Sole Proprietors, Corporations, Limited Liability Companies and Other Forms of Business Entity

One of the most basic questions anyone thinking about starting a business should consider regardless of how small or how large that business may be at the outset is the question of what legal form their business should take. There are several forms a business can take and it is important to choose what’s best both for the business and its owners.

There are, of course, pros and cons to each available form but choosing the best form for your business can increase the ultimate profitability of your business for you as an owner while limiting your personal responsibility for the liabilities of your business. Also, if there will be more than one owner of the business, there are potential threats to the business that should be answered before business begins such as questions of what will happen if an owner dies or wants out of the business.

The cost and effort of careful planning before starting a business often seems an unnecessary expense and distraction to entrepreneurs intent on pursuing their business dream. Yet such planning is essential if the business is going to maximize profitability for its owners and survive the possible events that could otherwise bring the business to a premature death.

What follows is not intended to be an all encompassing discussion of all those pros and cons. Instead, this article is only a brief sketch of some of the principal benefits and drawbacks to each form for doing business.

Also, this discussion only addresses issues in closely held entities and does not speak to the peculiar issues of publicly traded entities or to various securities law issues that may arise even in the context of a small, closely held business entity.

Finally, it’s important to note that this discussion relies on Oregon law. While the law of other states may often be identical or similar, it is essential to determine the best form of business entity on the basis of the law applicable to your anticipated business activity.

Sole Proprietorships.

A sole proprietorship without distinction between the business and its single owner is the easiest form of business to run, at least in the beginning. In a sole proprietorship there’s no difference between the owner and the business because the owner is the business and, at least to a large extent, the business will be the owner. In a sole proprietorship:

1. The owner is personally liable for all of the obligations and liabilities of the business; and,

2. The owner will, in addition to income taxes, pay self employment taxes on all business income.

These considerations generally make the sole proprietorship an unacceptable form of business entity to most individuals starting a new business who think about how they want to do business.

Partnerships.

A partnership is a business relationship between 2 or more individuals. Although a written partnership agreement is not essential to create a partnership, such a written agreement defining the partners’ respective rights with respect to each other and the partnership itself is prudent.

In a partnership each partner contributes capital and other value which becomes that partner’s capital account. In a partnership:

1. No partner owns partnership property and the only interest a partner can transfer or sell is their respective share of the partnership’s profits and losses and the partner’s right to receive distributions from the partnership;

2. The partnership must maintain books and records which are available for inspection by the partners and their agents such as attorneys;

3. Each partner has fiduciary duties of loyalty and of care to the partnership and to their partners;

4. A written partnership agreement can provide for different classes or groups of partners with different powers and duties including different voting rights;

5. All partners are jointly and severally liable for all obligations of the partnership incurred while they are partners; and,

6. Income earned by the partnership is ascribed to each partner in proportion to their partnership interest for tax purposes as self employment income whether it is actually received by the partner or not.

While partners can significantly limit the personal liability of limited partners in a limited partnership, a limited partnership must have a general partner who is personally liable for the partnership’s obligations.

Because a partnership is largely defined by the agreement of the partners, a written partnership agreement is essential at the outset of the business.

Though well suited for some business ventures, a partnership is often not the best choice of business entity.

Corporations

Corporations are owned by one or more shareholders who elect one or more directors to oversee management of the corporation’s activities. Corporations can consist of a single shareholder who is also the sole director and president or can consist of many shareholders who elect directors who may have no relationship with the corporation except for their role as directors supervising the corporation’s officers who in turn may have limited, if any, equity interests in the corporation.

For income tax purposes there are 2 kinds of corporation: “C” corporations and “S” corporations. An S corporation must satisfy the following conditions:

1. Must not have more than 100 qualified shareholders (primarily individuals but including certain trusts while excluding nonresident aliens, corporations, and partnerships);

2. Have one class of stock; and,

3. Not be an ineligible corporation such as certain financial institutions, insurance companies, and domestic international sales corporations.

