E-Counsel on Understanding the Basics of Choosing an Entity Structure When Starting a Business

July 2011
Dear Clients and Friends:
Rich - Business Photo  
Welcome to e-Counsel, a legal newsletter for clients and friends of the Law Office of Richard C. Petrofsky.  Our goal is to provide periodic newsletters on relevant and interesting legal topics.  We hope you find informative and educational material in this and future issues. 

This issue marks a first for e-Counsel.  We are pleased to have a guest writer who just happens to be my son, Chad Petrofsky.  Chad is entering his junior year at Truman State University where he is majoring in accounting.  As a proud parent, I must also say that Chad is on the Truman track and cross country team and was named as an Academic All-American.  

But enough about the writer, lets get into the topic.  

Now that the economy may be starting to rebound, many people might be thinking about starting their own business.  One of the first issues to consider is what type of entity should be used to operate the business - a sole proprietorship, partnership, limited liability company or corporation.  In this issue of e-Counselwe examine the various types of entities a person can select when starting a business and the considerations that a person should think about before choosing an entity
.  

Please feel free to forward this newsletter to others who you think may benefit from it.  Also, please visit our website at www.petrofskylaw.com for additional information about the law, our practice areas and our expertise.  On our website, you can also bookmark and follow our legal blog or find archived newsletters.

 

If you have any comments on how we can improve our newsletter or any suggestions for future topics, please e-mail Rich Petrofsky at rpetrofsky@hnjlaw.com.  

 

Sincerely,
Rich Petrofsky
Understanding the Basics of Choosing an Entity Structure When Starting a Business

 

When an individual or a group of individuals decide to create a business, one important decision that must be made is to select the form of the business entity.  For the most part, the potential business owner or owners will chose between one of the following five types of entities:

  • Sole Proprietorship;
  • General Partnership;
  • Limited Partnership;
  • Limited Liability Company; or
  • Corporation.

Each entity has its own advantages and disadvantages.  In this issue of e-Counsel, we examine, compare and contrast the types of entities that a person may utilize to conduct a business.  We have also attached a summary chart which lists the similarities and differences between each of the entities noted above.

 

Please note that this issue of e-Counsel is only intended to be educational and informative in nature and is not intended to give legal or other advise regarding any person or businesses particular situation.  If you have any questions about the contents of this newsletter, please do not hesitate to contact us.

 

 

Sole Proprietorship

 

            A sole proprietorship is a business owned by only one individual.  That individual owner is referred to as the "sole proprietor."  As a matter of law, there is no distinction between sole proprietorship (meaning, the business) and the sole proprietor (meaning, the owner).   

 

            1.         Advantages of Sole Proprietorship.  There are a number of advantages to doing business as a sole proprietorship, including the following:

 

                        a.         Ease of Formation.  A sole proprietorship is easy to create.  In fact, a sole proprietorship can begin doing business immediately.  This is because there are generally no filing requirements to form a sole proprietorship as there are with corporations, limited liability companies and limited partnerships.   

 

                        b.         Management and Control.  The owner of a sole proprietorship has total control over the business because the sole proprietorship is owned by only one person (the sole proprietor).   Therefore, the owner of a sole proprietorship has the freedom to make all managerial decisions without restrictions. 

 

            2.         Disadvantages of Sole Proprietorship.  There are a number of disadvantages to doing business as a sole proprietorship, including the following:

 

                        a.         Unlimited Liability.  The greatest disadvantage of a sole proprietorship is unlimited liability.  The sole proprietor is both legally and financially liable for all actions of the business.  This is because in the eyes of the law, the sole proprietorship is considered to be an extension of the owner or sole proprietor.   What this means is creditors of the business can require the sole proprietor to pay debts with the owner's personal (non-business) assets.  For this reason, there is serious liability risks involved in starting a sole proprietorship which needs to be considered.

 

                        b.         Can Have Only One Owner.  By definition, a sole proprietorship can have only one owner.  Therefore, this "choice of entity" is not available where more than one person owns a business.

