When starting your own business, an important early decision is what form of entity will be used to operate the proposed business.
Generally, the new business owner will chose among one of four entities — sole proprietorship, general partnership, corporation or limited liability company. Each has its advantages and disadvantages relating to exposure to liability and tax consequences.
Sole proprietorship
The sole proprietorship is the easiest and simplest method of organizing and operating a business. Anyone who wants to operate a business without co-owners can do so in the form of a sole proprietorship.
A sole proprietorship is not a legal entity, but refers to an individual who directly owns the operating business and is directly responsible for its debts. To form a sole proprietorship, you do not need to file any organizing documents with any government agency.
The sole proprietorship, like all businesses, must still meet certain legal requirements such as a business license, permits and insurance. Any income and expenses generated from the operation of a sole proprietorship are reported on the individual’s personal tax return using Form 1040 Schedule C.
The basic advantages of a sole proprietorship are complete control by the owner and ease and simplicity of formation. The basic disadvantage is that the owner is liable for all acts of the business, including acts of negligence by employees or agents.
General partnership
If two or more business owners engage in a business for profit, they may be deemed to be general partners, even if they have no intention of being partners. There is no legal requirement for a written partnership agreement and no special formalities are required to form a general partnership.
However, partners should have a written partnership agreement detailing their relationship.
The basic advantages of a general partnership are its ability to operate as a separate legal entity (it can hold and convey legal title to real and personal property in the partnership name) and the partnership can sue and be sued in the partnership name, and the partnership itself does not pay taxes. Instead, its income and losses pass through to the partners, who pay their share on their personal return.
The disadvantages of a general partnership are that generally, each partner is liable for the partnership debts, each will be deemed an agent for the general partnership so that all other general partners will be bound by a single general partner’s actions and each general partner may be held liable for any tortious acts committed by another partner.
Corporation
A corporation is a legal entity, separate and apart from its shareholders. The major advantage of selecting the corporation as the operating entity for the business is its shield against personal liability.
If operated properly, the shareholders of a corporation will be able to operate and control the business operations of the corporation without exposing themselves to any form of personal liability Except for their own actions, a shareholder can still be sued for his or her own negligence while similarly acting on behalf of the corporation.
For example, a corporation can be taxed as a “Subchapter C” corporation or as a “Subchapter S” corporation under the Internal Revenue Code. The “C” corporation is subject to double taxation since taxes are collected from a corporation’s profits and again from shareholders when those profits are distributed as dividends. An “S” corporation is taxed as a partnership and is only subject to one level of taxation.
Limited liability company
A limited liability company (LLC) is a hybrid, separate legal entity that combines the pass-through tax treatment of a partnership with the general limited liability protection of a corporation. The owners of an LLC are typically referred to as members, and it only takes one person to form and establish an LLC.
The members of an LLC may manage the affairs of the LLC themselves or elect one or more managers to operate the LLC. Generally, the members will enter into a written agreement called an operating agreement, which delineates the rights, powers and obligations of its members.
Members of an LLC may elect to have the entity taxed as a corporation or as a pass-through entity, like a partnership, unless there is only one member. A single member LLC is either taxed as a corporation or is disregarded for tax purposes, so it is treated as a sole proprietorship.
Each member of an LLC may be involved in the daily business operations of the LLC but still have the protection of limited liability.
David S. Cooper is a partner at Gambrell & Stolz, LLP. His areas of practice include mergers and acquisitions, securities, corporate law and franchise law. Reach him at (404) 577-6000 or [email protected].
