This blog covers information to help perspective business owners choose which type of entity to form. It, however, does not cover tax considerations in making that decision. Tax considerations need its own blog.
In the United States entities are formed under state law. We have fifty states in the country, and each state drafts its statutes and regulations just a little differently. This remains true for entity formation law. In fact, although most if not all the states have the primary four types of entities (Sole Proprietorship, corporation, limited liability company, and partnership), the less known entities can often vary greatly from state to state: professional associations, non-profit corporations, general partnerships, limited partnerships, limited liability partnership, etc.
We will not be covering the more obscure entities today and only covering the primary entities: Sole Proprietorship, corporation, limited liability company, and partnership. Topics covered include
- protection of business assets from owner’s creditors,
- continuity and termination
Hopefully by reviewing these sections you will be able to determine which type of entity will be right for you, your business partners, and your business.
The sole proprietorship is the simplest and easiest type of entity to form, but is has serious drawbacks.
Few if any legal steps are required to start a sole proprietorship. Unlike the other business entities, we will be reviewing today, a sole proprietorship is not incorporated. For this reason, in most states there is usually no need to file documents with the state in order to form the sole proprietorship. The entity simply comes into existence once the owner and operator begins to conduct a business for profit.
If the sole proprietorship will be operated under a trade name or fictitious business name (called a DBA), it is likely necessary to register the name with the state. In addition, it will be necessary to obtain any required state or local licenses or permits such as a business license or other trade licenses. State law will generally treat the business and the owner the same because the business is the owner (has no existence independent of the owner).
Because a sole proprietorship is not an entity independent form its owner, there is no formal capitalization of a sole proprietorship. In other words you do not buy into the entity because there is nothing to buy into. The assets of the business are personally owned by the owner of the sole proprietorship under the owner’s personal name. There is no separate ownership.
A sole proprietorship has only one owner, thus the name “sole” proprietorship. If there is more than one owner, the business will generally be treated as a partnership unless another form of entity is created.
A sole proprietorship provides no liability protection for the owner. All the sole proprietorship’s obligations and liabilities belong directly to the owner; because, remember they are the one in the same. The owner is personally liable for the debts, obligations, and liabilities of the business. Although the purchase of liability insurance or joint ownership of nonbusiness assets with a spouse may mitigate some of the risks, the liability that an owner of a sole proprietorship takes on is a significant disadvantage.
The owners of a sole proprietorship that does not plan on growing should look into forming a single-member limited liability company if they are worried about owner liability.
Protection of Business Assets from Owner’s Creditors
A sole proprietorship does not protect the business assets from the sole proprietorship owner’s creditors. So, an owner of a sole proprietorship could get in a car wreck or have some other event which causes a judgment to be entered against the owner, and all the assets of the business could be used by that creditor to pay the judgment.
Because a sole proprietorship owner and the sole proprietorship itself are the same, and the owner personally owns all the assets of the business, the owner of the sole proprietorship has complete control over the management of the sole proprietorship.
Continuity and Termination
The business that is operated as a sole proprietorship technically continues until the owner dies, becomes disabled, files for bankruptcy, or simply decides to end the business.
In most situations, the owner of a sole proprietorship personally owns all the assets of the business in the owner’s personal name. For this reason the owner can sell or transfer the assets of the business by simply transferring the assets and goodwill to the new owner. The new owner would need to make sure they have all the requisite licensing which previously was held in the previous owner’s personal name.
Sole proprietorships do not dissolve, because business dissolution is the winding down, legal termination, and transfer of the assets of the business. A sole proprietorship simply stops operating when the owner stops operating, and the owner already owns all the assets, so nothing needs to get transferred. There may be some licenses and similar loops to close, but the entity itself really has no dissolution.
Because a sole proprietorship is not filed with the state, there are generally no public records regarding the sole proprietorship.
To transition to an incorporated business from a sole proprietorship, a new incorporated entity would need to be formed and the owner would then contribute the business assets of the sole proprietorship to the ownership and care of the new entity.
