Starting a new business is one of the most exciting and fulfilling professional experiences a person can have. It is also nerve-wracking, emotional, and sometimes downright scary. The purpose of this three-part series is to provide a basic understanding of the process so you and your attorney can focus on how to best meet your specific business goals. Part one discusses selection of a business entity; part two provides an overview of initial financing and capital structure; and part three discusses agreements founders may want to have among themselves.
There are a number of options that may be available to you when forming your new business. It is helpful to have a basic understanding of the different entities as you begin planning your future business. A qualified attorney can explain in detail how each entity structure would affect your particular business.
The Sole Proprietorship
A sole proprietorship is not actually an entity at all, but is often referred to when discussing business structures. A sole proprietorship means that the owner of the business has full liability of the company. Sole proprietorships are easy and cost effective, but there is no protection for the sole proprietor for any debts or liabilities of the business. Thus, this structure is only advisable where the company has little liabilities, operations or obligations.
A corporation is a fairly rigid entity structure. For instance, it requires articles of incorporation, a board of directors that appoints officers, and officers that generally employ employees. The board of directors is elected yearly by the shareholders (there is a variation on the corporation known as a “close corporation” that can vary this, but that is not discussed in this article). The failure to adhere to formalities (e.g. comingling funds, not conducting meetings, etc.) can lead to personal liability of shareholders for the obligations and liabilities of the corporation.
You may have heard of “C corporations” or “S corporations.” These designations refer to the way the corporation is taxed (named for subchapters C and S of the Internal Revenue Code). In a C corporation, the company itself is taxed on the business profits. The shareholders then pay income tax on the money they received from the corporation (e.g. salary, bonuses, or dividends.) An S corporation, on the other hand, allows the shareholders to enjoy the limited liability of a corporation while being taxed as a partnership. This is referred to as pass-through taxation, meaning the business profits “pass through” to the shareholders in their proportionate share, who are taxed individually. Once the income tax is paid, any amount left that has not been distributed to the shareholders is previously taxed income or PTI, which can be distributed without taxation. The S corporation itself does not pay any income tax. In order to enjoy the status of an S corporation, however, you have to follow certain restrictions, including a limitation on the classes of stock, number of shareholders, and persons who can be shareholders.
If you intend to operate your business primarily as a source of income for the shareholders and plan to pull out all earnings other than necessary for the next year’s working capital, you will likely want a pass-through entity such as an S corporation, a Limited Liability Company (an “LLC”), or a partnership. If you are intending on building up earnings in the corporation to, for example, prepare for a public offering in the future, you may be better suited by selecting a C corporation.
A partnership can be general or limited. A general partnership is formed by two or more persons engaging in business activity. Like the sole proprietorship, nothing is filed with any government entity. Further, no partnership agreement is necessary (although it is prudent to have one). Anything not covered by an agreement is covered under the Uniform Partnership Act. The major distinction from corporations and LLCs is that limited liability is not available – the partners are liable for all debts, taxes, or tortious liability and the partners’ personal assets can be reached to pay such liabilities.
Like a corporation or an LLC, a limited partnership is formed with a filing. Those partners actively managing the business are referred to as “general partners” while those passively investing are referred to as “limited partners” (so they have limited liability for the debts, taxes, etc. of the business). Limited partners cannot actively participate in the management of the business, otherwise they risk losing their limited liability status.
All partnerships are taxed as pass-through entities – income and expenses of the entity are treated as income and expenses of the investors or owners and the entity is not separately taxed, avoiding the double taxation issue of a C corporation.
The Limited Liability Company
An LLC is basically a corporation that is taxed like a partnership. A shareholder in a corporation is generally not liable for debts of the corporation, except for his investment. This is the same for an LLC. Income and expenses of an LLC pass through to owners, like in a partnership and S corporation. However, an LLC has the option to be taxed as corporation or partnership. Perhaps the most attractive feature of an LLC is its flexibility. For instance, in general the failure to comply with statutory formalities does not jeopardize the limited liability status. If you are considering forming an LLC, it is important to discuss this with an attorney as recent changes to the laws governing LLCs have created new default provisions to the operations of LLCs.
A qualified attorney can work with you to choose the appropriate entity and help you file the appropriate documents with the state and draft the operative documents you will need to run a successful business.