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.