What Kind of Business Should You Be? Choices, Choices, Choices
One of the first decisions any new business faces is what kind of company should it be. The choices used to be simple: sole proprietor, partnership or corporation. Then came subchapter S corporations and limited partnerships. Now add limited liability companies and in some states limited liability partnerships.
How do you choose what's best for you and your business? First, lets check out the alternatives.
Sole proprietor. A single human being running his or her own business, without any formal structure. This is the easiest kind of business to set up, though some states and localities may require the filing of a certificate, especially if you don't practice under your own name. Examples of businesses that could be sole proprietorships are solo professionals (doctors, lawyers, accountants, consultants), especially just starting out. The sole proprietor is fully responsible for all the obligations of the business, even if they are more than the amount he invested in the business.
General Partnership. Essentially a group of sole proprietors running one business together, where all the partners are actively involved in the management. Again, a simple form of business, generally held together by a partnership agreement that spells out the rights and obligations of each of the partners. Each of the general partners, like a sole proprietor, is fully responsible for all the obligations of the business, without limits. Law firms, medical practices and accounting firms invariably used to be general partnerships.
Corporation. The corporation was a grand legal invention. It is considered a legal "person" separate and apart from the human persons who own and operate it. As such, it owns its own assets; its shareholders do not. Consequently, only the corporation is responsible for its obligations, and only its assets can be glommed by creditors. The shareholders, and their personal assets, generally cannot be liable for the debts of the corporation, their exposure being limited to the amount they originally invested. This is the wondrous phenomenon known as "limited liability," which, it can be safely said, is the legal concoction most responsible for our modern commercial world.
Ah, but there is no free lunch. The corporation is easily enough formed by filing documents with the secretary of state, and by adopting by-laws that govern management and shareholders, but it is relatively high maintenance. It must follow rules concerning finances and the election of directors and officers. It requires annual legal work, at least for shareholder meetings or resolutions. It requires a certain amount of record-keeping. If you don't do everything right in forming and operating a corporation, you risk being deemed a general partnership--and losing your precious limited liability. These sometimes cumbersome maintenance requirements are one disadvantage of the corporate form.
There are also tax differences between corporations, on the one hand, and sole proprietors/partnerships on the other. Basically, corporations are limited in how they can return money to their investors. Corporations can only do so by paying dividends. But dividends can only be paid out of money left over after the corporation pays its income taxes. And, to make matters worse, dividends are taxed as income to the shareholders. If you think about it, you will see that a dollar of profit used to pay dividends is taxed twice, once at the corporate level when it is first earned, and then what's left is taxed at the shareholder level as a taxable dividend. This "double taxation" is the second major disadvantage of being a corporation.
Yet, for many years (even centuries) those were the only three ways of organizing a business, and our forefathers had to make severe compromises in deciding which way to go. Over the years, people got tired of compromising and invented new entities that tried to combine the best features of corporations and sole proprietors/partnerships. Those efforts led to the development of Subchapter S corporations, limited partnerships, and most recently limited liability companies and limited liability partnerships.
Subchapter S Corporation. This is a creation of the Internal Revenue Code. A corporation, if it meets certain qualifications and abides by certain limitations, can elect to be treated as a "small business corporation" under subchapter S of the Internal Revenue Code. The corporation retains all the attributes of a corporation, including the all-important limited liability, but will be taxed as if it were a partnership. The subchapter S corporation was the first, and for many years the most popular, way for a small business to acquire a limited liability shield without losing the benefits of having the owners themselves be taxed directly on the profits and losses of the business. However, a sub-S is still a corporation, and still has the maintenance requirements of a corporation.
Limited Partnership. In much the same way that the sub-S is a corporation that is taxed like a partnership, the limited partnership is a partnership that has some of the attributes of a corporation. In particular, the limited partnership retains the corporate distinction between those individuals who manage the business (officers) and those who own the business (shareholders). In a limited partnership, there are general partners, who are just as personally liable for the debts of the business as are partners in a general partnership, and there are limited partners, who, so long as they are not actively involved in the management of the business, have the same limited liability as shareholders. The limited partnership is governed by a partnership agreement, just like a general partnership, and does not have the annual maintenance requirements of a corporation. It was a way for businesses to be run as simply as general partnerships, have the tax benefits of a general partnership, but still be able to offer limited liability to attract investors. The investors had minimal say in the running of the business, much like shareholders. Limited partnerships were especially popular ways to own real estate, oil and gas interests, research and development projects, and investment funds.
By the way, the unlimited liability of the general partners of a limited partnership did not in practice bother anyone. By a simple feat of legal engineering, it became possible to give everyone limited liability. How? By making a corporation the general partner of the limited partnership. But doesn't using a corporation introduce the double-taxation penalty? Well, that's an interesting question. Taxes are paid on profits, and profits are generally determined after expenses. The onerous tax issues faced by a corporation were easily avoided by making sure that the profits of the corporate general partner of a limited partnership were limited or eliminated. You could do that by limiting the amount of the limited partnership's profits that went to the corporate general partner, and by having the corporate general partner pay a lot of expenses. If properly done, this was all perfectly legal. By mixing and matching limited partnerships, general partnerships and corporations, it is possible to create business structures with amazing abilities to allocate profits, losses, risks and rewards to diverse interests. I've seen, and played roles in creating, some limited partnership structures that would make Rube Goldberg proud.
But what started as a simple business organization has now become complex, and the cumbersomeness of the corporate form and its annual maintenance needs have not been avoided. Yet, it all seemed so unnecessary, and in fact limited partnerships were but a step on the road of entity evolution. If the available legal structures can be manipulated like so many Lego blocks to create anything you want anyway, why not just let you do anything you want, and let the lawyers who had to create these structures become, say, Web designers. And so was born the modern day wonder, the. . .
Limited liability company. The limited liability company ("LLC") finally collapses into one entity all the best features of partnerships and corporations. First, LLCs are not corporations. The IRS has said so. They are, for tax purposes, partnerships, which means they are tax-wise invisible. No corporate taxes; no double taxation. Moreover, in structure they are more akin to partnerships than they are to corporations. They are governed by operating agreements that are very similar to partnership agreements, and can be just as flexible. The profits and losses of an LLC can be allocated to different members much like a partnership's. No stuffy board meetings. No straitjackets on how money can be distributed. No annual maintenance. But, all the limited liability of a corporation. What's not to like?
Well, for one thing, LLC's are more expensive to form initially, but you more than save over the course of few years. And, LLC's don't have stock, which is the universal currency for trading pieces of business equity. Finally, there are times, many actually, when you want to be taxed as a corporation.