For profit corporations are the oldest and most traditional of the entity types.
Because a corporation is incorporated under the laws of the state where it is formed, it is a legal entity separate from its owners (“shareholder”). To form a corporation the shareholders’ representative, normally called an incorporator, must file documents with the state usually called certificates, articles, or charter.
Shareholders should also be required to adopt bylaws to govern the affairs of the corporation, elect a board of directors who elect officers, and hold an organizational meeting of the shareholders and directors. The formation of the corporation should be reflected in the organizational minutes. The formalities of the corporate structure as well as the strict three step management structure, which may or may not needed, as well as a possible increased supervision by regulatory agencies, and larger administrative expenses, are the main nontax disadvantages of the corporate form.
A person becomes a shareholder of a corporations by transferring property to the corporation in exchange for shares of stock in the corporation. The property can be cash, real estate, equipment, or some other type of property. From a strictly entity formation standpoint, there is no limit on the number of shareholders that a corporation may have. But there are strict restrictions regarding how one can sell ownership in corporations, the effect the number of shareholders has on tax election (subchapter S), and corporations must also state an actual number of shares the corporation is allowed to sell. Corporate stock may be divided into different classes of shares, with different rights to voting, distributions, and liquidation.
The shareholders of a corporation are generally not liable for liabilities which belong strictly to the corporation. This is true because a corporation is treated as a separate legal person under the law with the ability and responsibility to maintain its own debts and obligations. However, shareholders are always liable for debts and obligations they co-sign or guarantee. This veil of protection (“corporate veil”) may be pierced if the shareholders take or fail to take certain actions, such as, fail to follow corporate formalities, commingle personal and corporate funds, engage in fraudulent behavior, or inadequately capitalize the corporation to the detriment of creditors.
Protection of Business Assets from Shareholder’s Creditors
A creditor of a shareholder owning shares in a corporation usually may foreclose on those shares to pay a debt or obligation of shareholder. If the creditor is successful in foreclosing on the shareholder’s shares, the creditor will succeed to the shareholder’s rights to distributions and management of the corporation. Although limited liability companies are normally better suited in protecting the entity from the creditor’s of its owners, my firm has developed methods to use in corporations to help in this same area and in a similar way.
The corporation’s articles and bylaws set out how to control the management of the corporation. State law varies as to what extent these documents can be drafted to take control away from the shareholder’s and maintain in with the board of directors. State law also fills in the gaps and provides clarity where the corporation’s articles and bylaws are silent. These documents normally set up the corporation to be managed by directors and officers. The most straight forward method of control is to have a majority vote of the shareholders elect the board of directors, have a majority vote of the board of directors elect the officers, and clearly set out what items the board can vote on and what items require a vote of the shareholders.
Many methods and provisions abound to retain control with one type of shareholder, directors, or officers. The corporate structure is normally the best type of entity equipped for such management techniques.
Continuity and Termination
Corporations have perpetual existence until they are dissolved or a pre-determined date or benchmark is met which terminates the entity. Dissolution can occur several different ways, including by the court, by the shareholders, by creditors, or most commonly by the state for failure to file annual reports or naming a registered agent.
Shareholders in a corporation may transfer stock at will, unless the formation documents or a shareholder agreement (sometimes called a buy-sell agreement) states otherwise. There are many types of triggers for that can be built into the transferability of stock, including, upon death, incapacity, termination, etc.
Most states require the corporation to follow a process to dissolve the entity and liquidate the assets. This process usually requires shareholder or court approval. Usually the corporation must also file the required documentation, articles of dissolution, with the state. Creditors get paid first and then shareholders in the order according to their type of shares.
Corporation enjoy less privacy than the sole proprietorship. Although filing requirements vary from state to state, usually corporations must file the formation documents and annual reports with the state. Those documents normally become public record, and can be viewed by third parties. The corporation’s other internal documents and records are normally not public record but are maintained exclusively by the corporation. These documents include bylaws, minutes, resolutions, ledger, etc. These internal documents may be obtained and reviewed by shareholders of the corporation according to the direction by the formation documents and state law.
