For the majority of small enterprises, business owners will want to incorporate under an LLC structure (offering you a mix of limited liability with favorable tax treatment) as ChooseWhat.com recommends. However, an LLC designation might not necessarily be for everyone. In this STARTicle we detail some of the other types of business entities, the advantages and disadvantages of each particular structure, and some examples of businesses for which it is best suited.
As the name suggests, a sole proprietorship is a type of business entity that is owned and run by one individual and in which there is no legal distinction between the owner and the business. Many small businesses start off this way when a person decides to, “be his own boss.” Sole proprietorships are often run out of one’s home: a furniture maker, a freelance writer or graphic designer, and an operator of a small home-based day care center are all examples of this type of business.
The risk and reward are equal. The owner receives all profits (subject to taxation) but also has unlimited liability for all losses, debts, and legal action. This means that the owner has no less liability than if they were acting as an individual instead of as a business.
Although it is cheaper and easier to do business as a sole proprietor, if you want to eventually raise capital the structure can work against you. A sole proprietorship is difficult to formalize and the investor has less peace of mind concerning the use and security of his or her investment.
A general partnership, or simply a partnership, refers to an association of persons who work together as an unincorporated company. Partnerships are created by agreement, proof of existence, or estoppel (an equitable legal remedy in which a court will “estop” parties from claiming a partnership does not exist based on the previous actions or words of the people involved). It also offers pass-through taxation just like an LLC, meaning that money made by the partnership is deemed the personal income of the partners, not the business, and is only taxed once.
Other characteristics of partnerships include formation by two or more persons, all of whom are personally liable for any legal actions and debts the entire company may face. Each partner is personally liable – jointly and severally – for all business debts, taxes, or any torts. (Jointly liable means partners are equally responsible, while severally means partners are only liable for their proportionate responsibility in the business or the action causing a dispute.)
For example, if a partnership defaults on a payment to a creditor, the partners’ personal assets are subject to attachment and liquidation to pay the creditor. By default, profits are shared equally amongst the partners. However, a partnership agreement will usually detail the manner in which profits and losses are to be shared. Each general partner is also deemed the agent of the partnership. Therefore, if that partner is apparently carrying on partnership business in the eyes of a third party, all general partners can be held liable for his dealings.
A limited partnership is a form of partnership similar to a general partnership, except that one general partner (GP) has more liability and authority than the other limited partners (LPs). Like shareholders in a corporation, an LP’s liability to the business is limited only to how much he or she invested. An LP also has no management authority. The GPs pay the LPs a return on their investment (similar to a dividend), the nature and extent of which is usually defined in the partnership agreement. GPs thus carry full personal liability, and in cases of financial misfortune, the GP becomes “the generous partner.” Profits in a limited partnership are also pass-through for taxation.
Limited Liability Partnerships:
An LLP works primarily like other partnerships except each partner is not liable for the conduct or misdeeds of the other parties. Each state has specific rules around the creation of an LLP. Taxation is also pass-through.
Typically, partnerships in all their various forms consist of businesses such as law firms, medical practices, and other similar groups of skilled professionals working together.
There are four characteristics of a business corporation: legal personality (or legal entity), limited liability, transferable shares, and centralized management under a board structure. A corporation is a formal business association with a publicly registered charter, recognizing it as a separate legal entity having its own privileges and liabilities distinct from those of its members. There are many different forms of corporations.
Corporations exist as a product of corporate law, and their rules balance the interests of the management operating the corporation with its creditors, shareholders, and employees. An important (but not universal) feature of a corporation is limited liability. If a corporation fails, shareholders normally only stand to lose their investment, and employees will lose their jobs, but neither will be further liable for debts that remain owing to the corporation’s creditors. There are, of course, exceptions to this but it is rare. Virtually any type of business, provided it is legal, can take on corporate status.