 

                        c.          Limited Life.  Since a sole proprietorship is just an extension of the individual owner, the business usually terminates when the owner retires or dies.  Therefore this type of entity does not have the same potential for perpetual existence like other entities such as a corporation or limited liability company.

 

                        d.          Difficulty Raising Capital.  Many sole proprietorships lack the resources to raise capital.  This is especially true if the owner does not have a good credit history.  Without an ability to raise sufficient capital, a sole proprietorship could struggle to get off the ground.

 

            3.         Taxation of Sole Proprietorship.  With a sole proprietorship, the sole proprietor must report all business income or losses on Schedule C of his or her individual income tax return (Form 1040).  This is because any income of the sole proprietorship is deemed to be income of the sole proprietor.  The sole proprietorship itself (meaning the business) is not taxed as a separate entity and has no independent federal income tax filing requirements. 

 

 

General Partnership

 

A partnership is a business owned by two or more people called partners.  There are two basic types of partnerships - general partnerships and limited partnerships.  With a general partnership, all of the partners are known as "general partners."  The general partners are the ones who manage and control the general partnership (the business).  

 

            1.         Advantages of General Partnership.  There are a number of advantages to doing business as a general partnership, including the following:

 

                        a.         Ease of Formation.   General partnerships are easy to create.  This is because the formation of a partnership does not require any burdensome legal formalities.  There is not even a requirement that a partnership agreement be in writing, but it is advisable to document many important issues, including:

        • The amount of capital contributed by each partner;
        • The rights, duties, and responsibilities of each partner;
        • The relationship of the partners to each other;
        • How profits and losses will be divided;
        • How disputes will be settled; and
        • How partnership interests can be sold or transferred.

                        b.         Management and Control.  The general partners have total control over the management and business of the general partnership.  Therefore, there is a degree of centralized control subject to disagreements among the partners (see disadvantages below).

 

                        c.          Greater Resources.  With multiple owners, a general partnership will generally have a greater pool of resources, expertise and capital than a sole proprietorship. 

 

            2.         Disadvantages of a General Partnership.  There are a number of disadvantages to doing business as a general partnership, including the following:

 

                        a.         Unlimited Liability.  The greatest disadvantage of a general partnership is unlimited liability.  A general partner is jointly and severally liable for all of the debts, obligations and expenses of the general partnership.  This means that if one general partner owns 1% of the business and the business fails, then that partner should have to pay 1% of the bills and the other partners should have to pay the remaining 99%.  However, if the other partners cannot pay their 99%, then the partner who owned 1% of the business may be called on to pay for all of the debt (which may have to come from that partner's personal assets). 

 

                        b.         Disagreements Among Partners.  Since a general partnership by definition has more than one owner, there is always the possibility of disagreements among the owners. 

 

            3.         Taxation of General Partnership.  General partnerships are advantageous from a federal income tax perspective.  A general partnership is treated as a flow through entity.  This generally means that the income and expenses of the general partnership flow through to the general partners' individual income tax returns (Form 1040).  The general partnership itself does not pay any tax although it does file an informational tax return (Form 1065).  The general partnership issues K-1's to the partners which shows the partners share of the income and expenses of the general partnership.

 

 

Limited Partnership

 

A limited partnership is a special type of partnership that has two classes of owners or partners - general partners and limited partners.  The general partners of a limited partnership control and manage the affairs of the partnership.  The limited partners, on the other hand, have no voice in management or control.  They are, in essence, silent partners.  

 

            1.         Advantages of Limited Partnership.  There are a number of advantages to doing business as a limited partnership, including the following:

 

                        a.         Limited Liability.   The primary advantage of a limited partnership is that it limits the limited partner's exposure to liability.  This means that limited partners are not personally liable for the debts, obligations and expenses of the limited partnership.  Therefore, the most limited partners stand to lose is their investment (capital contribution) in the limited partnership.  The general partners, however, are responsible for all of the debts, obligations and expenses of the limited partnership.

 

                        b.         Management and Control.  Since management and control of a limited partnership is vested in the general partners only, this type of entity can be particularly useful when a business may have multiple owners, but only some (the general partners) will be involved with actively carrying on the business while others (the limited partners) are only passive investors.

