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Julianne Gern

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Phone: (307) 766-3296

Email: sls@uwyo.edu

Student Entrepreneurship

Student Legal Services - ASUW

Which Business Structure is Right for You?

This article was researched and written by Kirk Powers, a University of Wyoming College of Law student, and supervised by Student Legal Services.

Notice

This article is in no way intended to be taken in the place of legal advice from a licensed attorney. It is merely meant to be a source of concise information to begin the process of considering how to organize your business.  The author, Student Legal Services, and the University of Wyoming are in no way liable for the successes or failures of any business based on the information herein.  You should hire a licensed attorney to help consider all of these factors before making any decision about forming a business.

6 Main Legal Differences Amongst Business Structures

 

1. Tax Treatment

How you decide to structure your business will determine how it is taxed.  Certain business types have their taxes levied directly on the owner of the business, whereas others are taxed as their own separate entity.  Which of these scenarios is preferable depends on your personal situation and what type of business you are operating.

2. Owners Liability Exposure

How you decide to structure your business will determine that amount of liability you are exposed to from the successes and failures of the business.  There are pros and cons of setting up your business in a manner that limits your liability.

3. Management/Governance of Business

How you decide to structure your business will determine the rules it has to operate under in terms of how it is governed and managed.

4. Opportunities to Raise Funds

How you decide to structure your business will determine what means of fundraising are available for your business.

5. Exit Strategies

How you decide to structure your business will determine how you can exit the business should you decide that you no longer wish to be a part of it.

6. Formation

Each business structure has different rules and steps for formation.

 

Sole Proprietorship

A Sole Proprietorship is the most simple business organization.  It involves one person running a business, and that person is solely and completely responsible for the entirety of the business including debts.  A Sole Proprietorship is not legally separate from the owner.

I. Tax Treatment

Legally, a Sole Proprietorship is not different whatsoever than the person who created it.  Therefore the person that created it files their taxes in the exact same manner as they would beforehand, there are just a few more forms to fill out.  Overall, the tax scheme is the same as any individual person who is not a business owner.

II. Owner’s Liability Exposure

The owner of a Sole Proprietorship is solely and completely liable for all debts occurring from the running of the business.  This is not preferred because if the business fails to such an extent that it still owes money after its demise, the owner is liable for it out of his own personal assets.  This complete liability is a trade-off for the relative ease of the formation and taxation of the business.

III. Management/Governance

A Sole Proprietorship is entirely and completely managed and governed by the owner, in whatever manner he chooses.  There are no rules or regulations as to how a Sole Proprietor has to manage or govern his business.

IV. Opportunities to Raise Funds

There are little to none of the same opportunities to raise funds that the other business organizations may have.  Shares of the business cannot be sold to others.  The only options are really personal assets of the owner himself, but luckily in this situation comingling of personal and business funds is completely allowed.

V. Exit Strategies

An owner can exit the business by dissolving it entirely.  If he decides that the business is no more then the business is no more.  However, he cannot nearly as easily transfer the business to somebody else.  Generally, the Sole Proprietorship dies with the owner.

VI. Formation

A Sole Proprietorship is the easiest business organization to form.  It only requires the owner to register the name of the business, and then secure any necessary licenses needed for whatever the purpose of the business is.  Some Sole Proprietorships will not need licenses at all.

 

General Partnership

A General Partnership is where two, or more, people join to form a business as co-owners for profit.  This is applicable only if there is another (or multiple) people that would be considered an owner if a business was formed.

I. Tax Treatment

In a General Partnership the business itself is not taxed.  Instead the owners of the business have their income from the business taxed directly.  This is called Pass-Through Taxation (or Flow-Through Taxation).  The main benefit of this is that the business is not taxed twice, as the business itself and then as the income of the owner.

II. Owner’s Liability Exposure

The liability faced by the owners of a General Partnership is unlimited.  This means that any creditors you may owe from the operation of the business are not only limited to seeking your business related assets if you default on paying them. Essentially, any creditors may come after your personal money and assets to satisfy even business related debts.

III. Management/Governance of Business

Legally, all partners have the equal capability, opportunity, and responsibility to govern and manage the business.  No one partner has any greater rights or responsibilities than the other.  However, partners can choose to delegate the duties and responsibilities of the business.  This is either done informally or laid out in a partnership agreement.  It is also important to note that all partners have a fiduciary duty to one another, which means they have a duty to act in the best interests of the other partners.

IV. Opportunities to Raise Funds

Generating a large amount of money is difficult in a General Partnership.  Without putting up your own personal assets, the only easy way to generate money is through debt financing (loans, etc.) which is not the most attractive option.  It is possible to sell part ownership of the company (equity interest), but this is hard to do on a large scale because of the potential personal liability the buyer takes on as well as the limited market for which the buyer could resell their interest.

