Business Formation: Sole Proprietorships, Partnerships, LLC’s and Corporations
By Richard E. Korb, attorney ©2011[1]
For a free consultation with an experienced business attorney-Richard Korb, please call 510-524-0903
Thinking of starting a business? When forming one alone or with a spouse, you’ll normally form a sole proprietorship. If you are embarking on this with one or more partners, there are quite a few options to choose from: General Partnerships, Limited Partnerships, Joint Ventures, Limited Liability Partnerships (LLP), S-Corporations, and C-Corporations. Business owners should pick the structure that best fits their needs. Each form has its own advantages and disadvantages, differing in respect to taxation, how liability is allocated, and the amount of paperwork required for the formation, and filing fees. Special licensing and permit requirements as well as specifics for how the business is formed will be governed by the laws of the state in which it is formed, so it is essential to check these or get help from a licensed business law attorney.
Sole Proprietorship
Sole proprietorships are the simplest forms to set up. They don’t require you to file any special forms or pay any filing fees, nor do you have to follow any special operating rules. To legally form a sole proprietor, you must obtain any business permits or licenses that the state and local governments require, and register a trade name with the county or city. In a sole proprietorship, you are essentially the business. This means you are entitled to the profits, and are also personally liable for any business related debt. You may have employees, and your spouse may also work for you without formally hiring them as an employee.
Liability for business related debt implies that if you or your employee injures someone while on the job, you are financially responsible. If your business defaults on a loan or a payment, you are also personally responsible. Legally, the damages to a victim or the obligations to a creditor can be claimed via your personal possessions (car, home, etc.) if there aren’t enough funds in the business. If your assets aren’t enough to satisfy the outstanding debts, you may be forced to declare personal bankruptcy.
Sole Proprietorships are taxed in a “pass-through” method: All of the profits and losses will pass through the business to the owner, who will report their share of profits or losses on their personal income tax records. It’s a good idea to set up separate accounts for the business and your personal expenses, and it’s crucial to keep accurate records of the income and expenses incurred by the business.
General Partnerships
General Partnerships involve two or more partners who agree to enter business together in order to make a profit, and who share equal rights and responsibilities in a business. Like the Sole Proprietorship, they are not required to file any special forms or pay filing fees, nor operate under any special rules.
General Partnerships must register with the state or local government to obtain any licenses and permits required, and also may register an assumed or fictitious business name (if the business name desired doesn’t contain the last names of the partners). The owners of a partnership are not required to have a written business agreement, but it is sensible to have one that details each partner’s responsibilities and share of profits, as well as any arrangements and options for the dissolution of the company should one partner die, retire, or want out.
As in the Sole Proprietorship, the partners are personally liable for all business debts and obligations for the partnership. This means that if the business itself can’t pay a creditor or other lender, they can legally come after any partner’s car, home, or other possessions. General Partnerships are also taxed in the same way as Sole Proprietorships: the partnership does not pay income taxes on profits, but rather the owners report their profits and losses on their personal income tax records.
Limited Partnerships
Limited Partnerships are a business form that involves one or more general partners and one or more limited partners. The advantage of Limited Partnerships is that limited partners can contribute capital to the project but are limited in liability to only that contribution in the event of any business debts or obligations. The general partners assume unlimited liability just as in a General Partnership. Doing business as a limited partnership can be as costly and complicated as doing business as a corporation or LLP, but also allows for investment of capital into the partnership without binding unlimited liability to the investing partners.
To form a limited partnership, a certificate must be filed with the Secretary of State of the state of formation, and there must be significant compliance with the limited partnership law of the state. The state requires that the partnership be governed according to the limited partnership agreement written by the partners (which although required, doesn’t have to be filed). Invalid creation and compliance with state regulations results in a general partnership with unlimited liability for all of the partners. Like General Partnerships, Limited Partnerships are only taxed once at the partner level on their personal income tax records.
Joint Ventures
A Joint Venture is very similar to a General Partnership, except that it’s formed for a specific, limited purpose or project or for a limited interval of time. Companies might want to form a joint venture with each other if, for example, they need to fund research or development of something they both find useful, but can’t independently afford. To form a joint venture, the partners are typically required by the state to file a “trade name certificate” and compose a business agreement. This agreement would typically include a contract showing the parties’ intent that a business be established, an agreement for joint control, and each party’s shares of profits and losses. The state also typically requires a contribution of money and property or services by the parties. The Joint Venture shares the guidelines for liability and taxation with General Partnerships.
Limited Liability Partnership (“LLP”)
An LLP is a type of general partnership that provides its general partners with limited liability. All LLP owners are protected from business debts and claims, and thus can only lose the money they have invested in the LLP. There are a few exceptions when an owner may be liable to business debts, including when the obligations arise from their own misconduct or the misconduct of a person they directly supervise and control, or when they have had notice or prior knowledge of misconduct by another partner.
