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.
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.
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 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.
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.