 

                        c.          Greater Resources.  With multiple owners, a partnership will generally have a greater pool of resources, expertise and capital than a sole proprietorship. 

 

            2.         Disadvantages of a Limited Partnership.  There are a number of disadvantages to doing business as a limited partnership, including the following:

 

                        a.         Unlimited Liability.  As discussed above, a general partner in a limited partnership has unlimited liability for the debts, obligations and expenses of the partnership.

 

                        b.         State Filing Requirements.  A limited partnership is a creature of statute.  This means in order to create a limited partnership, the partners must comply with state law.  In Missouri, a Certificate of Limited Partnership (together with a filing fee) must be filed with the Missouri Secretary of State and a written partnership agreement must be drafted.    A written partnership agreement addresses, among other things: 

 

        • The amount of capital contributed by each partner;
        • The rights, duties, and responsibilities of each partner;
        • The relationship of the partners to each other;
        • How profits and losses will be divided;
        • How disputes will be settled; and
        • How partnership interests can be sold or transferred.

 

                        c.          Disagreements Among Partners.  If there are multiple partners disagreements could ensue.  It is important to note, however, that limited partners have no voice in the management of the limited partnership.  Therefore, the possibility for disagreements really exists when there are multiple general partners.

 

            3.         Taxation of Limited Partnership.  Limited partnerships, like general partnerships, are also advantageous from a federal income tax perspective.  A limited partnership is treated as a flow through entity.  This means that the income and expenses of the partnership flow through and are reported on the partners' individual income tax returns (Form 1040).  The limited partnership itself does not pay any tax although it does file an informational tax return (Form 1065).  The limited partnership issues K-1's to the partners which shows the partners' share of the income and expenses of the partnership.

 

 

Limited Liability Company

 

A limited liability company ("LLC") is a hybrid business entity between a partnership and a corporation.  The owners of the LLC are called members.  LLCs could have one member or multiple members.  The members can manage the LLC by themselves or they can elect other people as managers to operate and manage the business.

 

            1.         Advantages of LLC.  There are a number of advantages to doing business as an LLC, including the following:

 

                        a.         Limited Liability.  A major advantage of an LLC is limited liability for its members.  The members of the LLC are liable up to their capital contributions to the LLC.  However, the members are not personally liable for the business' debts (unless, of course, the members personally guarantee the debt). 

 

                        b.         Management and Control.  Management of an LLC can be with all of the members or the LLC can appoint a manager or managers.  Therefore, an LLC offers flexibility when multiple members are involved.

 

                        c.          Limited Recordkeeping Requirements.  An LLC has no formal recordkeeping requirements unlike a corporation which is required to keep and maintain records and minutes of meetings and other shareholder or director actions.   

 

            2.         Disadvantages of a LLC.  There are a number of disadvantages to doing business as an LLC, including the following:

 

                        a.         State Filing Requirements.  Like a limited partnership, an LLC is a creature of statute.  This means that in order to create an LLC, the members must comply with state law.  In Missouri, Articles of Organization (together with a filing fee) must be filed with the Missouri Secretary of State.  Members of an LLC must create an operating agreement (which is similar to a partnership agreement) that outlines the rights and duties of the members.      

 

                        b.         Disagreements Among Members.  If there are multiple members with management rights disagreements could ensue. 

 

            3.         Taxation of Limited Partnership.  LLCs have a major tax advantage in that they have the freedom to decide if they want to be taxed as a partnership or as a corporation.  Generally LLCs choose to be taxed as a partnership to benefit from the pass through taxation of that entity.  This avoids the disadvantage of possible double taxation that corporations have by having their income taxed at the entity level and then again, if the corporation pays dividends, at the shareholder or individual level.  In addition, an LLC that has only one member can be taxed as a sole proprietorship. 

