To Be or Not to Be a Business Entity: Advantages and Disadvantages of Business Entity Selections

6/21/2001

You realize that your hobby has the potential to become a profitable full-time business. Or, perhaps while mowing the lawn you have an epiphany that will revolutionize the widget industry. In either case, you consider starting your own business. You ask yourself, do I need to bother with the time and expense of creating a separate business entity; can’t I just "do business"? If I do create a business entity, what type of business entity should I create? Will I need the assistance of a lawyer or an accountant? Let’s take a closer look at these issues.

The short answer is to protect your personal assets from potential creditors of your business. In the absence of a separate business entity, or in the event that your business entity is improperly organized or the legal formalities of operating your business are not followed, you risk your personal assets. In the worst case scenario, that means having to sell investments, drain savings, or file bankruptcy to settle claims that may arise as a result of your business activity. However, this can be avoided by properly setting up and maintaining a separate business entity and taking advantage of the liability shield such action affords. With a properly organized and maintained business entity, creditors usually can only collect against the assets of the business and not against the personal assets of the owners.

The liability shield also has other advantages. If the business is looking for investors, those investors will almost always want the limited liability protection of a business. After all, they do not want their other assets (beyond their investment in the business) at risk either.

There are a number of recognized forms of business. Which one you choose depends upon the unique facts of your particular business, your plans for the business and an understanding of the advantages and disadvantages of each entity choice. While the following list is not exhaustive, it will provide an overview of some of the more popular business entities.

  Sole proprietorship

A sole proprietorship is probably the easiest and least expensive way to begin operating a business. In fact, you may already be a sole proprietorship if you are operating a business by yourself, even if you have not drafted or filed any legal documents indicating that. There are no documents or forms needed unless the business will operate under a name other than that of the owner. If the business will be operated under a name that is different from the owner’s, you may be required to file a document that informs the public and the government that the business is operating under an assumed name.

An advantage of a sole proprietorship is that the owner has complete control over the business. There simply are no shareholders, officers, directors, partners or others to answer to; it is YOUR business. Also, because there is no one else involved in the business and since there are few, if any, legal documents needed to create the enterprise, a sole proprietorship is easy and inexpensive to start and operate. Lastly, since the business is not treated as a separate taxable entity, the income is reported on the owner’s tax return and is therefore only taxed once.

A disadvantage of a sole proprietorship is that the owner is personally liable for any obligations of the business. As noted at the outset, avoiding personal liability for the activities of your business is the main reason to create a separate business entity. Also, a sole proprietorship is limited, by definition, to one person. Therefore, if the owner wants to have another owner, such as a spouse, family member or friend, the sole proprietorship would end and a new business arrangement, such as a partnership, would be created either by default or intent.

  Partnership

There are a number of forms of partnership available including a general partnership, a limited partnership and a limited liability limited partnership. The form of partnership most likely to be used for a business, at least in Minnesota, is the limited liability partnership. Forming a partnership entails an agreement between two or more prospective partners. The agreement can be oral or written but should be written to avoid conflicts later. A partnership agreement should address the amount and timing of contributions of partners, the management and control of the partnership, the allocation of profits and losses, the terms for making distributions, and the responsibilities of the partners. It should also address how the withdrawal or death of a partner is to be handled. A partner can be an individual, another partnership, a limited liability company, a corporation or a trust.

While a general partnership and a limited partnership do not provide a liability shield for its partners or its general partners respectively, the limited liability partnership does offer such protection. That is to say, partners in a limited liability partnership are only liable for the debts of the partnership to the extent of their investment in the partnership. However, in order to assure that the liability shield is in place, various forms will need to be filed with the secretary of state’s office in the state in which the partnership does business at the time the partnership is created. Thereafter, forms may need to be filed on an annual basis to maintain the liability shield.

A primary advantage of a partnership is pass-through taxation. The partnership is not a separate entity for tax purposes so all profits of the partnership pass through it to the partners and are reported on their individual tax returns. Also, a partnership form is flexible and can be adapted to allow for the partners’ and partnership’s changing needs.

A disadvantage of the limited liability partnership is that if filings are not properly made with the secretary of state’s office, the partners may lose their liability shield. Also, in the absence of clearly defined parameters in the partnership agreement, the actions of one partner are the binding actions of the partnership.

  C Corporation

The best known and most widely used business entity is the corporation, sometimes known as the C corporation. The main advantage of a corporation is the liability protection it offers to its owners or shareholders. The corporation is a legal entity separate from its shareholder owners and, therefore, the liability of those owners is limited to their investment in the corporation; that is, what they paid for their shares. The personal assets of the shareholders may only be reached by "piercing the corporate veil." The corporate veil can only be pierced when the required corporate formalities such as having annual meetings for directors and shareholders are not followed or when a court determines that the corporate form is a mere sham. If the veil is pierced, the shareholders will be personally liable for the obligations of the corporation.

