The Basics of Business Structure
This article is excerpted from Business Structures, by Michael Spadaccini.
The most common forms of business enterprises in use in the United States are the sole proprietorship, general partnership, limited liability company (LLC), and corporation. Each form has advantages and disadvantages in complexity, ease of setup, cost, liability protection, periodic reporting requirements, operating complexity, and taxation. Also, some business forms have subclasses, such as the C corporation, S corporation, and professional corporation. Choosing the right business form requires a delicate balancing of competing considerations. Learn how to select, plan, and organize the business form that is a perfect fit for you.
The Sole Proprietorship
The sole proprietorship is the simplest business form under which one can operate a business. The sole proprietorship is not a legal entity. It simply refers to a natural person who owns the business and is personally responsible for its debts. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name, such as Nancy's Nail Salon. The fictitious name is simply a trade name--it does not create a legal entity separate from the sole proprietor owner.
The sole proprietorship is a popular business form due to its simplicity, ease of setup, and nominal cost. A sole proprietor need only register his or her name and secure local licenses, and the sole proprietorship is ready for business. A distinct disadvantage, however, is that the owner of a sole proprietorship remains personally liable for all the business's debts. So, if a sole proprietor business runs into financial trouble, creditors can bring lawsuits against the business owner. If such suits are successful, the owner will have to pay the business debts with his or her own money.
The owner of a sole proprietorship typically signs contracts in his or her own name, because the sole proprietorship has no separate identity under the law. The sole proprietor owner will typically have customers write checks in the owner's name, even if the business uses a fictitious name. Sole proprietorships can bring lawsuits (and can be sued) using the name of the sole proprietor owner. Many businesses begin as sole proprietorships and graduate to more complex business forms as the business develops.
Advantages of the Sole Proprietorship
- Owners can establish a sole proprietorship instantly, easily, and inexpensively.
- Sole proprietorships carry little, if any, ongoing formalities.
- A sole proprietor need not pay unemployment tax on himself or herself (although he or she must pay unemployment tax on employees).
- Owners may freely mix business and personal assets.
Disadvantages of the Sole Proprietorship
- Owners are subject to unlimited personal liability for the debts, losses, and liabilities of the business.
- Owners cannot raise capital by selling an interest in the business.
- Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.
A partnership is a business form created automatically when two or more persons engage in a business enterprise for profit. Consider the following language from the Uniform Partnership Act: "The association of two or more persons to carry on as co-owners of a business for profit forms a partnership, whether or not the persons intend to form a partnership." A partnership--in its various forms--offers its multiple owners flexibility and relative simplicity of organization and operation. In limited partnerships and limited liability partnerships, a partnership can even offer a degree of liability protection.
Partnerships can be formed with a handshake--and often they are. Responsible partners, however, will seek to have their partnership arrangement memorialized in a partnership agreement, preferably with the assistance of an attorney. Because partnerships can be formed so easily, partnerships are often formed accidentally through oral agreements. A partnership is formed whenever two or more persons engage jointly in business activity to pursue profit.
Don't operate a partnership without a written partnership agreement. Because of its informality and ease of formation, the partnership is the most likely business form to result in disputes and lawsuits between owners--oral partnership arrangements are usually the reason.
The cost to have an attorney draft a partnership agreement can vary between $500 and $2,000, depending on the complexity of the partnership arrangement and the experience and location of the attorney.
Advantages of the Partnership
- Owners can start partnerships relatively easily and inexpensively.
- Partnerships do not require annual meetings and require few ongoing formalities.
- Partnerships offer favorable taxation to most smaller businesses.
- Partnerships often do not have to pay minimum taxes that are required of LLCs and corporations.
Disadvantages of the Partnership
- All owners are subject to unlimited personal liability for the debts, losses, and liabilities of the business (except in the cases of limited partnerships and limited liability partnerships).
- Individual partners bear responsibility for the actions of other partners.
- Poorly organized partnerships and oral partnerships can lead to disputes among owners.
In my law practice, I would almost never recommend a partnership to clients. The lack of liability protection is simply not an acceptable risk that I could ever recommend that a business owner undertake. The rare occasion where I recommended a partnership was when a corporation or LLC was legally unavailable to the owners, as is the case with law partnerships, for example. Another example would be when all the owners of the partnership were already liability-protected entities, such as when two LLCs come together as owners of a partnership.
The Limited Liability Company (LLC)
The Limited Liability Company (LLC)
The limited liability company (LLC) is America's newest form of business organization. There is little historical precedent for LLCs. They are essentially creations of the state legislatures, although some commentators trace the origin of the LLC to a 19th century form of business organization called the partnership association, or limited partnership association. The great bulk of laws authorizing LLCs in the United States were passed in the 1980s and 1990s. Wyoming passed the first law authorizing the LLC in 1977. Florida followed in 1982. The watershed event in the rise of the LLC was a 1988 Internal Revenue Service ruling that recognized partnership tax treatment for LLCs. Within six years, 46 states authorized LLCs as a business form. By 1996, Vermont, the last state to recognize LLCs, had an LLC statute in place.
The LLC is often described as a hybrid business form. It combines the liability protection of a corporation with the tax treatment and ease of administration of a partnership. As the name suggests, it offers liability protection to its owners for company debts and liabilities.
Simplicity and Flexibility
While LLCs are essentially new creations of state legislatures, corporations are truly ancient--and today's corporate law still carries some unwanted baggage. The modern American corporation has antecedents that date to Roman times, inherited by us through English law. The basic principles of American corporate law have not changed significantly in centuries. Probably the single greatest disadvantage of the corporate form is the burdensome range of formalities that corporate managers must observe. A modern corporation's heavy administrative burden is a remnant of the more traditional and formal legal system under which corporate law was cultivated.
