When a person decides to start up a business, one of the first things he or she must do is decide which type of business structure to operate under. There are six major types of business organizations from which to choose. They are the:
- sole proprietorship
- general partnership
- limited liability partnership
- limited partnership
- limited liability company
- business corporation
Which form the business owner chooses will depend upon a number of factors. Questions of liability, taxation, control, and the raising of capital are a few of the issues to be considered. Each form of business structure has advantages and disadvantages that make it a prudent means of conducting business in some circumstances but not in others. The help of a legal professional is essential in evaluating all of the factors upon which the choice of business organization is based.
The sole proprietorship is the most common form of business organization. One person conducts business for him or herself. A sole proprietorship is not a legal entity. It has no life of its own separate and apart from the owner of the business.
A sole proprietorship is the least complex form of business. It is easy and inexpensive to start up since the sole proprietor merely has to start doing business. Unlike some other forms of business organizations, like corporations or LLCs, the sole proprietorship does not have to register as a business entity with the state business entity filing office before conducting business.
It should be noted however, that permits or licenses may be necessary where state or local law requires them for a particular type of business. For example, a restaurant operator may need special permits, such as a liquor license, to conduct business. Plumbers, attorneys, accountants and other trades and professions need licenses from the state to perform these services. If the sole proprietorship is engaged in an activity subject to state and local sales taxes, a sales tax certificate must be obtained. If the business employs people, a Federal Employer Identification Number must be obtained.
Another exception to the general rule that no filings are required occurs when the sole proprietor conducts business under a name other than his or her true name. For example, if John Jones does business under the name ABC CONSULTING, he must file a statement indicating that ABC CONSULTING is actually John Jones doing business under a different name. This name is known in different states as an assumed, fictitious or trade name. State law determines how and when assumed/fictitious/trade names must be filed.
In addition to being relatively easy to set up, a sole proprietorship is easy to run. Since one person is the owner, that person makes all of the decisions. No meetings or votes are required for these decisions to be made. Another advantage of the sole proprietorship is that all profits and losses belong to the owner and become part of his or her income tax return. The business itself is not taxed.
The major disadvantage to operating as a sole proprietorship is that the sole proprietor is personally liable for the business' obligations. If the assets attributed to the business (tools, inventory, cash, real property, etc.) are not sufficient to meet the business' obligations, the personal assets of the sole proprietor can be used to satisfy those obligations.
If two or more persons agree to do business together, a partnership is formed. Doing business as a partnership is a common-law right. This means that no specific state statute is needed to form a partnership. However, all states have statutes dealing with partnerships. These statutes mostly contain default provisions that will apply only if the partners have not addressed those issues in their partnership agreement. These statutes provide, for example, that unless there is a partnership agreement providing to the contrary, all partners have equal rights to manage the partnership. They also share equally in the profits and losses and distributions of income. It is also provided that each partner is considered an agent for the partnership and may bind the other partners in connection with the partnership business.
A general partnership may be formed informally by oral agreement, or formally by a written partnership agreement. However, it is usually advisable to have a written partnership agreement. This written agreement will generally set forth the:
- Names and addresses of the partners
- Relative rights to management and profits of each partner
- Nature of the partnership business
- Duration of the partnership
- Requirements for admission and withdrawal of partners
- Provisions concerning the dissolution of the partnership and any other provision the partners wish to govern their relationship and the operations of the business.
A general partnership has many of the most attractive aspects of a sole proprietorship. It is easy to start up and run. A general partnership does not have to pay an entity level income tax. It is a "flow through" entity. Its profits and losses flow through to the partners. However, a partnership also shares the sole proprietorship's most unattractive aspect-unlimited personal liability for the business' debts.
Limited liability partnership
Another entity that may be chosen is the limited liability partnership, or LLP. An LLP is a special kind of general partnership. The main difference between a limited liability partnership and an ordinary general partnership is in the partners' exposure to liability. Partners in LLPs have limited, rather than unlimited liability. In most states, partners in an LLP are shielded from liability for any of the partnership's debts and obligations. In some states, however, the partners are not liable for debts arising from the negligence or wrongful acts of the other partners, but remain liable for other debts and liabilities.