To form an LLP, you need to file “articles of organization” with the appropriate division of your state government, specify the operating name and address, supply contact information for a person (or persons, depending on the state) involved to receive the legal papers on its behalf, and pay filing fees. The fees normally range from $100-$800 dollars. You also must create an operating agreement that sets out the member’s rights and responsibilities, share of the profits, and percentage interests in the business. Again, this document does not have to be filed with the state. An LLP is taxed the same as a Proprietorship or General Partnership, with the pass-through taxation method. Depending on the state, LLP’s may be restricted to certain types of professionals, like accountants and attorneys.
Corporations
Forming a corporation can be a complex matter, with the specific requirements determined by the state in which it is incorporated. Normally, to form a corporation you must file a document with the state, write the articles of incorporation and the corporate bylaws, pay a fee, and elect officers to run the company. Corporations also have to keep records of important business decisions and follow other specific formalities determined by the state in which they are registered. The benefits of a corporation are the ability to sell ownership shares through stock offerings, and the fact that the corporation’s directors, officers, and shareholders cannot be held personally liable for business debts (except in special cases, like mentioned for an LLP).
There are two types of corporations for tax purposes: the normal corporation, called a “C-Corp”, and a special type of corporation, called an “S-Corp”. The difference between them is that the S-Corp is taxed as a Sole Proprietorship or Partnership is taxed, where the profits “pass-through” the business and are taxed on the owner’s or shareholder’s income tax records. The regular C-Corp is taxed twice, once on the corporation’s profits (and it can deduct its losses), and once again on the owner’s or shareholder’s income tax, and they cannot take deductions for the companies losses.
Limited Liability Company
An LLC is a type of business that enjoys the same tax benefits as a sole proprietorship or partnership (the “pass-through” method), although the profits members receive may in addition be subject to self-employment taxes. An LLC also enjoys the same limited liability that an LLP or corporation does. Owners of an LLC are called members, and limited liability shields them against the company’s debts and obligations to the extent of what they have invested in the company. Exceptions to the limited liability are the same as mentioned for an LLP. To form an LLC, you must file similar documents as an LLP (articles of organization, the LLC’s name and address, and contact information for an individual to receive papers), pay a fee, and also create an operating agreement. LLC’s may have an unlimited number of members, and unless stated in the operating agreement to vest management in a few of the members or a non-member manager, they are all responsible for running the business. Some states permit one-member LLC’s, while some require that an LLC have at least two members.
Corporations (C-Corps)
Forming a corporation can be a complex matter, with the specific requirements determined by the state in which it is incorporated. Normally, to form a corporation you must file a document with the state, write the articles of incorporation and the corporate bylaws, pay a fee, and elect officers to run the company. Corporations also have to keep records of important business decisions and follow other specific formalities determined by the state in which they are registered. The benefits of a corporation are the ability to sell ownership shares through stock offerings, and the fact that the corporation’s directors, officers, and shareholders cannot be held personally liable for business debts (except in special cases, like mentioned for an LLP). The C-Corp is taxed twice, once on the corporation’s profits (and it can deduct it’s losses), and once again on the owner’s or shareholder’s income tax, and they cannot take deductions for the companies losses.
S-Corps
An S-Corp is a type of corporation very similar to the regular corporation (“C-Corp”), but differs in the way it is taxed. While the C-Corp is taxed twice, the S-Corp is taxed just once because of it’s elected special federal tax status. The S-Corp follows the same structure and requirements for formation as a normal corporation, but is taxed as a Sole Proprietorship or Partnership is taxed, where the profits (and losses) “pass-through” the business and are taxed on the owner’s or shareholder’s income tax records. The S-Corp also shares the same protection for liability as C-Corps: the owners and shareholders hold limited liability and are thus not personally liable for the corporation’s debts and obligations.
Your initial choice of a business structure doesn’t have to be permanent. You can start out as Sole Proprietorship or Partnership and if the business later grows or the risk of personal liability increases, you hold the ability to convert it to an LLC or a corporation if desired.
For a free consultation with an experienced business attorney with offices in Berkeley-Oakland -Walnut Creek, Please call Richard Korb at 510-524-0903.
[1] RICHARD E. KORB is a seasoned attorney with 30 years of business, real estate, civil litigation and transactional (contracts) experience. Over his legal career, Richard has successfully litigated and resolved over 300 court cases in the fields of contract law, real estate, employment, unfair competition, bankruptcy and general civil law and he has drafted and negotiated over 250 contracts and licenses for large and small companies alike. Richard leverages his experience as a former partner in a 100-person law firm and chief counsel for a public software company to assist individuals and companies, from start-ups to multi-nationals, with a broad spectrum of legal matters. In addition to his legal practice, Richard is a court-approved mediator and serves on the Alternative Dispute Resolution (ADR) panel for both the Alameda and Contra Costs County Superior Courts. ©2010
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