Choosing the Right Business Entity
Many entrepreneurs are concerned about liability when starting their business. However, many of those same entrepreneurs fail to follow through on those concerns. Those concerns usually start with what type of business entity they should form. From a sole proprietorship to a corporation, entrepreneurs need to understand what each of these entities will mean for them and their business.
A sole proprietorship is the most used and inexpensive type of business entity. Most businesses start in this form because of the low cost and ease of formation. All it takes is a trip to the county clerk’s office and less than twenty bucks and you are in business. A sole proprietorship is a business that is owned and operated by one person. Typically identified as an “assumed name,” it is a way of operating a business under a different name other than the business owner. If you have a low-risk business or intend to keep the business as small or part time operation, this could be a viable option.
The best thing about a sole proprietorship is the ability to have control and make decisions by yourself. You are the business, and the business is you. There is no separation between the two. There are no requirements to maintain minutes or other formalities. You may file your personal tax return form 1040 and simply add a schedule C. Depending on the amount of income you make by running the business this can be a simple and inexpensive option.
The same benefits of operating as a sole proprietorship also act as serious liability traps. Because there are no distinctions between the owner and the business, the owner’s personal assets are at risk along with the business’ assets. This means that if there is ever any liability that is associated with the business, it will be associated with you as well. Moreover, you will be taxed at your individual tax level, which means that if you have a lot of personal income (i.e. salary from other employment) and are in a higher income bracket, you will have to pay taxes in that higher bracket.
If you are operating a business with high risk you should not operate as a sole proprietorship. Furthermore, you have a lot of personal assets or your business acquires a lot of income a sole proprietorship should not be your entity of choice. When deciding what type of entity to start and seek legal counsel from an attorney that deal primarily with businesses.
Ideally, if you are going to enter into a partnership, you should have a written agreement which is drafted to accurately reflect the agreement. Sadly, many perspective partners fail to focus on this issue. Sometimes the partners are friends and/or family and believe that there will never be any disagreement. However, it is my experience (as well as most business attorneys) that this belief often leads to disaster. It is always prudent to spend the time and money on a proper partnership agreement that will guide the partners through the good and bad times. A properly drawn partnership agreement will prevent disagreements from getting out of hand and will cut down (if not prevent) costly litigation costs in the end. The time and money that you are willing to spend properly drafting an agreement will well worth it.
General Partnerships are formed by either an oral or written agreement. Based on the foregoing paragraph you already know which I think is best. This entity is relatively inexpensive to form because there is no requirement to file documents on the state level. The partners will have to file an assumed name certificate with the county clerk’s office in the county which it operates business. Much like the sole proprietorship, there is generally no distinction between the partners and the business. Unless there is a written agreement to the contrary, each partner has equal management rights and equal opportunity to run the business. Partners are accountable to each other and to the business. General Partners are equally and severally liable for the debts of the business. This means that there is no distinction between the partners, their personal assets and the business. Everyone is accountable for the business.
Limited Liability Partnerships (LLP) require written agreements. LLPs are filed at the state level and require annual filings with the state. LLPs are good entities for professionals such as lawyers, accountants, and financial advisors. An LLP will limit liability for each individual partner to the extent that he/she is not personally liable. This means that if one partner commits malpractice, the other individual partners will not be held liable. Furthermore, if the partnership is sued and does not have sufficient assets, the individual partners (in most circumstances) will not be held liable. LLPs are expensive to create and require insurance before the filing can take place.
Limited Partnerships (LP) are good entities to bring in investors. Most commonly identified by laymen as “silent partnerships,” an LP will allow a partner to invest money without incurring liability for the company debts. The LP must have at least one general partner that will assume the liability for the partnership. This partner will be responsible for the day-to-day operations of the company and are solely responsible for the decision making. By contrast, the limited partner cannot be involved in the day-to-day operations of the company if it seeks to protect its limited liability. The limited partner will be entitled to profits and to be informed regarding the financial position of the LP. The LP is also required to file documents on the state level and requires a written agreement.
The most common and well-known business entity is the corporation. Usually, most entrepreneurs choose this entity because this is all they know. While it is not a bad choice making this choice comes with much responsibility. Incorporating your business requires a filing with the Texas Secretary of State. Articles of Incorporation, Bylaws, Employer Identification Number, and meeting Minutes are all mandatory documents. A corporation usually has what I would like to call a “three-tiered management system.” Shareholders are the owners of the corporation and elect the Board of Directors; the Board of Directors oversees the overall direction of the company and elect the officers; the Officers run the day-to-day operations of the business.
In a traditional corporation, the shareholders do not run the business, but only receive income from it. Shareholders are shielded from the liability of the corporation. A Corporation has its own legal identity, separate from its owners. It exists separate and apart from the people, who own, manage, control and operate it. The Corporation issues stock of its own as evidence of ownership. The persons who own the stock are the owners of the Corporation and are entitled to any dividends the Corporation may pay and to receive all the Corporation’s asses after all creditors have been paid if the Corporation is liquidated.
Board of Directors and Officers generally manage the Corporation. The shareholders, Board of Directors, and Officers must hold annual meetings and keep records of each. This can become relatively expensive if there is a large number of shareholders who do not live in the same area. The Bylaws govern the rules and regulations of a particular corporation. Board of Directors makes decisions, officers carry them out.
Another popular choice is a Limited Liability Company (LLC). An LLC is an unincorporated business entity that shares some aspects of the “s” corporation. The LLC provides its members with limited liability and pass-through tax advantages without the restrictions imposed on “s” corporations and limited partnerships. The LLC is owned by the member and may elect managers to run the company. The management and operation of the LLC are governed by its regulations, which are similar to corporate bylaws. Members of an LLC are agents of the LLC to the extent the articles reserve management in the members. If management is vested in managers, then they are the agents of the LLC to the extent the articles vest management in them. An agent of the LLC has power to bind the LLC by an action apparently for carrying on in the usual way the business of the LLC.
Members of an LLC are not liable for the debts of the LLC, except with respect to make the contributions to the LLC that they agree to make; and with respect to the distributions received by the members when they knew the distribution caused the LLC’s liabilities to exceed the fair market value of its assets.
*Except provided by From Entrepreneur to CEO ©The CEO Effect, LLC 2016
Nothing in this article is intended as legal advice and you should consult an attorney before making any decisions.
