So you’re going to start a company? That’s what we like to hear. Obviously, you have a lot of considerations to balance and choices to make. This is our attempt to make your choice of entity a little bit easier.
Let me start by saying that what is best for one might not be the best to another. Choosing a legal structure is not rocket science, but there are a lot of options, and you should know what to look out for. To me, as an attorney, the most important considerations are the following:
limitation on liability
The pragmatist in me also typically considers the likelihood that a particular client will have the wherewithal to maintain the formalities of the more complicated entities. You will no doubt have additional concerns. Some industries all but require corporations. Sometimes people just think they lend an extra air of credibility for marketing purposes. Whatever your concerns, they are valid, so don’t ignore them, and don’t let your business lawyer brush them aside without good explanation.
The basic entities used for most businesses are sole proprietorships, partnerships, LLCs, and corporations. These are all creatures of state law, which means that the requirements of formation and reporting, and the governing case law will vary depending on your jurisdiction. However, the general purpose, pros, and cons behind each is relatively consistent. Those are what we will cover here.
The sole prop is the simplest of all the forms. There is no form really. It is just you, a human being, hanging it all out there. You can use a trade name if you want, but every transaction is done in your name, and every asset is held in your name. You are personally responsible for all contracts, bank accounts, business licenses, insurance, and liability. You are taxed as a self-employed individual, and your business deductions are mostly taken via Schedule C on your 1040. Your income is subject to self-employment taxes as well.
The perks are that there are no special legal requirements to maintain the form. You do not need to answer to partners or shareholders. You do not have to file with the secretary of state, or write out bylaws for how you want to govern yourself. You don’t need business credit since creditors will know you are the one on the hook, even if a business line is a little different from your Macy’s card. Additionally, many states require certain types of entities to pay a minimum tax, which does not usually apply to sole props.
The bad news is that you have full liability for just about everything. A creditor typically has full recourse against you and your personal assets, and probably your marital community assets if you live in a community property state like mine. Creditors can include anyone who claims you breached a contract, or that you hit her with your food truck, or that you failed to pay him back on time.
Transferability is also a problem for the sole pro route. If you ultimately want to sell your business or take on a partner, you obviously cannot sell yourself. You will need to transfer the assets of the business, including any tradenames and the good will associated with them. Don’t worry though. If you want to start as a sole prop, you can always transfer your assets into an entity at a later time if an opportunity presents itself.
The sole proprietorship is a good choice for those who are young and brave and too busy to be bothered with a lot of formalities. If you incorporate, but can’t follow the requirements of a corporate form, a court will probably treat you as a sole prop anyway (i.e. pierce the veil). Then the rigamarole of incorporation was all in vein. As a practical matter, if your business is inherently low risk and you do not want any partners, the sole prop can be a great option.
If you are working with another person, and you do not take steps to formalize your legal structure, your for-profit activities will default into a general partnership. A general partnership can also be created by agreement. Because it is the default entity, no special filing will usually be required. However, I strongly urge you to formalize an agreement no matter how good your relationship with your partner is when you start out.
The major benefits of a general partnership are the minimal formal requirements and corresponding low cost of existence. In most states, general partnerships are treated as distinct legal entities, separate from the partners themselves. This means a general partnership can own property and enter contracts in its own name, rather than the names of the partners.
The downside to a general partnership also derives from the fact that there are minimal formal requirements. It might seem attractive on the surface, but the practical result is less so. You become subject to the default rules established by courts and the legislature. For instance:
Every partner has the authority to bind the partnership, without the consent of the other partners
Every partner assumes joint and several liability for the partnership’s obligation, and the acts of their fellow partners
Every partner is entitled to an equal share of the profits, no matter how much he has contributed
Any payment made by a partner that gives rise to a partnership obligation becomes an interest bearing loan to the partnership from the date the payment was made
Each partner has a fiduciary obligation to the other partners
There are many more such rules, and they are not all bad. However, they are important to keep in mind. If you are not proactive in defining how you want to govern yourself through a partnership agreement, you will be reactive to the laws governing your enterprise.
Partnerships have flow-through taxation, meaning that income and expenses pass through to the individual partners. All your income from the partnership will be subject to self-employment taxes. The operation of how this works can be quite complicated. We recommend that any partnership agreement details the treatment of contributions and distributions of property and the allocations of profit, loss, and various deductions. It would be worthwhile to find a tax lawyer or CPA to assist with this.
Despite the downsides, a general partnership can work well for those who embrace the risk and trust their partners not to make dumb decisions. This is a very tiny percentage of the population.
A limited partnership (LP) has two types of partners. General partners have all the liability they would have in a general partnership. Limited partners, unsurprisingly, have limited liability—limited to their respective contributions to the partnership.
There are a number of benefits to this form. Typically has more flexibility in transferring capital interests than in general a partnership. Assets are assignable.
There are more formal requirements for an LP than a General Partnership:
Formation typically requires the filing of a Certificate of Limited Partnership and the creation of a Limited Partnership Agreement
Most states will require the partnership to have a legal name expressly using the words “limited partnership,” “LP,” or “L.P.”
Usually an agent must also be designated for service of process.
Annual reports are often required
Limited partners are usually prohibited from extensive involvement in managerial duties.
The limited liability for the limited partners can be attractive to prospective investors. They can share in profits/losses without having to be fully involved or bare full liability. In fact, limited partners are dissallowed from performing managerial duties. Limited partners can also leave or be replaced without dissolving the partnership. Limited partners are also not typically liable for self-employment taxes on their income from the partnership, though general partners are.
There are also Limited Liability Partnerships (LLP), and Limited Liability Limited Partnerships (LLLP). They are less typical, so we will not cover those here.
Next week we will cover corporations and LLCs.
To be continued…