In legal terms, a business is often referred to as a business entity. Business entities can take on a variation of forms, depending on its legal structure. This legal structure determines how the entity is taxed, where liability within the entity falls, and how control within the entity is defined, among others. When starting a business, it is important for entrepreneurs to understand the differences between each form in order to properly determine which type of entity best suits their needs.
A sole proprietorship is an individually owned and operated business in which the owner is the one and only owner and decision maker for the business. The business must be for-profit, and from a legal standpoint, is not a separate entity from the owner. As a result, any income from the sole proprietorship is reported and taxed on the owner’s personal tax return.
From a liability standpoint, the owner assumes unlimited personal liability for the business. This means that the owner is responsible for the business’s debts, any lawsuits filed against the business, and torts of both the owner and the owner’s employees.
Sole proprietorships are relatively easy and cheap to form. There is rarely any paperwork to file with state or local governments, although a business operating license or permit may be required. Also, when the proprietor wants to operate the business under a name other than their own, they must locally file for an assumed or fictitious name, commonly expressed with the phrase "d/b/a" (doing business as).
A partnership is an association of two or more persons with capacity to carry on as co-owners of a for-profit business. In a general partnership, co-owners must share management and operational control as well as profit (and losses) equally, unless noted otherwise in a partnership agreement. A general partnership cannot be an investment or real estate venture.
Like a sole proprietorship, taxation occurs at the personal level. Each partner (owner) is taxed on their income tax return, based on their ownership percentage and the amount of income they receive. This form of taxation is often advantageous to owners because they aren’t "double taxed", which happens with other forms of business entities. However, partnerships as an entity must also file tax returns for informational purposes.
Co-owners of a general partnership are subject to unlimited personal liability. This means that the partners are responsible for the business’s debts, any lawsuits filed against the business, and torts committed by themselves, their co-partners, and their employees.
The co-owners of a general partnership have certain duties to each other and the partnership. They have a fiduciary duty and duty of obedience, with violations resulting in personal liability. Furthermore, they have a duty of care, which, when violated, looks at the intent of the violator in order to determine consequences. Lastly, all partners share rights that, unless noted differently in the partnership agreement, include the following:
Right to their share of distributions (profits/losses).
No right of return of their investment before liquidation or withdrawal.
No right to salary compensation.
Right to equal management, including voting rights.
New partners need approval from all current partners.
Right to inspect the books (financial statements, etc).
Starting a general partnership is usually relatively cheap and easy. State and local laws dictate whether or not registrations must be made and what licenses and permits need to be obtained, if any. Also, a federal tax identification number must be obtained for the partnership from the International Revenue Service (IRS).
A limited partnership is a partnership in which there are one or more general partners and one or more limited partners. Limited liability exists for the limited partners, to the extent that they are only liable for the amount of their investment and any torts they commit. Limited partners are only investors, and have no management authority or rights. Once they take any management control, they can legally lose their limited liability status. General partners in a limited partnership are in the same legal position as general partners in a general partnership. See General Partnership for further details.
In terms of duties to each other, the general partners have a fiduciary duty to the limited partners, but not vice versa. Furthermore, limited partners do not owe a duty of care to the other partners or partnership because this duty only applies to managing partners.
Each partner is taxed on their personal income tax return, based on their ownership percentage and the amount of income they receive. This form of taxation is often advantageous to owners because they aren’t "double taxed", which happens with other forms of business entities. However, partnerships as an entity must also file tax returns for informational purposes.
The formation of a limited partnership is relatively cheap and easy, but requires more work than the formation of a general partnership. State and local laws dictate whether or not registrations must be made and what licenses and permits need to be obtained, if any. In some states there may be a more formal filing and larger fee than in a general partnership. Also, a federal tax identification number must be obtained for the partnership from the International Revenue Service (IRS).
A limited liability partnership is a partnership in which all partners are general partners and are granted limited liability. Because limited liability partnerships are relatively new, the laws that govern them vary from state to state, and as a result, the amount of liability the partners are subject to differs in each state. In some states, partners are only liable up to the amount of their investment and torts they commit, while other states include liability for the torts their partners commit.
Some states only allow limited liability partnerships to exist for certain business professionals such as doctors and lawyers. In these states, partners are generally not liable for the torts of their partners.
Since a limited liability partnership is comprised of only general partners, each partner shares managerial control equally, unless noted differently in a partnership agreement. Each partner is taxed on their personal income tax return, based on their ownership percentage and the amount of income they receive. This form of taxation is often advantageous to owners because they aren’t "double taxed", which happens with other forms of business entities. However, partnerships as an entity must also file tax returns for informational purposes.
Starting a limited liability partnership is relatively cheap and easy, although more work is required than registering for a general or limited partnership. Proper filings must be submitted to their state and a federal tax identification number must be obtained for the partnership from the International Revenue Service (IRS).