For tax purposes, an S corporation is a pass through entity. In an S corporation profits earned by the corporation in excess of the corporation’s expenses, payroll and other deductions (including compensation paid to shareholders as employees) is ascribed to the shareholders in proportion to their stock ownership as personal income for tax purposes. An S corporation does not itself pay income tax though it must file an annual income tax return.

The profits of the corporation are ascribed to the shareholders of an S corporation whether or not the corporation has actually paid all or any part of those profits to the shareholders during the tax year. Such income ascribed to the shareholders of an S corporation is taxed at ordinary income rates but is not subject to statutory withholdings.

In a C corporation, the corporation does pay income tax at the corporate level. Shareholders only pay tax on income they receive from the corporation by way of compensation and dividends. A C corporation only pays dividends to its shareholders from its after tax profits. Consequently, a C corporation’s dividends are subject to taxation at both the corporate and the individual shareholder levels.

As a form of business entity corporations (both C and S) have certain distinct benefits including the protection of owners from personal liability for corporate obligations. However, in order to preserve that protection from personal liability, two conditions must be met:

1. The corporation must be adequately capitalized; and,

2. The shareholders must observe corporate formalities and respect the corporation as a legal entity distinct from themselves and their personal interests.

If the shareholders fail to satisfy these conditions it is possible for a court to “pierce the corporate veil” and hold the individual shareholders liable for a corporate liability.

In closely held corporations the shareholders owe each other and the corporation fiduciary duties of loyalty and fair dealing. A shareholder can incur personal liability by violations of those duties.

In closely held corporations of more than a single shareholder (a husband and wife are together one shareholder) it is best to have a written agreement defining the shareholders rights and obligations to each other and to the corporation with respect to their ownership and sale of shares of stock since, for instance, the death of a shareholder without a prior agreement may threaten the corporation’s business viability while also creating problems for the decedent’s estate which wants to withdraw the value of the deceased shareholder’s equity interest.

Limited Liability Companies

Limited liability companies (“LLC’s”) are a relatively new form of entity intended to allow the owners to contractually define their relationship within the broadest legal limits while providing the equity owners protection against personal responsibility for company liabilities. Instead of shareholders or partners, the owners of limited liability companies are called “members” and their equity interest is called a “membership interest.” The nature, rights and obligations of various members can be differentiated in a limited liability company far more than in a corporation or partnership.

Instead of by-laws which govern the operation of a corporation, LLC’s are governed by their “operating agreement” which defines the rights and obligations of the members, managers, and the company in relation to one another. Although oral operating agreements are valid, they are difficult to enforce in the event of a subsequent dispute in which the terms of the oral agreement itself are often in question. Absent an operating agreement, the state’s limited liability statute will supply the terms of the operating agreement regardless of what the members may have intended or wanted.

There are two kinds of limited liability companies: member managed companies and manager managed companies. In a member managed LLC, all members presumptively share in responsibility for management of the company. In a manager managed company, the members designate one or more managers with authority to manage the company.

Entities and individuals who cannot be shareholders in S corporations may be members of limited liability companies. Also, unlike S corporations which can only have one class of stock, an LLC can have many different kinds of membership interests.

A single member LLC is a pass through entity like an S corporation for tax purposes. That is, the single member LLC does not pay income tax itself though it does file a return. All taxable income of the LLC is ascribed to its member for income tax purposes. A husband and wife who own the only membership in an LLC are considered a single member.

An LLC with more than one member may be taxed either as a partnership or as a corporation. Unless the company elects to be taxed as a corporation, it will be taxed as a partnership.

As with partnerships, an LLC’s income is generally ascribed to the members as personal income for tax purposes. As with partners, individual members must generally pay self employment tax on such income.

The fiduciary duties of members in a member managed limited liability company are, absent agreement to the contrary, limited to the duties of loyalty, good faith and fair dealing, and of care. Under Oregon law the duty of care only requires a member to refrain from conduct that is grossly negligent or reckless, intentional misconduct or a knowing violation of the law. A member of a manager managed LLC who is not also a manager owes no duties to the company or to the other members solely because of their membership.

