There are a number of business structures that you may choose for your startup business. Selection of the suitable business entity appropriate for your business (and your needs) will determine the amount of taxes you pay and exposure to risks of liability you face. The type of structure you select may also impact the ease you have in obtaining bank loans or raising capital from potential investors. Among the most frequently used legal entities are sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and corporations.
A sole proprietorship is the simplest form of business that exists and does not require state registration. Basically, these enable a one-person owner (including one formed by a married couple) to assume the risk of running the business, potentially using their own name for the business, without being beholding to anyone else. Typical examples are various professionals (e.g., attorneys, physicians, hairstylists, etc. that practice their professions on their own) and persons that want to form a retail business where they are the sole owner/operator (e.g., owning a pet grooming facility).
The sole proprietor need not register the business with the state. Depending on the industry and location, your city may require that you obtain a business license or permit. Moreover, if you intend to conduct the business using a name other than your own, you will need to file a so-called “fictitious business name statement” with the county in which you are conducting your business. This certification will enable you to “do business as” another name without having to create a separate legal entity.
Among the advantages of the sole proprietorship are:
You won’t need significant money to form the business, although if you need to rent and furnish a facility, obtain inventory, employ staff, and market your business, you may need as much capital as you would with a more formal form of business entity.
It will be easier (and possibly less costly) for filing taxes compared with other types of entities that may require filing separate returns for the business in addition to your personal returns.
You will not need to file annual reports with the California Secretary of State.
Among the disadvantages of conducting your business as a sole proprietorship are:
As the sole owner of your business, you will be solely responsible for all expenses associated with your business.
As a sole proprietor, it may be impossible to raise money from potential investors.
It also may be more difficult to obtain loans for the business.
You will have unlimited personal liability for the debts of your business.
The general partnership is similar in most respects to a sole proprietorship, with the main difference being that two or more people will be the owners. Typically, the ownership is divided between all the partners who share in the profits, business assets and legal liabilities in some proportion as agreed to by the partners. However, as is the case with the sole proprietorship, these owners will be subject to unlimited personal liability for the debts of the business.
Advantages of using a general partnership for your business are:
You will have a smaller financial burden and can share the running of the business with your partners.
You need not file the business with the state.
The profits and losses from the business are shared equally among the partners unless the partners agree upon the division of the profits based on unequal percentage ownership.
Disadvantages of the use of the general partnership include:
All of the general partners will be equally responsible for the debts and liabilities of the business.
Each of the partners is considered to be “agents” of each other and therefore responsible for the business acts of each partner, regardless of whether they disagree with such actions.
Disputes among the partners can have dilatory effects on the operation of the business.
The partners can’t make business decisions without the approval of the other partners.
If one partner decides to leave the partnership, or if the business ends, valuation of each partner’s interest in the assets and dividing them up may be most difficult, especially in the event of the decision to dissolve the partnership.
Somewhat similar to the general partnership, in the limited partnership, there is a general partner who is responsible for managing the business operations and is solely liable for the business and personally liable for the business debts. On the other hand, the limited partners are investors who, unlike the general partner, have no say in the day-to-day management of the business operations but enjoy limited liability protection from the debts and liabilities of the business.
Advantages of the limited partnership are:
Lower start-up costs than formal entities such as corporations and limited liability companies.
Generally easier to raise capital than the sole proprietorship or general partnership.
If you are a limited partner, you enjoy limited liability for the business debts – that is, you are only personally responsible for the amount you invest in the partnership.
Disadvantages of the limited partnership include:
You must register the limited partnership with the California Secretary of State, just as with other formal business entities.
The general partner is responsible for the company’s liabilities, and their personal assets may be at risk.
The general partner must be engaged in the day-to-day operations of the business.
The limited partners have only limited say in the operation of the business, all of which should be spelled out in a written partnership agreement.
Limited Liability Company
The limited liability company (“LLC”) has all of the positive aspects of other corporate entities, that is, there are a number of owners, generally called “members”, none of whom are generally personally liable for the debts and liabilities of the business, including the so-called “manager” or “managers” if appointed to supervise the day-to-day operations of the business.
Advantages of the LLC include:
Allows for flexible management choices to handle day-to-day business operations.
It may be easier to obtain investment capital and/or small business loans than with a sole proprietorship.
Enables the members to elect how to be taxed by the IRS.
Other than a relatively small tax in California, there is no federal tax imposed on the LLC; rather, the members are responsible for reporting income, losses and credits on their personal individual income tax returns.
Disadvantages of the LLC include:
The LLC is somewhat more expensive to operate than a sole proprietorship, requiring registration and annual filings with the California Secretary of State and, with some exceptions, preparing and filing separate partnership return of income both with the IRS and State.
The LLC may be required to pay unemployment compensation to its employees.
The corporation is the type of entity used by almost all publicly registered companies. Ownership of a corporation is evidenced by “shares” issued to its investors, called “shareholders”, who are required to meet at least once a year to elect the governing body of the corporation, the so-called “board of directors.” In turn, the board of directors meets periodically (at least once each year) to oversee major decisions of the persons they appoint to run the day-to-day operations of the corporation, the so-called “officers.” The officers include, at a minimum, a president or CEO (“chief executive officer”), a secretary, and a CFO (“chief financial officer” or “treasurer”). Other officers that may be appointed by the board of directors include vice-presidents, chief operating officer, controller, etc.
Advantages of the corporation:
The shareholders generally have no personal liability for the debts and liabilities of the corporation.
The shareholders, as investors, do not have to worry about the day-to-day operations of the business unless they are elected to serve on the board of directors or appointed as officers. Of course, if you form a corporation as the sole shareholder or with few other shareholders, you will serve both as a director and officer and have primary responsibility for the operation and success of the business.
Investors, banks and other financial institutions are familiar with the corporate form of business and accordingly may be more willing to invest in, or loan to, the corporate entity.
Although most large corporations, so-called “C corporations” must file a corporate tax return and are taxed on profits of the business (and, if the corporation declares and pays dividends to the shareholders, the shareholders are personally taxed on dividends), an election may be made with the IRS to elect to be taxed as a so-called “Subchapter S” or “S” corporation) in which the corporation is not taxed at the corporate level and only the shareholders report income, loss and credits on their personal individual income tax returns.
Disadvantages of the corporation include:
You must register with the California Secretary of State and file annual reports.
Unless you are the sole shareholder (including your spouse), you must file a separate corporate income tax return, both federally and with the State of California.
There are certain so-called “corporate formalities” that must be carefully followed including (i) holding annual meetings of shareholders and documenting them with so-called written “minutes” of the actions taken at the meeting, (ii) holding meetings of the board of directors at least annually and documenting the meetings with written minutes of the actions taken and (iii) assuring that you do not commingle personal assets or debts with those of the corporation, and visa-versa.
Selecting the type of entity appropriate for your business is complex and often limited by the type of business and regulations under state law. The options will be explored with the client at the initial meeting to enable the client to select and move forward with the form best suited to their business.