Conversion generally means the ability to change one type of entity to another. Conversion of one type of incorporated entity to another is completely dependent on state law but is possible in most states. It is generally easier to convert from a noncorporate entity to a corporation than from a corporation to a noncorporate entity. If conversion does not work an entity can consider a merger to obtain the same purpose, and the tax consequences of such actions should always be considered.
LIMITED LIABILITY COMPANY
Limited liability companies are normally the sweet spot between all the entities. They are by far the most popular because they provide so much flexibility.
A limited liability company is must be incorporated, just like a corporation, but it normally does not require as many provisions. It is recognized as a legal entity separate from its owners (“member”) for purposes of state law, because just like corporations it is its own legal person under the law. Formation statutes vary from state to state, but generally a member must agree with an incorporator to file documents with the state: articles of organization, certificate of organization, charter, etc. The members should also adopt an operating agreement which govern the day-to-day operations of the company.
A person becomes a member of a limited liability company by transferring property to the company in exchange for shares of stock in the corporation, but can also be appointed by the person who formed the company. From a strictly entity formation standpoint, there is no limit on the number of members that a company may have. But there are strict restrictions regarding how one can sell ownership in companies, and the effect the number of members has on tax election (subchapter S). Unlike corporations, limited liability companies do not have to state in their formation documents a limit on the number of units the company is allowed to sell. Also, limited liability company units may be divided into different classes of shares, with different rights to voting, distributions, and liquidation, but all this information is normally outlined in the operating agreement.
The members of a limited liability company are generally not liable for liabilities which belong strictly to the company, thus the name “limited liability.” Incorporating the company makes it treated as a separate legal person under the law with the ability and responsibility to maintain its own debts and obligations. However, members are always liable for debts and obligations they co-sign or guarantee. This veil of protection (“corporate veil”) may be pierced if the member take or fail to take certain actions, such as, fail to follow formalities, commingle personal and corporate funds, engage in fraudulent behavior, or inadequately capitalize the company to the detriment of creditors. However, in some states it is harder to pierce the corporate veil of a limited liability company, perhaps because they are expected to be more informal.
Protection of Business Assets from Shareholder’s Creditors
Most state law permits a member’s creditors to obtain a charging order against that member’s membership interest. The charging order allows the creditor to collect the distributions from the company which would normally go to the member. Normally charging order rights do not give the creditor the right to vote or otherwise control the membership interest.
In some jurisdictions a creditor may also foreclose on the membership interest and take complete control of the ownership, thus giving the creditor full ownership and control of the company. However, this right in many states is very often restricted for multi member limited liability companies.
My firm has developed methods of protecting multi-member limited liability companies from both charging orders and from foreclosure.
There are two primary ways to control the management of a limited liability company. The first is by listing in the certificate of formation (also known as articles of organization) how the company is managed (i.e. manager managed or member managed). The next is to outline in the company’s operating agreement how those managers will be chosen. State law provide default rules that govern the entity when these organizational documents do not exist or are silent on management control.
Continuity and Termination
In some states, limited liability companies exist until they are affirmatively dissolved by the members. Some states treat withdrawal of a member as an event that triggers an automatic dissolution. Members should always have provision in the formation documents which govern around state law so that the members can maintain their desired outcome.
Members are generally free to transfer their membership interests in a limited liability company unless restricted by the formation documents or by the operating agreement or some other agreement between the members.
Most states require the limited liability company to follow a process to dissolve the entity and liquidate the assets. This process usually requires member or court approval. Usually, the company must also file the required documentation, articles of dissolution, with the state. Creditors get paid first and then members in the order according to their type of interest.
A limited liability company’s formation documents and annual reports are filed with the state and can generally be viewed by third parties either through the state’s website (as in Florida) or by ordering the documents from the state agency. The companies operating agreement, minutes, resolutions, and other books and records are not publicly record. They are owned and maintained by the members or managers of the limited liability company.