As with a corporation, an LLC must be adequately capitalized and its members and managers must respect it as a separate “legal person” to preserve the protection it affords them against personal responsibility for company liabilities.

Conclusion

This briefly summarizes just some of the principal considerations in choosing the right form of business entity. How these and other considerations may apply to any particular business will depend on the specifics of that business and its owners. The considerations discussed here as well as other factors bearing on determining which form of business entity best suits a particular venture should be considered with the advice of both an attorney and an accountant to reach the best result.

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Choosing the Right Business Entity

Probably one of the most confusing yet important decisions you will need to make when starting up your business, is choosing the right business entity. There are various types of business entities to choose from. Each one has different legal and tax implications for owners and managers.

You’ll need to analyze the consequences of utilizing different types of business entities along with the purpose and goals of the business entity. Choosing the right entity will depend on three primary factors: liability, taxation and record-keeping.

Types of Business Entities

Sole proprietors, partnerships, “C” corporations, “S” corporations and limited liability companies or LLC’s are the most common forms.

The Limits

We will be focusing on LLC’s(Limited Liability Corporations) here since LLC’s have become the most popular form of business entities for new companies. Many existing entities have changed over to this form as well. Partially due to the edge they have on general and limited partnerships from a business standpoint.

Pros

LLC’s are extremely flexible, more suitable for a very wide range of businesses. Ideal for small businesses with a limited number of partners. It’s somewhat of a hybrid between a corporation, which has shareholders, and partnerships, in which the partners own the company but don’t have shares.

Offers many of the same advantages of a corporation, sole proprietors, and partnerships. The biggest advantage is that unlike sole proprietors or partnerships, the members, who are the owners, are legally separate from the entity. Unless someone makes a specific personal guarantee, the amount at risk for members is limited to their investment.

Without risking their limited liability status, members can be active in the management of the corporation and utilize the same management structure of a partnership.

With two or more members, the LLC has the flexibility in allocating profits and losses. Passing the profits directly to the partners without the double taxation of a “C” or “S” corporations. With the additional option to be taxed as a C corp if it is beneficial. Plus, they are not limited by the same restrictions which S corporations are.

When it comes to taxes, sole proprietors, partnerships and LLCs come out about even (they’re all pass-through entities). Unlike the double taxation of a “C” corporation.

Cons

Unlike a C corporation, no losses can be carried forward into future tax years and an LLC cannot keep retained earnings, meaning that it must distribute the profits or losses to its members every tax year. One potentially major drawback is that the legal treatment of a Limited Liability Corporation varies by state. So, for business that plan to operate in multiple states, this entity might not be viable.

Your Future

Choosing the businesses entity for your business is an important decision you will need to make that will effect your business’ future. When you have the facts, this decision will not be as difficult as you might think when you addresses the pros and cons of the different types of business entities that exist.

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Costly Mistakes Made With Your Business Entity

Investing in a powerful tool and not using the tool properly does not make a lot of sense. I know when it comes to running a business it requires multiple hats to wear and very often you are off and running on 10 different projects, calls, appointments, presentations… and perhaps the very foundation of your business may be in jeopardy. Here are the top costly mistakes I have seen made over the past 15 years:

Not completing the transition from a sole proprietorship to a separate legal entity. If you started a business in your own name for a few months before you formed an entity odds are part of what you did you completed as an individual and you need to connect the dots to the new entity. If you filed a DBA (doing business as) with yourself as the applicant that needs to be cancelled and re-linked to the entity. That means your entity needs to be the applicant, not you! If you don’t do this you still are exposed to unlimited liability and filing a schedule C with a higher audit potential. Next, point is to open a bank account in the name of the business, not just keep the account in your personal name. Use a business credit card in the name of the entity, not just your personal credit card and keep track of expenses. You will want to minimize the amount of debt that shows up in your personal name. Update all affiliate programs, vendors with your new entity information so any income is going to your business entity, not to your name personally. Update your websites, business cards, letterhead with the new name of your business. Another important tip make sure your website is in compliance, most are not.