 

 

Corporation

 

Corporations are the main type of entity used for large businesses, but it can be used for a business that has only one owner.  Corporations are owned by shareholders who elect a board of directors to manage the business.  The board of directors, in turn, can appoint officers to manage the daily operations of the corporation.  Usually with closely-held businesses, the shareholders (owners) are also the corporation's directors and officers (managers), but this does not have to be the case.  It could be that some of the shareholders are not as knowledgeable about running the business.  These shareholders could still be owners, but maybe not officers or directors.  Often this is seen with a family business that is passed down to children, some of whom are involved in the business while others are not.

 

            1.         Advantages of Corporation.  There are a number of advantages to doing business as a corporation, including the following:

 

                        a.         Limited Liability.  A major advantage of a corporation is limited liability for its owners or shareholders.  The shareholders of a corporation are not personally liable for the corporation's debts (unless, of course, the shareholders personally guarantee the debt). 

 

                        b.         Management and Control.  If needed, management of a corporation can be different than the shareholders or owners of the corporation.  Therefore, a corporation, like an LLC, offers flexibility when multiple owners are involved.

                       

            2.         Disadvantages of a Corporation.  There are a number of disadvantages to doing business as a corporation, including the following:

 

                        a.         State Filing Requirements.  Like limited partnership and LLCs, corporations are creatures of statute.  This means that in order to create a corporation, the shareholders must comply with state law.  In Missouri, Articles of Incorporation (together with a filing fee) must be filed with the Missouri Secretary of State.   Missouri corporations must also file annual reports with the Missouri Secretary of State which report specifies who are the corporation's officers and directors.      

 

                        b.         Recordkeeping Requirements.  Corporations are required to document the actions it takes by maintaining records and minutes of meetings of the corporation's shareholders and directors.  In addition, the corporation must have bylaws and issue stock to its owners.  Following these formalities is important because failure to maintain records can lead to personal liability for the shareholders.   

 

                        c.         Disagreements Among Directors.  If there are multiple directors who manage the corporation, disagreements could ensue. 

 

            3.         Taxation of Corporations.  Generally, corporations are designated as either Subchapter C corporations ("C Corp") or Subchapter S corporations ("S Corp") for tax purposes.  A corporation will be treated as a C Corp unless it affirmatively elects to be treated as an S Corp.  If a corporation is taxed as a C Corp, the corporation must pay a corporate level tax on its net income.  This can result in a double tax that is often cited as a detriment to this type of entity.  A double tax can occur because the corporation pays tax on its net income and if dividends are paid to shareholders, the shareholders pay tax on the dividends they receive.  An S Corp avoids double taxation because, much like a partnership, income flows out to the shareholders and does not incur a corporate level tax.  A corporation must satisfy a number of tests in order to be eligible to elect S Corp status.  For example, an S Corp cannot have more then 100 shareholders.  If a corporation has over 100 shareholders, it will not be eligible to be an S Corp.

 

 

Conclusion

 

One form of business entity does not fit all new businesses.  Ultimately, it is up to the owners to select the entity which is most suitable for their needs.  Although liability and taxes are two fundamental issues to consider, there can be other issues as well.  

 

We hope this newsletter gave you an overview of the considerations to think about when selecting a business structure.  If you have any questions or comments regarding the contents of this issue of e-Counsel, please do not hesitate to contact us.

 

  

CIRCULAR 230 DISCLOSURE

 

Under U.S. Treasury Department guidelines, we are required to inform you that (1) any tax advice contained in this communication is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or by any party to market or promote any transaction or matter addressed herein without the express and written consent of Helfrey, Neiers & Jones, P.C. and The Law Office of Richard C. Petrofsky, (2) Helfrey, Neiers & Jones, P.C. and The Law Office of Richard C. Petrofsky imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein, and (3) any fees otherwise payable to Helfrey, Neiers & Jones, P.C. or The Law Office of Richard C. Petrofsky in connection with this written tax advice are not refundable or contingent on your realization of federal tax benefits from the advice contained herein.

 

 
About Our Law Firm
 
The Law Office of Richard C. Petrofsky
120 S. Central, Suite 1500
St. Louis, Missouri, Missouri 63105
Phone:  (314) 725-9100
 
Rich Petrofsky acts as Of-Counsel at Helfrey, Neiers & Jones, P.C.