A limited liability company is an association whose characteristics are a combination of those of a corporation and a partnership. Unlike a partnership, an LLC is a separate legal entity from its owners. The owners, often referred to as members, have limited liability to the extent that they are only liable for any torts they commit and in some situations for their personal investment. They are not personally liable for the torts other members commit or any debts or obligations of the LLC.
In terms of control, limited liability companies are either member-managed or manager-managed. An operating agreement determines how the company will be managed. In a member-managed LLC, one or more of the owners will run the company. In a manager-managed LLC, the members appoint people who will run the day-to-day operations of the company. Larger limited liability companies often use a manager-managed structure so the members can focus on the work of the company. There is a lot of flexibility in how the company is controlled.
In a member-managed LLC, all members have a fiduciary duty, duty of obedience, and duty of care to the other members and to the LLC. In a manager-managed LLC, the managers have all of these duties, while the members do not.
There is also flexibility in the taxation of an LLC. Members generally elect to be taxed on the personal level, like that of a partnership. Each member is taxed on their personal income tax return, based on their ownership percentage and the amount of income they receive. Members can also elect "double taxation" similar to that of a corporation. The LLC must file tax returns as an entity for informational purposes as well. In certain states, LLCs must also pay a franchise tax.
A limited liability company is more difficult to start than any partnership, but much easier to start than a corporation. The starting members must file the required registration with the state, and must follow certain laws that govern LLCs within that state. Most states have laws that make members include “LLC” in the name of their company. Members must also create an operating agreement and obtain a federal tax identification number for the company from the International Revenue Service (IRS).
A limited liability limited partnership is a modification of a limited partnership that gives the general partners limited liability. The general partners of a limited partnership have unlimited personal liability, but in an LLLP, their liability is limited to the extent of their own investment, their own torts, and the torts of other partners or employees. The limited partners of an LLLP still have the least amount of liability, usually limited to the amount of their investment and their own torts.
Managerial control, taxation, and the duties of partners is the same in an LLLP as that of a limited partnership. See Limited Partnership for further details.
Starting an LLLP is a bit more expensive than starting a limited partnership. Because the LLLP is usually a conversion of an LP, there may be fees associated with this conversion. Because LLLPs are a new type of business entity, only a handful of states have statutes that allow the formation of them. It is important to check with the state to see if they are in fact allowed.
A corporation is a legal business entity that is separate from its owners (shareholders), offers limited liability to its shareholders, and has a distinct organizational and management structure. The shareholders of a corporation are only liable for their investment and for torts they commit, like limited partners in a partnership.
Corporations have certain legal abilities and requirements that they must follow. As a separate legal entity, corporations may be perpetual in existence and shares of stock must be freely transferable. The organizational and managerial structure is dependant on the type of corporation. There are two main types of for-profit corporations: C Corporations and S Corporations.
A C Corporation, informally referred to as a general or regular corporation, is the most common form of corporation. Most C Corporations are privately or closely held, meaning their stock is not publicly traded in a market. These corporations often have a structure in which the shareholders are both the directors and officers.
Many larger corporations are public, meaning their shares of stock are offered to the public and that they can be freely traded through a stock market. The structure of publicly held corporations is different than that of most closely held corporation. Shareholders elect a board of directors who serve as the supervisors of the corporation. The board of directors have fiduciary duties to the corporation and must perform their actions in good faith, in the best interests of the corporation, and with due care. They must also have a duty of loyalty. The directors elect officers, or managers, that run the day-to-day operations of the company. They usually have the same fiduciary duties and duties of loyalty and care as the directors.
A C Corporation is named for Subchapter C of Chapter 1 of the Internal Revenue Code. The Internal Revenue Code consists of the tax laws that govern the United States. Under Subchapter C, a corporation’s income is taxed as a separate entity from its shareholders. This differs from pass-through taxation that occurs in the other forms of business entities. In a C Corporation, the shareholders are personally taxed as well, on dividends they receive from the corporation. This is referred to as "double-taxation", since the corporation was already taxed once on this income.
The formation of a C Corporation is the most complex of all the business entities. There are certain steps that must be followed to form a C Corporation. The promoter, or person in charge of organizing the business before it becomes incorporated, must file the appropriate registration filings with the state as well as the articles of incorporation. Next, after appointing the directors, bylaws of the corporation must be created. Finally, all necessary permits and licenses must be obtained that are required for operating the business.
An S Corporation, rather than taxed like any other corporation, is taxed like a partnership. The corporation’s income is reported on the shareholders’ personal income taxes, based on their percentage of shares owned, regardless if they received distributions of the corporation’s income. There are certain requirements that must be met in order for a corporation to qualify for S Corporation status. The entity must be domestic, have no more than 100 shareholders, and have only one class of stock. The formation and management structure of an S Corporation are similar to that of a C Corporation.
Starting a business, regardless of the size, requires research, paperwork, and many other legal issues that need to be addressed. Although not mandatory, a business attorney will help you through the legal process of forming and incorporating your business in various ways. From helping determine which business type is best for you and writing and reviewing contracts, to the state registration process and taxation issues, a good business attorney will facilitate this process and continue to be there for you and your business once it is off and running.