Funding concerns. 95% of businesses fail within 5 years and undercapitalization is the #1 reason. The pattern I have seen is that small business owners are mostly hoping for revenue to come in as the primary source of money to grow their business. What happens if your revenues are off or don’t come in at all? You may be working on that great new product and all your emails go out and no one converts. That is a real problem. The key is to model success. Almost all successful companies do not use only their own money to grow. I know you know the concept, “OPM”, other people’s money, yet are you doing that? Are you only self funding your business on your own personal credit? Did you know that once the entity was filed the business credit bureaus will start creating a file. They scan the Secretary of State’s records to create a file with any new filings. They look for the name of the business, the start date, and name of the officers/managers the address… If you are not paying attention on how you fill out forms with the business address, business license, state forms you can create disconnects in the database. In one business credit bureau, NCP is spelled four different ways. The NCP part is the same, but one way has “Inc.”, one has “,Inc.” other has “, Inc” and the last one is “Inc”. Did you notice the differences with the comma and period? That created four different files! Don’t make that same mistake. Unlike the personal credit bureaus, the business credit bureaus are very difficult to fix any mistakes. They have their own set of rules and are not set up for changes after mistakes happen. This creates a problem when it comes to developing credit for your entity because you basically have one shot at the apple to get it right the first time. Banks and vendors are very interested in your financial strength of your company. Now joint venture partners can check you out for free to determine who stable is your operation. You may be losing business and not knowing it. It is really a must to be financially solid in your business and your developing business credit is a must for your long term success.

Safe and risk asset. Mixing asset classes is a major risk to your wealth that is unnecessary. A risk asset is any asset that would cause liability to your entity. That may be a business, real estate, equipment, again, anything that may cause liability to an entity. A safe asset is one that does not cause liability to an entity, like cash, ownership of another company, investments… If your business falters and you need to reply upon your safe assets to recover short term, why unnecessarily put your safe assets at risk? It happens all the time. There are two reasons this may be happening to you, first, you have thought that your amount of safe assets are not large enough to protect. Imagine having $25K in a brokerage account in your name and losing all of that because of a personal lawsuit. Wouldn’t you wish that you took the time and invested a small amount to protect that amount? Most clients will tell us they will get to it later but never do. Don’t make that mistake. Set in place a safe asset LLC in your home state and transfer your safe assets into it immediately. This LLC does not have to be based in Nevada, because the protection of the entity veil is not important in this situation because as a safe asset entity there should be no one to sue the operating entity because there are no public clients! This is why your home state is fine for a safe asset LLC.

Now clear on who does what? A partner can help you grow a business quickly and destroy it even faster if you are not on the same page. Very similar to being married. I have been married for 16 years with three girls and it is a lot of work and requires meetings, discussions to do the best to be on the same page. Business like marriage can be very exciting at first and you really need to be able to communicate well as to what you are looking to accomplish. The fun part of business is discussing how you will bring in revenue and all the possibilities that can happen with profits. The part that is not a lot of fun is the expense side of the ledger. First, you must agree upon what is actually considered an expense, does that include things like cell phones, travel, meals… ? You may assume this is obvious but typically that is not the case. What happens if revenues are way off and there is not enough money to pay each partner and you need more capital from each partner to keep it going? This can be a very uncomfortable problem. It is best to presuppose the challenges ahead of time and see if you can calmly discuss through them and come up with solutions that make sense. If you can’t get to first base on the uncomfortable parts even before you get started that is a bad sign and perhaps you should NOT be a partner. If fact, odds are the business is doomed to fail if you can’t get through some of these basics uncomfortable discussions from the start. Now, that does not mean your partner is telling their spouse the same story. That can and often does create more issues. Having as much in writing from the start and a business plan in place makes the most sense. Almost ALL, not all, but close, partnerships that refuse to take the time to put things in writing fail. It is like clockwork. If anyone wants to start a business with you and they refuse to put things in writing, run! Most of the time the only one that makes money in that situation is the attorney’s after the partners sue each other! Take the time to be clear and put it in writing!