V. Exit Strategies

Partnerships are considered discrete assets.  This means they can be sold to other people or transferred in other ways, such as inheritance.  This allows for free transference to other people, allowing a partner to get out of the partnership easily.  However, some partnership agreements may stipulate exactly how and when an interest can be sold.

VI. Formation

General Partnerships can be officially formed with as little as an oral agreement between two people.  However, it is recommended that the partners create a partnership agreement to solve disputes and help guide the business.  This generally requires the services of a competent attorney to assist in drafting this document.

 

Limited Partnership

A Limited Partnership is a lot like a General Partnership, except that alongside the general partners it has limited partners who have limited liability for the debts of the company but also have limited say in the management of it.  This is a way to allow people to become involved with the company as investors, but in a more passive way with limited exposure.

I. Tax Treatment

A Limited Partnership is taxed in the same way a General Partnership is, using Pass-Through Taxation.  The company’s profits are solely taxed under each individual partner as their income tax.  This applies to both partners and limited partners.

II. Owner’s Liability Exposure

For the regular partners, the liability exposure is the same as it is in a general partnership in that all personal assets are fair game for business related debts.  However, for the limited partners, their liability exposure is limited solely to what they invested in the company.  To get this preferential treatment, they relinquish their right to have an equal control over the management and governance of the company.

III. Management/Governance of Business

The regular partners retain all of the management and governance rights that they do in a general partnership.  However, the limited partners get much less say in the management and governance of the business.  This is one of the sacrifices that a limited partner makes to get preferential low liability exposure.  Essentially, they get less of a say in the business but their assets are protected if the business fails.

IV. Opportunities to Raise Funds

Generating a large amount of money is difficult in a Limited Partnership as well.  Without putting up your own personal assets, the only easy way to generate money is through debt financing (loans, etc.) which is not the most attractive option.  It is possible to sell part ownership of the company (equity interest), but this is hard to do on a large scale because of the potential personal liability the buyer takes on as well as the limited market for which the buyer could resell their interest.

V. Exit Strategies

Partnerships are considered discrete assets.  This means they can be sold to other people or transferred in other ways, such as inheritance.  This allows for free transference to other people, allowing a partner to get out of the partnership easily.  However, some partnership agreements may stipulate exactly how and when an interest can be sold.

VI. Formation

A Limited Partnership requires not only the partnership agreement, but also a state filing establishing the Limited Partnership.  A few select states, such as California, allow for Limited Partnerships to be formed orally.  However, most states do require the filing to create the Limited Partnership.

 

Limited Liability Partnership

A Limited Liability Partnership, or LLP, is a lot like a General Partnership except that all people involved have limited liability exposure when it comes to the business.  In fact, it is considered a subset of a General Partnership.  This requires registering your company as an LLP with the appropriate government official, as well as including LLP in your name.  Any other state statutory requirements for LLPs must be complied with.  Lots of LLPs are comprised of licensed professionals such as attorneys or architects.  The LLP structure allows them to avoid liability for negligence stemming from the actions of another partner.

I. Tax Treatment

LLPs offer Pass-Through Taxation, which is the same as partnerships do.  This means that the profit from the business is only taxed once, as the business owner’s income tax.  This is one of the strongest benefits of having an LLP instead of a Corporation, since Corporations are taxed twice.

II. Owner’s Liability Exposure

LLPs offer extensive liability protection from creditors going after the business to settle debts.  Under the limited liability, creditors only have access to the capital invested into the business.  Therefore, they cannot seek to settle the debts with the partner’s personal assets.  This is preferred, because if the business fails the partner won’t see his personal financial situation fail with it.  However, not every instance of liability is protected.  For example, if the business gets sued for negligence someone’s personal assets are likely on the table for damages.  The amount of protection afforded by the applicable LLP statute in a given state will determine who is protected or not.  In states with “full liability shield” LLP statutes, the partner not responsible for the negligence still has his personal assets protected.  In states with “partial liability shield” LLP statutes, protection is stripped from the assets of all partners for that specific incident.

III. Management/Governance of Business

All partners in an LLP have an equal right to the management and governance of the business.  However, as with other types of partnerships, these duties are commonly delegated in the partnership agreement signed before the business is formed.  Once you sign this agreement you are bound to the duties within, unless all parties signing the agreement unilaterally decide to change the agreement.

