For new businesses, the plethora of entity structure options for initial formation can seem endless and confusing. The following guide was compiled to lay out the basics of corporate structure and to assist in analyzing said options in preparation for a consultation with your lawyer.
Sole proprietorships are made up of only one individual managing the business, who takes on all of the risks of the business personally. There is not a distinction between the individual and the business, meaning the liabilities and debts of the business can be satisfied with personal assets. Put simply – if you default on a business loan, lenders can come after your personal cars, real estate, and much more.
These particular entities are subject to pass-through taxation, requiring all business profits and losses to be reported on a business owner’s personal tax returns. Sole proprietorships do not survive the death of the owner, so, upon death, all the business assets are liquidated and distributed to the estate. If you are an individual with a business and have not taken formal action to set up your business, this is the default structure.1 This business structure is not recommended.
Legally defined, partnerships are formalized agreements between two or more parties to share in the profits and losses of a business. There are several subtypes of partnerships for businesses to create, each with their own drawbacks and advantages for prospective companies.
The default structure for partnerships, formal filing is not required for general partnerships. Similar to sole proprietorships, all debts and liabilities of the partnership can be satisfied with personal assets. In other words, each general partner is accountable for the actions of the partnership and of the other general partners, such liability extending to the entire net worth of each partner. This business structure is not recommended.
A limited partnership has two separate categories of partners: general and limited partners. In most instances, only one or two general partners handle daily business operations. Assuming liability of the partnership, these partners use personal assets to cover applicable debts and liabilities. On the other hand, the limited partner is typically more of a passive investor that does not take part in managing the corporation. The investment provides a limit to a limited partner’s personal liability.2 A fairly common structure in certain types of investment vehicles, limited partnerships are often utilized by hedge funds and venture capital firms.
For limited liability partnerships, all partners have limited liability and do not appoint a general partner. Each partner is allowed to act on behalf of the partnership and further able to enter into binding contracts for the partnership itself. This entity type is popular among professionals that do not want to take on potential personal liability for another partner’s actions within the partnership.
It is important to note that this partnership type is a relatively new corporate form and is not recognized in all states, causing potential issues if the business' operations are to be conducted across multiple states. This structure is the same as a limited partnership, however, it includes limited liability for the general partner(s). LLLPs are most often used as investment structures, and largely in the real estate industry. For example, a group of investors forms an LLLP to build an apartment community or hotel, and the investors enjoy the fact that they are not personally liable for the debt of the partnership and can only lose what they invested.
LLCs provide the most simple and flexible entity structure for establishing a corporate form and limiting the liability of the business’s owners. The owners’ liability is limited to the value of the assets contributed to the LLC. It is the most common entity selection for small businesses in the U.S. This type of entity can be owned by one or more people (including other entities) and is created by filing formal documents with the state. One drawback of forming an LLC is that there are limits to the liability. If you find yourself in court, a judge can rule that the LLC structure does not completely protect your personal assets.
A corporation is an organization authorized by a state authority to act as a stand-alone legal entity that is owned by its shareholders. When a corporation is created it must go through the process of incorporation in order to establish the business entity a distinct identity. This identity creates a liability shield for the owners in the event of a lawsuit or legal claim.3
This is the default corporate structure. It provides unmatched flexibility when it comes to raising capital because the directors can issue as many classes of shares as is needed and can attach different rights to each class. Additionally, C-corporations are generally easy to value, something that is essential if you plan on conducting more than one round of financing. C-corporations are subject to double taxation, meaning the company is taxed on its income at the corporate level and individual shareholders are also subject to personal income taxes on the dividends they receive.
S-corporations are a legal fiction that only exists at the federal level. An S-corp. election modifies the taxation status of the underlying entity to cause it to be a flow-through entity for tax purposes, which means that shareholders are taxed on corporate profits at a personal level, thereby avoiding double taxation. Such an election can be made at the time of incorporation or within 75 days of the date of formation. S-corporations predate the creation of LLCs, and in some ways, they are very similar. In fact, the rise in the popularity of LLCs has caused a significant decrease in the use of S-corporations, however, they do still have utility in the right circumstances.
The S-corporation designation does come with some significant restrictions though, as companies that take the election are limited to 100 shareholders, cannot issue more than one class of stock, cannot have foreign shareholders, or be owned by another entity.4 Additionally, owners and employees opt for a smaller reasonable salary, pay income taxes on that salary and then take any remaining profit as a distribution, which is almost always taxed at a lower level. In choosing to operate in such a manner it is vital that shareholders work with a CPA to determine a defensible salary to avoid a run-in with the IRS.
Not to be confused with the B-Corp certification that any type of business can apply to receive, a benefit corporation is a traditional C-corporation or S-corporation that commits to creating a public benefit and adding sustainable value in addition to generating profit. The leaders of the company must make decisions with this social justice lens, rather than the traditional view of maximizing profit. There is also a higher reporting standard for benefit corporations. They are expected to show progress toward achieving social and environmental goals for the public.5
The key difference between non-profit corporations and traditional corporations is the way that profits are distributed. Instead of making profits for shareholders, non-profits focus on making money to put back into the corporation. These types of corporations are also eligible to qualify for a tax-exempt status, which is helpful for maximizing profit to cycle back into the business.
The Rodman Law Group has extensive experience in helping business owners of all kinds make the optimal entity selection for their needs and in helping them select a jurisdiction in which to incorporate. Contact us if you would like assistance with what will be one of the most important decisions you make for your new business.
The information in this blog post (the "Blog" or "Post") is provided as news and/or commentary for general informational purposes only. The information herein does not, and shall never, constitute legal advice and therefore cannot be relied upon as a legal opinion. Nothing in this Blog constitutes attorney communication and is not privileged information. Nothing in the Post or on this website creates any kind of attorney-client relationship or privilege of any kind.
Originally published March 9, 2020, at https://therodmanlawgroup.com.
