What Type of Business Entity Should I Choose?

May 28

One of the most important questions one should consider when forming a new business is the choice of entity question. Not only will your choice of entity affect the structure, operation and tax liability of your business, perhaps more importantly, your choice of entity dicates the extent to which your personal assets are protected.

There are six basic entities commonly used to structure a new business.

The oldest business entity is the sole proprietorship. If you own your business as an individual and have not filed any documents with the Secretary of State, you are operating as a sole proprietorship. As with every business structure, the sole proprietorship comes with its own set of pros and cons. The strengths of a sole proprietorship are flexibility, pass through tax liability, simplicity, low cost of formation and elegance of management. The weakness of a sole proprietorship, however, is significant. If you own a sole proprietorship, your personal assets remain unprotected and can be attached should anyone secure a judgment against your company. It should be noted, however, that if you are a new business, many institutions with whom you do business will require you to personally guarantee any debt incurred by your company even if you are an LLC or corporation. As such, status as a sole proprietorship generally only creates more personal exposure of your personal assets than an LLC or corporation with clients, customers and those vendors not requiring a personal guarantee. There are clauses that can be utilized in your client and customer service agreements to minimize this exposure. Thus, if you prefer to operate your company as a sole proprietorship, at least in the beginning, you should seek legal advice regarding the terms of your client or customer service agreements.

Similarly, if you operate your business with another individual or other individuals but have not entered into a written agreement or filed documents with the Secretary of State, you are a general partnership. In the absence of an agreement between partners, a California partnership is governed by the Revised Uniform Partnership Act. In a general partnership, all of the partners remain personally liable for the debts and obligations of the partnership. Thus, like the sole proprietorship, the general partnership offers no protection of the personal assets of the partners. Also like the sole proprietorship, a general partnership also offers pass-through tax liability, low cost of formation and flexibility. If you are a partner in a general partnership, you are strongly advised to, at the minimum, enter into a partnership agreement with your other partner(s). I cannot tell you how many cases I have litigated that involved a partnership gone bad, many of which could have been avoided if the partners had actually sat down and put on paper the terms of their agreement. In many cases, this simple act can reveal that the partners were not actually on the same page regarding some material terms, giving them an opportunity to work it out before the company becomes profitable and there was a pot of money to fight over.

Third, we have the limited partnership. In a limited partnership, the limited partners are liable for the obligations of the company only to the extent of their investment in the same. The limited partners generally passive investors who do not have an active role in the management of the company's affairs. The general partners remain liable for the debts and obligations of the company.

Fourth, but seldom used, is the limited liability partnership or LLP. This entity requires the filing of documents with the Secretary of State and allows for the protection of the personal assets of the partners. In most other ways, it resembles a general partnership, allowing for pass-through tax liability and flexibility of management. The partners can run the business themselves, have protection for their personal assets and incure tax liability as if they were each operating their own sole proprietorship. This entity is not frequently utilized because the LLC, which was developed after the LLP, offers many of the same benefits with more flexibility and is generally more attractive to investors.

The Limited Liability Company or LLC, is one of the most common choices for business entities among newly formed businesses. The LLC offers protection of personal assets, significant flexibility in the management, ownership and operation of the company, pass-through tax liability. The individuals with an ownership interest in an LLC are referred to as members, with one or more members being designated as the managing member. The biggest drawback for many small companies is the $800 annual fee for maintaining an LLC. However, the benefits conferred by the LLC structure far outweigh this cost which, is minimal if the company becomes profitable. While the formation costs can be limited to $800, as it is not required that an LLC prepare and sign an operating agreement, it is strongly advised that you do execute an operating agreement. I have litigated many cases that involved a business relationship gone bad, most of which could have been avoided if the parties had actually sat down and put on paper the terms of their agreement. In many cases, this simple act can reveal that the owners were not actually on the same page regarding some material terms, giving them an opportunity to work it out before the company becomes profitable and there was a pot of money to fight over.

The Corporation is also frequently used for many of the same reasons that an LLC is used. Forming a corporation does require the filing of documents with the Secretary of State as well as payment of a fee. Similarly, it also offers protection of your personal assets. However, the documents that must be filed to form a corporation are not as simple as the document required to file an LLC. You are strongly advised to seek legal counsel in the preparation of your corporate documents. Tax-wise, becoming a corporation can result in greater tax liability, depending on the type of corporation you select. It is possible, however, to set up your corporation for status as a pass-through entity for tax purposes. Some people are of the opinion that a corporation is the entity of choice for would-be investors. This is debatable, however, as an LLC is also generally attractive to investors. Obviously, if you have any intention of one day going public, you will need to be a corporation at that time.

*This article is for informational purposes only. It is not guaranteed to be a complete or thorough analysis of the issues discussed herein. It in no way shall serve to create an attorney-client relationship. The reader is advised to check for changes to current law and to consult with a qualified attorney on any legal issue.

- by Heather Orr