The LLC changed all that. The LLC offers the liability protection benefits of the corporation without the corporation's burdensome formalities. It is this simplicity that has made the LLC an instantly popular business form with businesspersons operating smaller companies.
Another attractive feature of LLCs that we will discuss throughout this book is their flexibility. LLC management can elect to be taxed either as partnerships or as corporations. An LLC can be managed like a partnership (a member-managed LLC) or like a corporation (manager-managed LLC). LLCs can create a board of directors, and can have a president and officers just like a corporation. LLCs can choose to have periodic meetings of their membership, or they can choose to ignore such formalities altogether.
Potential Disadvantages of the LLC
The LLC does carry some disadvantages that make it an undesirable business form for some purposes. The limited liability company is a new business form, and courts have not yet developed a body of legal precedent governing LLCs. Thus, LLC owners and professionals may face operating questions and issues for which they have little or no legal guidance. That said, this concern lessens as the states develop a reliable body of law concerning LLCs, and is no issue at all for very small companies. Furthermore, for companies that wish to pursue venture capital, accumulate a large number of shareholders, and/or eventually pursue an initial public offering, the LLC is not an appropriate alternative to a corporation. Venture capitalists and angel investors tend to shy away from investing in LLCs. That may change in the future, but today all large, publicly-held companies are corporations, not LLCs.
What should the owners of an LLC do if their company grows in size such that an LLC is no longer the appropriate business form? The answer is simple: it is possible to convert an LLC into a corporation. Thus, some small companies begin life as LLCs, outgrow the LLC form, and then the LLC's owners transfer the assets of the LLC to a newly formed corporation with the same owners as the LLC. Thereby, the LLC is converted to a corporation. We have included some sample conversion forms in the appendix. Furthermore, as one might imagine, it is also possible to convert a corporation into an LLC, or nearly any business form into any other. It is also possible to reorganize a business in another state by transferring the assets of a business into a newly chartered entity. Converting business forms does require some sophisticated legal and tax analysis and should not be attempted without the services of a qualified attorney and accountant.
The cost of setting up an LLC is roughly equivalent to setting up a corporation. The secretary of state's fees for filing articles of organization and for filing annual reports are often the same for both LLCs and corporations. Organizers who wish to seek help in organizing an LLC through an LLC formation service or through an attorney will find the fees to be roughly the same.
Advantages of the LLC
- LLCs do not require annual meetings and require few ongoing formalities.
- Owners are protected from personal liability for company debts and obligations.
- LLCs enjoy partnership-style, pass-through taxation, which is favorable to many small businesses.
Disadvantages of the LLC
- LLCs do not have a reliable body of legal precedent to guide owners and managers, although LLC law is becoming more reliable as time passes.
- An LLC is not an appropriate vehicle for businesses seeking to become public eventually, or to raise money in the capital markets.
- LLCs are more expensive to set up than partnerships.
- LLCs usually requires annual fees and periodic filings with the state.
- Some states do not allow the organization of LLCs for certain professional vocations.
The term corporation comes from the Latin corpus, which means body. Historically, in England, the term corporation was also used for the local government body in charge of a borough. A corporation is a body--it is a legal person in the eyes of the law. It can bring lawsuits, can buy and sell property, contract, be taxed, and even commit crimes.
Its most notable feature: a corporation protects its owners from personal liability for corporate debts and obligations--within limits.
A corporation has perpetual life. When shareholders pass on or leave a corporation, they can transfer their shares to others who can continue a corporation's business. A corporation is owned by its shareholders, managed by its board of directors, and in most cases operated by its officers. The shareholders elect the directors, who in turn appoint the corporate officers. In small corporations, the same person may serve multiple roles--shareholder, director, and officer.
Corporations are ideal vehicles for raising investment capital. A corporation seeking to raise capital need only sell shares of its stock. The purchasing shareholders pay cash or property for their stock, and they then become part owners in the corporation. Of course, the sale of corporate stock is heavily regulated by the U.S. Securities and Exchange Commission and by state securities laws.
A corporation's shareholders, directors, officers, and managers must observe particular formalities in a corporation's operation and administration. For example, decisions regarding a corporation's management must often be made by formal vote and must be recorded in the corporate minutes. Meetings of shareholders and directors must be properly noticed and must meet quorum requirements. Finally, corporations must meet annual reporting requirements in their state of incorporation and in states where they do significant business.
Advantages of the Corporation
- Owners are protected from personal liability for company debts and obligations.
- Corporations have a reliable body of legal precedent to guide owners and managers.
- Corporations are the best vehicle for eventual public companies.
- Corporations can more easily raise capital through the sale of securities.
- Corporations can easily transfer ownership through the transfer of securities.
- Corporations can have an unlimited life.
- Corporations can create tax benefits under certain circumstances, but note that C corporations may be subject to "double taxation" on profits.
Disadvantages of the Corporation
- Corporations require annual meetings and require owners and directors to observe certain formalities.
- Corporations are more expensive to set up than partnerships and sole proprietorships.
- Corporations require annual fees and periodic filings with the state.
Michael Spadaccini has 14 years of experience as a corporate attorney specializing in business, trademark, securities and internet law. He has written several self-help legal guides, including Forming an LLC, Incorporate Your Business, The Operations Manual for Corporations and Small Claims Court Guidebook, all available from Entrepreneur Press.