The single most common question clients and prospective clients ask me is
“How should I legally structure my new business? As a corporation? As a limited liability company (LLC)? As a limited partnership?”
While I often advise my clients to form LLCs, an LLC may not always be the best option.
In general, there are three principal considerations when choosing a business structure: (1) liability, (2) management, and (3) taxes. Unfortunately, the laws that affect some of these considerations are not uniform across the country.
I don’t want to bore you with a law-school treatise on federalism, so I’ll just say that because of the structure of the government in the United States, many of the laws associated with business entities are actually created by the individual states and can vary substantially from state to state. Because of this, the information that follows regarding some aspects of business structures, such as liability and management, is general.
Although there is indeed a lack of uniformity when it comes to state laws associated with liability and management, the taxation of business entities is, first and foremost, governed by federal law. As a result, the taxation of domestic business structures is generally consistent across the country.
- Managed by the business owner
- Unlimited personal liability
- One level of taxation
If one person starts a business without structuring the business as a limited liability entity, such as a corporation or LLC, that business is, by default, a sole proprietorship. This means, among other things, that there is essentially no distinction between the business and the business owner. In addition, the lack of distinction often reduces the ongoing regulatory compliance requirements and formalities that must be observed.
The simplicity of sole proprietorship can come at a fairly substantial cost: the business owner is personally liable for the debts of the business. At first glance, that might not seem like a major issue, but it can problematic. For example, if a sole proprietorship has employees and those employees injure a person while in the service of the business, the business owner may be personally liable for the injury.
While the simplicity of a sole proprietorship comes at a fairly substantial potential cost, that simplicity and lack of distinction also means that the profits of a sole proprietorship are taxed only once.
Although the lack of limited liability is a significant shortcoming in many cases, if the business won’t have employees, won’t use subcontractors, and the owner performs all of the work personally, structuring the business as a limited liability entity may not provide substantial benefit.
While not used exclusively with sole proprietorships, many sole proprietorships choose to register a trade name or D.B.A. (“doing business as”) for the business, but a D.B.A. is not generally required by law.
- Managed by partners (decentralized)
- Unlimited personal liability
- One level of taxation and flexible allocation of gains and losses among partners
If two or more people start a business without structuring the business as a limited liability entity, that business is by default a partnership or, more specifically, a general partnership.
Unless a partnership agreement specifies otherwise, each partner generally has full authority to bind the partnership and act on its behalf. However, state laws may require that a minimum percentage of the partners agree in particular circumstances.
Although this management flexibility may be appealing in some cases, it can be the source of significant personal liabilities for the partners. In particular, partners in a general partnership are sometimes, depending upon the laws of the state that govern the partnership, held jointly and severally liable for the debts of the partnership. In short, this means that if a partner in a general partnership incurs a liability in the name of the partnership or while acting on its behalf, each of the other partners is personally liable for the full amount of that liability.
General partnerships are taxed under Subchapter K of the Internal Revenue Code. Although Subchapter K is often very frustrating to business owners because of its complexity, it can provide significant benefits to business owners. In particular, Subchapter K allows for “pass-thru” taxation, which only imposes one level of tax on the partnership profits. It also provides significant flexibility when allocating profits and losses among the partners.
Because of the variety of and flexibility of limited liability entities that can be used to structure a business, few people actually intend to start general partnerships. In general, business owners typically try to avoid characterization as a general partnership.
You’ve probably noticed that these “default” structures don’t often provide limited liability protection. So, which structures do? Check back later this week for an overview of corporations and limited liability companies.