To LLC or not to LLC - What Type of Entity is Right for Your Business?
If you are just starting your business, one of the most important decisions you will make is what type of entity you will choose to operate as. This choice will impact every other decision going forward. You should make an intentional and thoughtful decision that will best meet the needs of your operation, your personal and business tax situation, your transition plans, and the needs of your family.
Depending on the state where you are doing business, there will be a wide variety of entity options for establishing your business entity. Most businesses, however, will fall into one of the following categories:
Sole Proprietorship;
General Partnership;
Limited Partnership;
Limited Liability Company; or
Corporation
Sole Proprietorship
A sole proprietorship is the simplest form of business organization. In reality, it is no organization at all. It requires no formal written documentation other than basic financial and tax records. If you are the sole owner of your business with no other entity in place, you are doing business as a sole proprietorship. In a sole proprietorship, the owner owns and manages the business, assumes all the risks, and receives all of the profit. Any tax on the profit is paid at the tax rate of the owner on his or her individual return. The main advantage of this form of business is simplicity. You really do not need to do a whole lot to get started. You generally don’t need to file anything to form the organization, you don’t need separate bank accounts, you don’t necessarily need a separate tax identification number, and you don’t file a separate tax return. The disadvantages are many. You and your personal assets are at risk for the debts and liabilities of the business. Another disadvantage is the lack of continuity. If you die, you are the business, and the business dies with you.
General Partnership
Like the sole proprietorship, the general partnership, in its basic form is easy to establish. When two or more persons carry on a business for profit as co-owners, they have formed a partnership. This can be true even if the individuals did not intend to form a partnership.
While there are occasionally good reasons for using the general partnership form, one significant drawback to a partnership is the unlimited personal liability that each owner has for the debts and obligations of the partnership. If you are in a partnership with another individual, you should at a minimum have a partnership agreement in place. The partnership agreement will govern the affairs of the partners.
Limited Partnership
The limited partnership is the close cousin of the general partnership. Like general partnerships, it is taxed as a partnership under the Internal Revenue Code. Limited partnerships, however, are creatures of statute and therefore, formal formation requirements must be followed. This includes filing appropriate formation documents with the appropriate state agency in the state where the limited partnership will be located. The document(s) to be filed and the agency where they are to be filed will vary from state to state. So, it is important that you know the rules that will apply to your farm or ranch. Most states will require at least one general partner and one limited partner. The limited partners only have a financial interest. They do not have any management rights. If a limited partner does participate in management, the limited partner may be deemed a general partner. The limited partners are only liable up to the amount of their individual investment in the limited partnership and may not be held personally liable beyond that amount. Just like in a general partnership, the general partner has unlimited liability for the debts and liability of the limited partnership. Therefore, if you are going to use the limited partnership form of doing business, it is important that individuals not serve as the general partner. As with a general partnership, the partnership agreement will govern affairs of the limited partnership.
Corporations
A corporation is a legal entity separate and distinct from its individual owners. Just like a limited partnership, a corporation is a creature of statute and therefore the formal formation requirements of the state where the corporation is located must be followed. This is usually accomplished by filing Articles of Incorporation or a similar document with the appropriate state agency in your state. The other basic document all corporations should have is the bylaws. The bylaws are basically the rulebook for the corporation. A distinction of the corporate form from the partnership form of business is that the corporation will have perpetual existence. This means the corporation will survive its owners and will only terminate upon a voluntary action of the owners or upon the failure to take some action required by state law, such as failing to file an annual report. Another distinguishing feature of the corporation is the fact that all owners, both passive and active, have limited liability protection. Most corporate statutes and the case law that has developed around them require certain formalities to be followed to maintain the protections from personal liability. Decision making in the corporate form is divided among three separate groups: the shareholders (owners), the directors, and the officers. Corporations are taxed under a different section of the Internal Revenue Code from partnerships and so the results of decisions can be different. By default, unless a corporation makes certain elections, the corporation will be taxed under subchapter C. These are commonly referred to as C Corps. If the corporation elects sub-chapter S status it is what is known as an S Corp. Like a partnership agreement, the shareholders can set the rules that govern their relationship by entering into a shareholder agreement.
Limited Liability Company (LLC)
The LLC has become the entity of choice for most businesses. The LLC is a form of business entity that provides the limited liability protections of a corporation but does so without the same legal formalities. Like a corporation, LLCs are authorized by state statute and are legally distinct from its owners. An LLC is formed by filing the appropriate documents required by your state with the designated state agency. An LLC can have a perpetual existence, or something less as established by the operating agreement. The LLC can own property, incur debts, enter into contracts, sue, and be sued. The owners of an LLC are referred to as members. An LLC can have one member (a single member LLC or SMLLC) or many members (a multi-member LLC). Members may be any combination of individuals, corporations, partnerships, other LLCs, trusts or other legal entities. While the LLC is governed by state law, through the adoption of an operating agreement, the members can determine for themselves the rules for many, if not most, issues related to the company, its management, and its organization. If maintained correctly, the LLC will shield its owners from personal liability. LLCs are unique in that the owners can choose from a variety of forms of taxation. Unless an election is made, an LLC with only one member is taxed as a disregarded entity, like a sole proprietorship. An LLC with two or more members is taxed as a partnership by default. An LLC, whether a single member or multi member LLC, may elect to be taxed as a C-corporation or S-corporation. An operating agreement, like a partnership agreement, is the legal document that governs the relationship between the LLC and its members and managers.
Choosing which entity is right for your business is a complex decision that involves the consideration of many operational, tax, asset protection, and estate planning considerations. It is crucial to get competent counsel from qualified advisors in making your decision. Making the wrong choice can be expensive. So don’t shortchange the time deciding what entity is right for your business.
This post is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.