Sole Proprietorships
What are they?
A sole proprietorship is simplest business form and that is because you are your business. There is no legal distinction between you and your business when you are a sole proprietor. Any profits, losses, debts and liabilities incurred in your business are yours and yours alone. Establishing a sole proprietorship costs next-to-nothing as there are just the minimal fees associated with registering your business and obtaining necessary licenses/permits. The ease and cost-effectiveness of establishing a sole proprietorship are the biggest advantages of this structure. The biggest disadvantage is that owners’ personal assets are fair game if things go south with the business’ finances. Sole proprietors are also inherently limited in how much they can grow because of how exposed they are to liability.
Who are they good for?
Sole proprietorships are generally good for one-person, service-based businesses that do not carry large amounts of risk and no do not require large amounts of outside capital (investments). Independent designers, copywriters, accountants and consultants are a few professionals that come to mind as good candidates for sole proprietorships.
What are they?
A partnership is an attractive structure when two or more people form a business and comes in one of two forms: general partnerships and limited partnerships. Partnerships are popular because they are relatively easy to form. While the formalities vary by state, they usually are minimal: a single filing with a designated state or local office and the run-of-the-mill paperwork to register your business and obtain any necessary licenses/permits. Like sole proprietorships, the profits, losses, debts and liabilities of a general partnership belong to the partners. The partners share ownership, management and control of the business and are individually and personally liable for the obligations of the business.
Things are slightly different in a limited partnership because there are general partners and limited partners. Limited partners in a limited partnership (also known as limited liability partnership) have limited control and limited liability in the business. Their liability is limited to the amount of their investment in the business (read: no personal liability). General partners enjoy the same privileges, liabilities and responsibilities as general partners in a general partnership. Profits of a limited partnership are usually split according to a partnership agreement. Because limited partnerships are more complex than general partnerships, formation is also more formal. Limited partnerships usually require filing articles or a certificate or a partnership agreement (varies by state) with the state corporation commission or state Secretary of State.
Who are they good for?
General partnerships are ideal for service-based (as opposed to product-based) businesses because they allow businesses to get up and running quickly and cheaply. Some believe that the level of personal exposure to liability makes riskier business ventures less-suited for a general partnership. Architecture firms, staffing agencies and medical practices are commonly formed as general partnerships.
Limited partnerships are best-suited for businesses such as law firms, real estate companies and entertainment production projects. These are business ventures that benefit from having an agreed upon distinction between the partners that put in the work and those that put in the money.
Limited Liability Companies
What are they?
The limited liability company (LLC) is one of the newer and more popular business structures. Much of the LLC’s popularity stems from its flexibility and limited liability. Whereas partnerships require two or more owners and sole proprietorships require one, LLCs can have any number of owners. The management structure of an LLC can resemble a sole proprietorship where a single person or entity manages the business, a corporation with a board of managing directors or a general partnership where everyone is a manager. The profits and losses of the business are usually allocated according to the operating agreement. Liabilities belong to the business which means that owners are not subject to personal liability for the debts and obligations of the business. The one exception to this rule is that single-member LLCs may be subject to personal liability in some jurisdictions.
Properly forming an LLC can be more complex than a sole proprietorship or partnership. I say “properly” because the fee and paperwork (articles of organization) for registering with your state is usually significant but it is not exorbitant or overly burdensome. The complexity is associated with the drafting of the operating agreement. Operating agreements are required in some states but are highly recommended in all states.
Who are they good for?
Because of the flexibility offered, LLCs tend to fit a wide range of businesses. Businesses NOT suited for the LLC form are those that foresee needing flexibility when it comes to raising money (either from venture capitalists or sale of stock) or selling the business.
Corporations
What are they?
Corporations are what many of us think of when we think of a business. These are usually mature businesses that are legally distinct from their owners. They are owned by shareholders, controlled by a board of directors and managed by employees of the corporation. Because corporations are legally distinct entities, the owners are shielded from liability for the debts and obligations of the business. Forming and maintaining a corporation is more complex than the other structures. Sole proprietorships and partnerships do not have any annual maintenance requirements while LLCs only require the filing of an annual fee in most states. In all jurisdictions, corporations have stringent recordkeeping requirements and annual filings.
Corporations come in two varieties: C corporations and S corporations. S corporations are essentially C corporations who elect and qualify for the IRS’s S status which allows the corporation to avoid double taxation on profits and losses. S corporations are restricted in who they can accept investments from and they can also only offer one type of stock (as opposed to two types in a C corporation where shareholders have different rights depending on the type of stock they hold).
Who are they good for?
Corporations are best for businesses that need strong protections against personal liability, are in a financial position to commit to the startup and upkeep of a corporation and know they will need to raise capital from venture capitalists in the future.
Note: Venture capitalists can only invest in C corporations but it is possible to later convert from an S corporation (or an LLC) to a C corporation. There are significant tax advantages to initially forming an S corporation and later converting to a C corporation. This, and other major tax considerations in picking an entity type, will be explored in a subsequent blog post.
Things to Consider
Picking an entity type is tough because you are picking an entity that you hope will work for your business in the future based on how it will work in the present. Thankfully, few things are permanent in this world and your entity type is no exception. While your entity type is not permanent, you can save yourself money, time and a lot of headache if you thoughtfully weigh all of the considerations. Naturally, some factors will weigh heavier than others depending on the type of business you have. Flexibility in ownership, control and management is important for some. Flexibility in the business’ capital structure and the ability to raise large amounts of money is key for some owners. For others, the personal and business tax implications are at the forefront. The important thing is to be thoughtful and intentional about your decision. Forming an LLP because you have a friend who has been through the process is not wise and could cost you opportunities or money in the future.
Stay tuned for Picking An Entity Type: Tax Edition!