By Bryan Zlimen
Choosing the right business structure for your company will determine not only how it operates but also what liabilities you might be exposed to and what your responsibilities are as a business owner. Being held personally responsible for business debts, managing business partners, and developing future plans to expand, sell or transfer your company are all impacted by the type of business you choose to form. This article will cover the four most common business types used today and pros and cons of each.
The most basic business type is a sole proprietorship, which is a person doing business as him or herself either under their own name or registered under an assumed name (also known as a d/b/a).
Advantages: There is little or no setup or maintenance work required. If you’re using your own name, in most states you can just start doing business. If you’re using an alternate name, the process to register that name with your state’s Secretary of State office is generally quick and affordable. Be mindful, however, that no matter what business type you’re operating under, you must comply with your state’s sales and use tax laws, which may require a business license or other registration.
Disadvantages: As the owner, you are personally responsible for the business’ debts. So, if the business owes on a contract, you owe on the contract. If someone gets hurt on the job site, your personal assets could be on the line. Another common problem is that a sole proprietorship cannot be easily sold or transferred. Because the owner is the business, the business cannot be transferred to a new owner. Instead, the assets must be sold and the buyer must either start a new business or incorporate those assets into the buyer’s existing business.
A general partnership is a sole proprietorship with more than one owner.
Advantages: Same as above.
Disadvantages: There is little or no barrier between a partner’s personal assets and the debts or liabilities of the company. Additionally, most general partnerships will end if one partner dies or leaves the company, making them difficult to pass on as family businesses. Because general partnerships have more than one owner, it is highly recommended that the owners have a partnership agreement that lays out the rights and responsibilities of the partners. A good partnership agreement can reduce conflict, streamline business operations and ease the transition if one partner dies or leaves the business.
A smaller business that wants to limit the business owner’s liability may choose to become a limited liability company (LLC). In that case, the owner would register the company with the state’s Secretary of State office and obtain a new Tax ID (called an EIN) for the company. Once created, the LLC is a new entity that exists separately from its owners. It will have its own assets, debts, bank accounts, finances and contracts. Its owners (“members”) own membership interests in the company, which can be split as percentages (e.g., Jane owns 40% and Chuck owns 60%) or membership units (Jane owns 400 units and Chuck owns 600).
Depending on how the LLC is set up, the members may be able to vote on direct operations of the business or may be limited to voting to appoint those that direct the daily operations. An LLC operating agreement will allow the members to decide who makes the decisions, what rights the members have within the company, and what (if any) restrictions will be on the sale or transfer of membership interests. LLCs can operate as long as one or more members own interests in the company.
Advantages: The biggest advantage to an LLC is the limited liability protection that it provides. While not an absolute shield, members will generally not be personally
liable for company debts. Note that this does not mean that you do not need insurance for the company; it means only that for those claims that insurance does not cover, the company - rather than the owners - will normally be liable. Another significant advantage is the ease of transferring ownership. Unlike a sole proprietorship or general partnership, an LLC can last forever because it exists separately from its owners. Ownership interests can be sold, gifted or transferred through a member’s will. If the members wish to limit any of those transfers, they have the option to do so through the company’s operating agreement. Another advantage is that its internal record keeping and maintenance requirements are generally fewer, simpler and more flexible than those of a corporation, making the LLC a great choice for a small company.
Disadvantages: There are more setup expenses and efforts required to create the company than what is required for a partnership or sole proprietorship. Additionally, most states require at least one annual state filing to maintain the LLC in good standing, though this filing is usually simple and requires no or only a very small filing fee. Finally, LLC interests cannot be publicly traded, so if you’re planning on taking your company to the stock market, this will not be a good choice for you.
Corporations, like LLCs, offer their owners (“shareholders”) protection from business debts or liabilities. Corporations, however, are a more formal type of business entity designed for larger companies or companies in which the owners may not work closely together. To ensure that all shareholders are treated fairly and have access to information about the company, most states have extensive record keeping requirements for corporations. Like an LLC, a corporation can exist forever and its shares can be sold, gifted and transferred unless limited by an agreement of the shareholders.
Advantages: Among the biggest advantages is how their formal nature can be helpful to investors. Also it creates a liability shield for shareholders, and their shares can be publicly traded. Corporate shares can be sold, transferred or gifted freely, unless the shareholders agree otherwise.
Disadvantages: There are limitations on the number and type of shareholders the company can have if it wants to have flow-through (S-Corp) taxation, and extra record keeping requirements can be a burden on small, closely held companies.
As a business grows and changes, it may be necessary to change its structure. The most common way this occurs is when a sole proprietorship or general partnership grows and its potential business liability grows with it. At that point, owners often want the benefits of an LLC or corporation to help protect personal assets from those risks. Sometimes adding owners or creating a plan to pass on the business to family members makes the transferrable ownership units of an LLC or corporation appealing, and business owners will choose to create a new entity at that time. It’s also possible in most states to convert a corporation to an LLC or vice versa, if a different governance structure becomes a better fit for the company. This process can be complex, so the need must generally be substantial to justify the time and expense required.
Laws vary from state to state, so if you have questions about which type is right for you, consult a business attorney licensed in your state.
This article provides general information on business matters and should not be relied upon as legal advice. Brian Zlimen is a founding member of Zlimen & McGuiness, PLLC. Contact him at 651-331-6500 or email@example.com.