That is your top 4 of the most costly mistakes that can be made with your business entity. There are more, but these are the biggest. The key is to take a few minutes and determine if any areas you are making mistakes and if so set an appointment on your calendar now to solve them!

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Choose the Right State For Your Business Entity

I have helped thousands of people set up Limited Liability Companies (LLCs) and Corporations in Montana and a few other states. Being a Montana attorney, the majority of the LLCs and Corporations I have helped form have been in Montana. For certain reasons, I have advised clients to form their business entity in another state, sometimes sending business away because it was in the best interest of the client.

Of the LLCs I’ve helped form, many have been for non-Montana residents to use as holding companies for vehicles. This strategy is useful for certain people to minimize tax and registration fees depending on the use of said vehicle. Other LLCs I have helped form have been for various profit enterprises or holding companies for real property, both rentals and private property. The LLC is an extremely versatile business entity and a preferred entity for many uses. However, because I have helped so many people with LLCs, I also get a flood of calls regarding LLCs and their use that is not in the best interest of the person calling. Therefore, I do spend a fair amount of time educating people on the benefits of LLCs, and most important, where to organize the entity related to their goals.

The organization of a Montana LLC is great for the tax and registration savings on a vehicle as long as the person operating the vehicle complies with the State laws of the operator’s State of residence and the use of the vehicle. The organization of a Montana LLC is great for a Montana based for profit business. It is also a great entity to own real property located in the State of Montana.

The problems arise when people from different states want to use a Montana LLC to own real property in different states, or to do business in different states. Yes, the LLC is a great business entity to use for asset protection, tax, and liability purposes, however, it must be organized in the right state to provide the most benefits.

My home state of Montana is a great state for vehicles because of the sales tax laws. Nevada is promoted all the time as the State to form business entities for income tax and asset protection reasons. And there are tons of promoters and services that will help you form these entities without providing you any guidance of the law. Sure they are experts at forming business entities. That means they can file the proper forms for you. But have they advised you on the law? I strongly suggest you speak with an attorney rather than some of these other promoters. Recommending everyone set up a Nevada entity, or a Montana entity, is poor advice at the least, and it may cost you much more in the end than paying an attorney up front.

This is why it is poor advice and may cost you. You might not have any liability protection at all! Yes, that’s right, the entity you set of for liability protection might not provide an ounce of that protection. Each State’s laws are different, so you really need to talk to an attorney in the state you reside in or are doing business in. However, in general you need to know that the asset protection and liability protection provided by a business entity is only provided by the State that the entity is formed in or registered as a foreign entity where the entity is doing business.

This means that if you are operating a for profit business with a Nevada or Montana business entity in a state other than Nevada or Montana and you have not qualified the business entity to do business as a foreign entity with that state’s Secretary of State or governing body, there is most likely no protection. If a business entity is doing business in a state where it was not created and was not qualified as a foreign entity, the owner or owners of the business may be held personally liable for any debt or obligation incurred by the entity.

Therefore, I usually recommend to people that they form business entities in the state where they will do business, and form business entities for owning real property in the state where the real property is located. If you are going to use a business entity formed in a different state, you need to qualify it in the state where you will do business or own real property. (This means paying the correct fees and filing the required documents to both states)

For certain situations, there are advantages to forming business entities in Montana, Nevada, Delaware, etc. However, it really depends on what the goals and objectives for having a business entity are, and where you will be doing business or purchasing assets. If you don’t do things right, you may not have the protection you believe you have. Do yourself a favor and seek out qualified advice before forming your entity, and remember that there is no single solution, single business entity, or single state that is best for everything or everyone. Do a little homework, ask qualified people, and you will be able to maximize the use of your business entity to satisfy your needs and goals.

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Learn the Differences Between Each Legal Business Entity Type

Your individual state will register your legal business entity, and it’s important to understand that not all states recognize every business entity type. The descriptions below are meant to give you a basic understanding of the differences between entities, but you should check with your local government to see which type of business designation is right for your new venture.

