyone who starts a business on their own and does not form a business entity. If you launch a blog tomorrow on the subject of growing turnips and sell an eBook you’ve written on the subject, you are a sole proprietor.
Operating as a sole proprietor is risky. You have no protection from the debts and liabilities of the business. If someone sues the business and wins a judgment for $100,000, you are personally responsible for it. If you can’t pay the judgment, the winning party can and will come after your home, investments, bank account, savings and any other assets of any value. In short, we are talking about a complete nightmare. To avoid this problem, most people form an LLC or corporation.
A partnership is a sole proprietorship, but with two or more people. For example, you and your neighbor would be a partnership if you both worked on the turnip blog and eBook. The problem, of course, is this exposes both of you to the debts and liabilities of the business. This exposure exists even if the “other guy” is the person who commits the act giving rise to liability.
There is an old saying in the legal profession – “Better to have died a child than be a partner in a general partnership.” If lawyers feel this way, perhaps you should take it as a hint that being in a partnership is not the best move.
A limited partnership is a business entity that attempts to cure the fundamental problems associated with the general partnership. A limited partnership consists of a general partner and a number of limited partners. The limited partners contribute money or assets in exchange for their limited partnership interest. The general partner runs the business on a day-to-day basis.
The advantage of this approach is the limited partners only risk the amount of money they contribute in exchange for their partnership interest. As long as they do not participate in the running of the entity, they are shielded from any further liability.
The general partner is not so lucky. The general partner is liable for all the debts of the business. There is a strategy for dealing with this risk, however. Instead of asking an individual to fill the general partner position, most limited partnerships use a corporate entity. If the limited partnership runs into legal or debt problems, the corporate shell protects the parties running the partnership on a day-to-day basis.
The limited partnership is a tremendous business entity, but also an expensive one to launch and run. The paperwork and filing costs alone are burdensome. As a result, this entity should only be used in high dollar projects.
Should you form a business entity for your new endeavor? You should consult an attorney to determine if it makes sense and, if so, which one is best for your particular situation. Feel free to contact me if you have any questions at (800) 966-1679.
Richard A. Chapo, Esq.
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