A general partnership may become an LLP by filing a registration document with the secretary of state or other proper filing officer. Or, in some states, an LLP may be newly formed without having been a pre-existing GP. A limited liability partnership doing business in a state other than its formation state will have to register with that state as a foreign limited liability partnership before transacting business there. In addition, in most states, limited liability partnerships are required to file an annual report.
Limited partnerships (lps) consist of two kinds of partners- general partners and limited partners. General partners have the same rights, powers, and liabilities as partners in ordinary general partnerships. They manage the partnership, share profits and losses and have unlimited personal liability. Limited partners are partners whose liabilities are limited to their investment in the business. This limited liability is similar to that of a shareholder of a corporation. As a general rule, limited partners do not participate in managing the business.
Limited partnerships are flow-through tax entities. A limited partnership does not have to pay federal income taxes.
A limited partnership may not be formed simply by doing business. A limited partnership is a statutory form of business organization. It can only be formed by complying with state statutory requirements.
A limited partnership must file a certificate with the information specified by its state of organization. State laws also generally place restrictions on the name the limited partnership may choose, require the limited partnership to appoint and maintain an agent for service of process in the state, and require filings to be made if it amends or cancels its certificate. State laws also permit out-of-state (foreign) limited partnerships to be licensed to do business upon filing the appropriate application.
Recently, a number of states have added provisions for a special kind of limited partnership called a limited liability limited partnership, or LLLP. The difference between an ordinary limited partnership and an LLLP, is that in an LLLP, those partners who would otherwise have unlimited liability will instead have the same liability as partners in a limited liability partnership.
Limited liability company
A limited liability company, or LLC, is another statutory entity. It is neither a partnership nor a corporation, but a "hybrid" entity, with some of the characteristics of each. It is formed, in general, by filing articles of organization with the proper state filing officer. Most of the provisions regulating the internal affairs of the LLC are contained in an operating agreement that is entered into by the owners. An operating agreement is similar to a partnership agreement. In recent years the LLC has become the most popular form of business organization in the United States.
An LLC may be solely owned or it may have several owners. The owners of an LLC are called members. The members of an LLC, like limited partners or shareholders, are not liable for the company's debts based upon their status as owners. The members also have the right to manage the company's business and affairs and will not lose their limited liability status by acting as managers. The members may also elect to have the LLC be run by one or more managers if they do not want to run it themselves.
A limited liability company has the advantage of flow-through taxation. Unless it chooses otherwise, a limited liability company will not have to pay an entity level income tax. Instead, its profits, losses and other tax items flow through to its members.
A limited liability company that transacts business in states outside of its state of organization will have to apply for authority to do business in those foreign states. The LLC laws provide that the laws of the state in which a foreign LLC was organized will govern its internal affairs and the liability of its members.
A business corporation is the most complex form of business organization. Its formation and its internal operations are governed by state law. A business corporation is an entity organized for profit under the laws of one state. Nonprofit corporations are formed under different sections of the law and are not covered by this publication. Although once the dominant form of business organization in the United States, in most states today more LLCs are formed than corporations. However, the corporation remains a popular and viable option for many businessmen and women and is still the main choice for publicly traded businesses.
There are four main advantages to doing business as a corporation:
- The investors are not liable for the corporation's obligations
- The corporation has perpetual existence
- Capital can be raised by selling stocks and securities
- The corporation has centralized management so the investors do not have to become involved in the day-to-day operations.
There are three major disadvantages to the corporate form of organization:
- It is the most expensive to form
- It is the most complex to operate
- It is subject to "double taxation"-that is, the corporation pays a tax on its income when earned, and its shareholders pay a tax on the income when it is distributed to them in the form of dividends or distributions upon the corporation's liquidation.
This material was taken from Chapter 1 of CT Corporation's "The Corporation Handbook: A Comprehensive Look at the Corporation for Business Owners and Legal Professionals." The Handbook also provides information on the nature, formation, finances, internal governance, changes in structure, and dissolution of business corporations.