Sole Proprietorships

Most small businesses choose the legal business entity of a “sole proprietorship”, where one person is the only “owner” of the business. Legally, there is no difference between you and your business, and while this business entity type is preferred by some because of the ease in setting it up and registering it, there is a greater legal risk assumed by the owner of a sole proprietorship. For example, if someone sues your business for infringement or fraud, they will be suing you, and your personal assets will be on the line if the case is taken to court – a disadvantage to this kind of legal business entity. This type of situation is rare to be sure, but from a business standpoint, it has the potential to be a risky move.

An advantage of this entity is the fact that you’re the only owner! You can make your own business decisions without having to consider the opinions of a board of directors, or other stakeholders. You receive 100% of the income from your business, and are free to file your profit on your individual tax return at the end of the year – a huge advantage to choosing this legal business entity type.

Partnerships

As the name implies, a partnership is an entity in which two or more people own a business together. Just like a sole proprietorship, there is no legal difference between the owners / members of a partnership and the business itself. As previously stated, choosing this legal business entity can have potentially negative consequences if someone were to file a suit against you or your business. An entity type of this sort carries an additional risk because of the added element of another person. For example, let’s say your business partner did something illegal and the court has decided to penalize your business assets because of his or her mistake. Although you have done nothing wrong, the whole business may be at risk of going under because of the partnership liability. Again, although this is rare, it is important to consider when choosing this kind of legal business entity. Types of considerations like this can protect your investment in the long run.

Speaking of investment, an advantage to a partnership is the ability to raise more funds with the influence of more people. Instead of having to shoulder all of the capital upon startup yourself, a partnership can help business owners divide the cost of operational expenses. And of course, because you’re sharing costs, you and your partner(s) will have to share profits as well. A benefit of this kind of legal business entity is the financial ease achieved by being able to file your profits under your individual tax return at the end of the year.

When starting a partnership, it is important to draw up a legal agreement detailing how costs and profits will be shared, what to do in the event of a partner wanting to leave the business, how to settle disputes about business strategy, etc.

Corporations

Unlike sole proprietorships and partnerships, where the owners are legally the same as their business, corporations offer business owners a unique legal and tax benefit in the sense that corporations are granted their own legal status. Therefore, this business entity type is considered as a separate legal business entity from you, your partners, and your shareholders. If your business were to be sued, it would not put you or your personal assets at any risk. So wait…who are shareholders? Whereas you’re an owner / operator / member of your sole proprietorship or partnership, you become a shareholder in a corporation, because this type of business operates with stock, or partial ownership distributed amongst several people. As a shareholder, you “own” a part of the business, but you also have to routinely answer to a board of directors who steer the direction of the company.

The downside to the legal business entity of a corporation is that you have less individual freedom to make executive business decisions, and you are not in total ownership of your business. This business entity type is more difficult to begin and dissolve, and often must comply with a series of complex federal and state regulations and taxes. However, the obvious benefit to this type of legal business entity is that you have more individual legal protection with the separation of yourself from your business in the event of a lawsuit.

Limited Liability Company (LLC)

Finally, a Limited Liability Company (LLC) is a sort of combination of all of the above business structures. Like the “corporation” business entity type, an LLC offers a legal distinction between a person and their company, but like a sole proprietorship or partnership, it offers the owner or member (we’re back to being called members now) control over business decisions, tax breaks, and offers no stock option. There is no limit to how many members an LLC may have, and it is also possible to just have one member. The obvious upside to this type of legal business entity is that it provides the best parts of both worlds, corporation and non-corporation, but the downside is that it is more difficult to file than a partnership (but is still less difficult than forming a corporation). To date, the federal government does not recognize an LLC as a classification when you file your federal taxes, so you must file either as a sole proprietorship, partnership, or corporation.

So What do I do Now?

As with any kind of legal decision, deciding which business entity type is right for your business is a big decision that requires a lot of thought. This is just an overview of the primary differences between each major legal business entity, so before making a decision, check with your lawyer or accountant to decide which is best for your financial and business interests. It seems complicated at first, but once you get registered with the state, you’ll be on your way toward owning and operating your own business!

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