For startups, which often operate at a loss during the first few years, forming as an LLC or an S-corporation might allow the owners to reduce their personal income taxes.
One of the first decisions that a new business needs to consider is what type of entity it should be. Most commonly, the choice is among a sole proprietorship, a partnership, a corporation, a limited liability company, or a limited liability partnership. For this decision, there is no “one size fits all” approach. In advising new clients, we will carefully discuss the pros and cons of each entity and review the specific needs of the owners so that we can recommend the best entity for each specific client.
The simplest way for an individual to organize a business is as a sole proprietorship. It generally can be formed simply and inexpensively by filing a “Doing Business As” (DBA) certificate with the city or town where the business is located. There is, however, one significant disadvantage to a sole proprietorship. The owner has no personal liability protection from claims against the business. This places all of the owner’s personal assets, including any real estate holdings and personal family savings, at risk. For this reason, other than in a few specific cases where the stated risk of claims is exceedingly low, very few new businesses choose to be sole proprietorships.
There are two types of basic partnerships: a general partnership and a limited partnership. General partnerships are akin to sole proprietorships, except with two or more owners, and are also formed by filing a DBA certificate. Typically, partnerships will also have a written Partnership Agreement laying out the rights and responsibilities of the owners. Like sole proprietorships, the partners of a general partnership have no personal liability protection, and risk losing personal assets if claims are brought against the partnership. Moreover, each partner may be held personally liable for acts committed by the other partners, which only multiplies the personal risk to each partner.
Limited liability partnerships operate essentially as general partnerships, except they have two types of partners—general partners and limited partners. The limited partners typically only invest capital, and are not involved with the day-to-day operation of the business. For such limited partners, liability is limited to the amount of their investment in the partnership. The general partners remain personally liable for all debts of the partnership. For certain types of businesses, a general partnership or (more frequently) a limited partnership might be a viable option.
Corporations have long been the “tried-and-true” entity for creating a business. The rights of corporations are well-defined by both statute and common law, and although less flexible than, for example, limited liability companies, corporations have a broad range of options in how they are established and governed. Under state law, corporations are separate legal entities, distinct from the owners (the shareholders) of the corporation. If properly formed, corporations provide personal liability protection to their owners. To set up a corporation, Articles of Organization and By-laws must be drafted. Depending on the needs of the owners, additional legal documents might also be required, such as shareholder agreements. Corporations are overseen by a Board of Directors and by corporate officers, including a president, a treasurer and a secretary. Once established, corporations must meet certain corporate formalities, including, among others, holding annual meetings of shareholders, board meetings, and maintaining proper minutes. Pathway Law works with its corporate clients to ensure these obligations are met correctly and in a timely fashion.
There are two types of corporations to choose from: a C Corporation and an S Corporation. The key difference is that for S Corporations, taxes pass through to the shareholders of the corporation, so that corporate profits and losses are included in the owners’ personal income taxes. This can be helpful, especially in the early years of a corporation when it is likely to generate significant losses. There are other specific advantages and disadvantages to each type of corporation, as well as limitations on which businesses can become S corporations, so a careful review with our attorneys is required before selecting either type of corporation.
Limited Liability Corporations and Limited Liability Partnerships
Limited liability corporations (LLCs) and Limited liability partnerships (LLPs) are relatively new breeds of legal entities created by state statutes. Like regular corporations, LLCs provide personal liability protection for the owners, provided that certain corporate formalities are met. Unlike corporations however, LLCs can be extraordinarily flexible with respect to the distribution of cash and other assets and the allocation of profits or losses. LLCs are created by filing a certificate of organization and drafting an operating agreement among the owners. LLCs have the flexibility of being operated similarly to a corporation, with a Board of Directors and officers, or as a partnership, with members or managers overseeing the business.
Limited liability partnerships (LLPs) are also relatively new, and allow for personal liability protection in a partnership-style entity. Formation of an LLP, as with an LLC, is governed by state-specific laws and regulations.
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