Conversion generally means the ability to change one type of entity to another. Conversion of one type of incorporated entity to another is completely dependent on state law but is possible in most states. Limited liability companies are normally easily convertible. If conversion does not work an entity can consider a merger to obtain the same purpose, and the tax consequences of such actions should always be considered.
With the advent of limited liability companies, partnerships have become less important and less used.
A partnership is a bit of both worlds as it is recognized as a legal entity separate from its owners for purposes of state law, but can also be incorporated. A partnership is an association of two or more persons who organize as co-owners to carry on a business for profit. So, you can form a partnership with someone simply by working together to carry on a business for profit. But, in most states you may also file papers with the state to make it more official.
There are several different types of partnerships:
General partnership. This type of partnership only has general partners. Each general partner takes part in the management of the partnership and is personally liable for obligations of the partnership.
Limited partnership. This type of partnership has both general and limited partners. General partners manage the partnership and are personally liable for partnership obligations, while limited partners do not participate in the day-to-day management of the partnership and are not personally liable for partnership obligations.
Limited liability partnership. This type of partnership is a hybrid form of partnership in which each partner can participate in the day-to-day management of the partnership, but without personal liability. It varies from state-to-state.
Because partnerships are formed by agreement between the partners, it is very important that the partners memorialize that agreement in writing.
Obtaining ownership in a partnership is accomplished by transferring property to the partnership in exchange for a partnership interest. Most partnerships have one class of partnership interest, but in some states a limited liability partnership can have different classes and types of partnership interests. These interests can have different rights to voting and distributions and different levels of liability for obligations of the partnership.
Different types of partnership have different types of ownership liability.
General Partnership. General partners are personally liable for the debts and obligations of the partnership because they are running the partnership. Of concern, the general partners can even be liable for the debts incurred by other partners. Because of this broad liability, general partnerships are a risky choice of entity type.
Limited partnership. General partners are personally liable for the debts and obligations of the partnership. Limited partners enjoy limited liability.
- Limited liability partnership. No partners are personally liable for the debts and obligations of the partnership; however, partners are personally liable for their own wrongful acts and for those of individuals they supervise. The upside is that their personal assets are protected from claims arising from the wrongful acts of the other partners or individuals the other partners supervise.
To escape the liability issue, some partnerships are structured with a corporation or some other entity acting as the general partner. Of course, all partners are personally liable for any debts or other obligations that they personally guarantee.
Protection of Business Assets from Shareholder’s Creditors
Most states allow creditors to obtain a charging order against a partner’s partnership interest. In most states, a charging order only confers the right to receive distributions that the partner would have otherwise received. In some states, the charging order is the only remedy viable remedy to a partnership’s creditors.
Management control of the partnership is largely dependent on the type of partnership formed. But generally, the person who controls the partnership is a specific partner named by the other partners as the manager. If there are multiple general partners, there are multiple decision makers. Limited partners should not participate in the management of the business. The partnership agreement is the document that largely controls management of the partnership and should be carefully drafted to avoid conflict.
Continuity and Termination
The partnership agreement and other formation documents largely determine the continuity and termination of the partnership. Unless there is a specific agreement to the contrary, general partnerships are usually dissolved by the death or withdrawal of one of the partners.
Unless there is a specific agreement to the contrary, general partnerships are usually dissolved by the death or withdrawal of one of the partners. This is also true for transferability of a general partner. That is one of the reasons that these types of transfers should be in writing and agreed by the partners. Most states allow a transfer by a limited partner without triggering dissolution. Partnership agreements may also have other provisions regarding the restriction of transfers.
Dissolution of a partnership is governed under state law, and varies from state to state.
The partnership agreement, books, and records of a partnership are not public record, but are maintained by the partnership. If the partnership files a certificate of formation and annual reports, those documents can be viewed by third parties.
In some states, a partnership may be converted to another form of entity. Conversion of partnerships are not as common. Many times conversion is accomplished through a more complicated distribution of assets to the partners followed by a contribution of those assets to the new entity. A similar outcome may be accomplished through a cross-entity merger or reorganization. All conversion discussions should take into account serious tax ramifications.