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Selecting a Business Format

Contents

Introduction

When starting a new business, one of the most important issues to consider is the "format" of the business. There are a wide variety of formats to choose from, and they range from the very basic to the extraordinarily complex. Each format has advantages and disadvantages in terms of simplicity, flexibility, cost (both to form and to operate), taxation issues, control, continuity of life, transferability of ownership, and liability protection.

This article is intended to provide an overview of the more common business formats, and to outline some key points to bear in mind when making your decision.

A Word About "Limited Liability"

First and foremost, there is no entity in the world that will protect you from your own wrongdoing. For example, if you are driving a vehicle and you negligently injure someone, your personal assets will be exposed to creditor claims whether you are doing business as a sole proprietorship, a limited partnership, a limited liability company, a corporation, or any other entity. Good business practice and asset preservation techniques dictate that you maintain an adequate level of insurance as additional protection against the kinds of claims for which you may be held personally liable.

Secondly, having limited liability does not mean you will not lose money; rather, it means you will not be personally liable for the debts of your business. For example, assume you form a limited liability company and invest $100,000 in it, and then the business is sued for $250,000.00 because of a breach of contract. If your business loses that suit you may lose your $100,000 investment, but absent fraud or other wrongful conduct on your part your personal assets not held in the business name will not be at risk.

Finally, it is important to understand that you can lose your limited liability protection in certain circumstances, such as if a court finds that you are using your business entity to defraud someone, or that you have not taken the appropriate steps to keep the business separate from your personal affairs. You will need to work closely with your lawyer and your tax professional to ensure that your limited liability protections are preserved to the maximum extent possible.

Sole Proprietorship

The simplest of all formats, a sole proprietorship is nothing more than one person going into business for himself. (The owner's spouse may work at a sole proprietorship as an employee, but if a husband and wife wish to operate the business together they must form a partnership or some other entity.) Because the business has no legal existence apart from its owner no particular formalities are required to form the business. (Note, though, that you may need to obtain certain licenses or permits, and to file an assumed name certificate if you are going to be doing business under any name other than your own.) Sole proprietorships do not pay franchise taxes, and earnings and losses are reported on your personal income tax return. Unfortunately, this format offers no liability protection whatsoever, so good insurance coverage is vital to protect your personal assets from business-related claims.

General Partnership

A partnership is formed when two or more people agree to jointly carry on a trade or business and share in the profits. Like a sole proprietorship no particular formalities are required to form the business, although a written partnership agreement is strongly recommended in order to minimize the risk of misunderstandings and disputes. General partnerships do not pay franchise taxes, and the partners each include their respective share of the partnership's profits and losses on their individual income tax returns. General partnerships do not offer any liability protection, which means that you can be held personally liable for the debts of the business and for the wrongful actions of your partners whether you participated in those actions or not.

Registered Limited Liability Partnership

A registered limited liability partnership (LLP) is a partnership that has "registered" with the Secretary of State to receive special liability protections. As explained above, each partner in a partnership ordinarily has full personal liability for the debts of the business and the acts of their partners. In a limited liability partnership, however, a partner is not individually liable for debts and obligations of the partnership arising from wrongful acts committed by another partner unless the first partner participated in or was aware of the wrongful act at the time it occurred. To maintain this protection, the partnership must file an annual registration with the Secretary of State along with a fee of $200 per partner. In addition, the partnership must maintain insurance or other security of at least $100,000 to cover the kinds of errors, omissions, negligence, incompetence, or malfeasance for which liability is limited.

Corporation

A corporation is a legal entity that has existence separate from its owners, which means that it can continue in operation even after the death of the owner. A corporation is formed by making the appropriate filing with the Secretary of State, and the business may not commence until the Secretary of State approves that filing. Certain formalities are strongly recommended, including the adoption of bylaws, issuing stock certificates, holding annual meetings of the directors and stockholders, and approval of written resolutions authorizing specific persons to act on behalf of the corporation. Corporations are required to pay franchise taxes and (except in the case of S-corporations) must pay income taxes on their earnings. In addition, the stockholders must pay income taxes on the dividends distributed by the corporation. Corporations do offer limited liability protection for the stockholders.

Once the entity of choice for all but the simplest of businesses, corporations are declining in popularity because other business formats offer better tax treatment while still providing limited liability.

S-Corporation

An S-Corporation isn't really a separate business format. Rather, it is a corporation that has elected to receive special tax treatment by the IRS. For that reason, the formalities associated with forming and operating an S-corporation are the same as with any other corporation, and S-corporations also provide limited liability protection to their shareholders. What makes S-corporations more compelling is that they avoid the double taxation that results when the corporation pays taxes on its earnings, and the stockholders pay taxes again on the dividends. Instead, the S-corporation's stockholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss (a feature called "pass-through taxation.") There are important restrictions, however, such as limitations on the number of stockholders, the types of entities that may be stockholders, stockholder residency, and classes of stock.

Limited Liability Company

One of the newest business formats, limited liability companies (LLCs) are rapidly growing in popularity, and for good reason. The process of forming an LLC is similar to that of forming a corporation. Like corporations, LLCs have continuity of life separate from their owners, offer limited liability protection to their owners, and must pay franchise taxes. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation with no restrictions on the number of the owners. Texas even allows single-owner LLCs, making them an excellent alternative to a sole proprietorship. LLCs offer an attractive balance of the most desirable features of the other business formats, and we expect them to become the de facto standard for small businesses in the near future.

Limited Partnership

A limited partnership is a special kind of partnership having one or more "general" partners and one or more "limited" partners. The partners may include other partnerships, limited partnerships, foreign limited partnerships, trusts, estates, corporations, persons acting as a trustee or executor, or other entities. To form a limited partnership, the partners must enter into a partnership agreement and file the certificate of limited partnership with the Secretary of State. Limited partnerships offer flow-through taxation and (currently) do not pay franchise taxes.

In a limited partnership, the "general" partner has all the management authority and full personal liability. In contrast, the "limited" partners have no management authority but enjoy limited liability. (Essentially, limited partners are "silent investors" and general partners run the business.) Because the general partner has full liability, it is common for an entity, such as an LLC, to serve as the general partner. If the limited partners own the general partner entity, they can have limited liability for themselves while still maintaining management authority of the limited partnership through their voting rights in the general partner.

When properly set up, limited partnerships offer excellent asset protection and may also be useful in reducing or eliminating federal estate taxes. However, because they typically involve two separate entities (the limited partnership itself and an LLC or other entity to serve as a general partner of the partnership) they tend to be the most complex and expensive formats to establish and maintain.

Professionals

Certain professionals, including doctors and lawyers, are restricted from operating in certain business formats. However, members of these professions may be qualified to form alternative types of entities such as professional associations, professional corporations, and professional limited liability companies.

Concluding Remarks

The choice of a business format should be made only after thoroughly discussing the relative advantages and disadvantages with your lawyer and your tax professional. Please call us if you would like to discuss these issues further.