Starting a business can be a daunting but rewarding challenge. One of the key decisions at the early stages of a new business is how to structure your business – i.e., what legal entity to form in order to carry on your business. This choice made at the outset, while not necessarily irreversible, can play a large role in determining the later success of a business.
First, this article briefly goes over some common business entities. Then, it looks at some of the major considerations in choosing a business entity.
A sole proprietorship is one of the traditional “default” forms of business. If one person owns and operates a business without forming a legal entity, he or she is presumed to have formed a sole proprietorship. The owner of a sole proprietorship has total control over the business and receives all the profits and losses. However, there is no liability protection with a sole proprietorship, and the owner is personally liable for all of the debts and obligations of the business.
A general partnership is an association of two or more persons who carry on as co-owners of a business for profit. Like sole proprietorships, general partnerships provide no liability protection for their owners/partners, who are personally liable for all of the debts and obligations of the business. But unlike sole proprietorships, general partnerships have multiple owners and thus face more complicated questions of control and management of the business, sharing of losses and profits, and transfers of partnership interests. These issues are usually addressed in a partnership agreement.
Limited partnerships are much like general partnerships except that they allow for two classes of partner: limited partners and general partners. A limited partnership must have at least one limited partner and one general partner. A general partner of a limited partnership is personally liable for all of the debts and obligations of the business but a limited partner typically is not. Generally, limited partners may not participate in the management of the business.
A corporation is a legal entity which separates its owners (stockholders) from its management (directors and officers). While the stockholders directly or indirectly elect management and may vote on certain significant matters, the operation of the business is generally left to management. The stockholders of a corporation are much like the limited partners of a limited partnership in that they generally are not personally liable for the debts and obligations of the business. The organizational documents of corporations include the articles of incorporation (called a certificate of incorporation in some jurisdictions), which must be filed with the state in order to form the corporation, and the bylaws, which contain many of the governing rules and formalities of the corporation.
Limited Liability Companies
Limited liability companies (or LLCs) are a hybrid entity of sorts, combining many of the advantages of a corporation, such as limited liability, with the flexibility of a partnership. An LLC is formed by filing articles of organization (called a certificate of formation in some jurisdictions) with the state and is governed by an operating agreement. The owners of an LLC are referred to as “members.” LLCs can be managed by the members or by one or more managers, who may or may not be members. Like stockholders in a corporation, members of an LLC generally are not personally liable for the debts and obligations of the business.
Now, we turn to some of the major factors to consider when choosing which business entity to form.
For all entities, individuals involved in the business typically remain liable for their own intentional or negligent acts or errors. However, the law has evolved in many cases to protect individuals from liability for the acts and obligations of their business associates or the business entity itself. While sole proprietorships and general partnerships offer no limited liability, most other business entities offer some liability protection. However, oftentimes certain formalities must be followed and other steps must be taken to maintain such limited liability.
Tax consequences are another well-known issue of entity formation. Some types of business entities are subject to double taxation – meaning that a tax is imposed at both the entity level and the individual level – while others are “pass through” entities where there is little or no tax at the entity level. General partnerships, limited partnerships and LLCs are generally treated as pass-through entities. If certain requirements are met, a corporation can elect to be taxed as a pass-through entity as well (commonly referred to as an S corporation).
Another consideration is the state income or franchise tax rates on business entities, which can be quite significant depending on the circumstances (e.g., what type of business entity, which state it does business in, etc.). The choice of business entity can also affect the business’s payroll and employment tax obligations.
Governing Law of State of Formation
Though this can vary by state, the internal affairs doctrine generally provides that the governance and internal affairs of a business, by default, is governed by the laws of the state in which the business is formed. This may affect matters such as shareholders’ voting rights, distributions of dividends, and fiduciary duties of management.
Although it is sometimes possible to override many of these default state rules in a business’s governing documents, choosing an entity may still require some deliberation because of the implications of this doctrine. So, in choosing an entity, one should look at how the applicable state law treats each possible business entity. States like Delaware (and more recently Nevada) are known as corporate havens as they tend to be more management-friendly in their laws and as a result attract more business formation. Additionally, the Delaware Court of Chancery is particularly well known for having significant business expertise and a well-developed body of case law when it comes to business litigation.
Your choice of entity also can have an impact on your exit strategy. For example, do you plan to grow and continue to operate the business indefinitely, to take the business public, or to find a buyer to acquire the business? Although many entrepreneurs do not have an exit strategy in mind when they form a business, those that do should factor in their existing strategy when considering the choice of entity.
In sum, choosing between different business entities is an exercise in evaluating trade-offs. It is important not only to understand the advantages and disadvantages of each type of business entity, but to determine what considerations and goals should be given more weight for the specific business at hand.