To form a corporation, articles of incorporation are filed with the secretary of state’s office in the state in which the corporation is going to be organized. A corporation does not have to be organized in the state in which it is going to be operated. It can be organized in any state. Many corporations are organized in Delaware to take advantage of Delaware’s favorable corporate laws. However, corporations do have to register as "foreign corporations" in all states in which they do business outside of the state of organization. Other documents may be drafted as part of the organizational process such as bylaws which guide the conduct of the business.

The corporation is owned by its shareholders. However, the shareholders do not have control over the day-to-day operations of the business. Shareholders elect directors. The directors oversee the corporation and make decisions such as the election of the corporation’s officers. The officers are then responsible for the day-to-day operations.

Among the advantages of a corporation is the liability protection afforded to its owner shareholders. Another advantage of the corporate form is that the earnings of the corporation can be retained for future investment in the corporation or used for dividends. There is no limit on the number and types of shareholders for a C corporation. Lastly, the formation of a corporation is a mechanical process dictated by state law and is, therefore, quick and efficient to set up.

Among the disadvantages of a corporation is that it must follow certain formalities dictated by state law to maintain its corporate status and the liability shield for its shareholders. Also, certain potentially costly state and federal tax procedures are necessary and certain accounting methods may not be available. Lastly, corporate earnings are subject to double taxation. That is, when the company earns money its earnings are taxable as income to the corporation. Thereafter, when the corporation makes a distribution of its earnings to its shareholders, those earnings are taxed again as income to the shareholders. This double taxation may be partially or completely avoided in a small corporation by paying a salary to an employee shareholder.

  S Corporation

An S corporation is not really a separate type of corporation. It differs from a regular corporation (C corporation) in that the S corporation elects to be taxed similar to a partnership for federal income tax purposes. After making an S election, the income, losses, credits and other tax items of the corporation flow through the corporation to the shareholders. Thus, like a partnership, income is only taxed once.

The tax benefits of an S corporation are its main advantage. Also, S corporations can often use certain accounting methods not available to regular corporations.

The main disadvantage of an S corporation is the limit on the number and types of shareholders. This rules out certain potential owners and investors including investment banks and venture capital firms. Also, an S corporation cannot easily carry money into the next year. The reason is that if an S corporation carries money into the next year the owners will be taxed as if they had received that money -- even though it was left in the corporation. This can make it hard for an S corporation to retain money for research and development or other future purposes. S corporations must adopt a calendar year for accounting purposes unless they can establish a business purpose for having a fiscal year. Lastly, S corporations may only have one class of stock which may hamper efforts to obtain capital for the corporation.

  Limited Liability Company (LLC)

A limited liability company is a relatively new entity that combines most of the benefits of the corporate and partnership forms; in particular, flow-through taxation and limited liability protection for members. To form an LLC, articles of organization must be filed with the secretary of state’s office. In addition, an operating agreement may be created, and in some jurisdictions is required, which guides the conduct of the business. Members of an LLC may also have a member control agreement which sets out such things as ownership interests and voting rights of the members.

Among the advantages of an LLC is that members are shielded from being personally liable for the acts of the LLC and its members. An LLC also allows for flexible membership. Members can be individuals, trusts or corporations and there is no limit on the number of members. Management of an LLC is flexible in that the company can be managed by the members like a partnership or can have elected management like a corporation. Lastly, income, losses, deductions and tax credits flow through the LLC to the individual members.

Among the disadvantages of an LLC is that some jurisdictions do not allow LLCs to have only one member, although the number of jurisdictions that do allow single-member LLCs is growing. Therefore, this form of business entity may not be available to individuals. Minnesota is among those jurisdictions that allows single-member LLCs. Also, since LLCs are new, there does not yet exist a great deal of case law to guide business owners, members of LLCs and the general public in their dealings with LLCs. Lastly, because of the great flexibility allowed in structuring and managing an LLC, LLCs usually cost a little more to form and to maintain than other entities.

Any of these forms of business can be created without the assistance of a lawyer or an accountant. However, a lawyer and an accountant can assist you in a number of ways which protect you and your business. For example, an attorney can help you choose the right entity for your business, can assure that the proper papers are filed, can assist you in maintaining necessary business records, can assist you in drafting contracts and leases for business space and furnishings, can defend your business if legal action is brought against it and can provide you with other helpful advice on running your business such as the rules for hiring and firing employees. An accountant can assist you in properly setting up and maintaining your books and payroll, can assist you in preparing your taxes and can provide helpful advice on deductions and retirement plans.

Other professionals whose assistance you may consider include bankers and insurance agents. Bankers can assist you in obtaining financing and can often offer business advice. Insurance agents can evaluate your insurance needs and provide proper coverage.

Whether you intend to simply broaden your hobby or intend to become the next Wizard of Widgets, there are a number of forms of business entities that will protect you and your business. And there are professionals who are willing and able to provide you the assistance you need in selecting the proper business entity and getting it organized and running smoothly.