IV. Opportunities to Raise Funds

Being a subset of a General Partnership, raising a large amount of money as an LLP is difficult as well.  Without putting up your own personal assets, the only easy way to generate money is through debt financing (loans, etc.) which is not the most attractive option.  It is possible to sell part ownership of the company (equity interest), but this is hard to do on a large scale because of the potential personal liability the buyer takes on as well as the limited market for which the buyer could resell their interest.

V. Exit Strategies

Partnerships are considered discrete assets.  This means they can be sold to other people or transferred in other ways, such as inheritance.  This allows for free transference to other people, allowing a partner to get out of the partnership easily.  However, some partnership agreements may stipulate exactly how and when an interest can be sold.  Also, LLPs are governed by the statute that created them, so if there is anything in the statute regarding how partners may exit it must be adhered to.

VI. Formation

LLPs are creatures of statute.  This means that they are expressly created by statute and have to be adhered to according to the statute.  Generally this means partnership agreements, registering with the state, and large insurance policies to help cover any negligence claims that may arise.

 

C Corporations

The standard business Corporation is a C Corporation.  If a business is formed as a Corporation it becomes its own separate legal entity, taking on a life of its own.  There are several key differences between Corporations and other types of business organizations that I will discuss below.  In order to legally form a Corporation, Articles of Incorporation must be filed with the applicable state.

I. Tax Treatment

Corporations are different from Partnerships in that they are taxed twice.  The income the Corporation makes itself is taxed, since it is its own separate legal entity, and then the dividends that each shareholder makes are taxed again.  This cuts into the overall profit of the corporation, but it shields the shareholders from tax liability and it allows for greater tax planning flexibility.

II. Owner’s Liability Exposure

One of the biggest benefits of a corporation is that it shields the shareholders from any personal liability.  This means that the only assets a shareholder could lose in a situation that a Corporation is liable for is whatever money they have invested in shares of the company.

III. Management/Governance of Business

Corporations are managed and governed under centralized management.  The shareholders (owners) of the corporation annually elect a Board of Directors.  This is where the management capabilities of the shareholder stops, except in extreme cases of things such as dissolving the corporation, changing the capital structure, or making a major acquisition.  The Board of Directors is then in charge of overseeing the overall direction of the Corporation.  They then appoint Officers to run the Corporation.

IV. Opportunities to Raise Funds

There are significantly better opportunities to raise large amounts of funds in Corporations than there are in the other types of business organizations.  The main opportunity is selling shares of stock, which equates to part ownership of the company.  Corporations can sell small fractions of ownership (stock) of their company and use the profits for whatever the business needs.  This stock is easily transferable between 3rd parties after it is initially sold.

V. Exit Strategies

In terms of a business owner exiting a Corporation he helped create, the most important thing to remember is that once created a Corporation is its own legal entity.  This means it cannot be completely dissolved without near unilateral agreement on the part of all of the people involved.  If the owner wishes to exit the Corporation without trying to stop it entirely, all he has to do is sell his stock in the company.  This essentially transfers all of his ownership out of the company in exchange for money or some other form of compensation.

VI. Formation

Corporations have quite a few more hoops to jump through than other business structures.  First, the owners will have to choose the state they wish to incorporate in and file Articles of Incorporation with that state.  Second, a Board of Directors must be appointed to run and govern the Corporation.  Third, this Board of Directors must write the Corporate Bylaws which are essentially the rules under which the Corporation operates.  Fourth, stock certificates must be issued to all of the initial owners of the Corporation.  Finally, any licenses or permits that the state requires for your type of business must be obtained.

 

S Corporations

An S Corporation is somewhat of a hybrid of a C Corporation and one of the business organizations usually used by smaller companies, such as any variation of a Partnership.  It combines many of the benefits of a corporation, such as separate legal status and low liability risk, with many of the benefits of the other types of organizations, such as Pass-Through taxation. S Corporations are generally closer held than C Corporations, which means there are less people involved.  For example, the Board of Directors, Officers, and shareholders could all be the same five people.

I. Tax Treatment

The main difference of S Corporations and C Corporations is that S Corporations are only taxed once using Pass-Through Taxation, whereas C Corporations are taxed twice.  This allows the generally smaller corporations to save money on taxes while enjoying the liability shield of having the separate corporate entity.

II. Owner’s Liability Exposure

Just like with a C Corporation, one of the best benefits of an S Corporation is the low liability exposure.  This is due to a Corporation being its own separate legal entity.  Any creditors must get what they seek from the Corporation itself, rather than the shareholders.  However, it should be noted that this liability protection may not extend to things like damages for negligence by employees.

III. Management/Governance of Business

Like C Corporations, S Corporations are governed by a centralized management structure.  However, since many S Corporations are closely held, this centralized management structure is made of the same people that would be considered owners/shareholders.  There is slightly more red tape to navigate since it is a Corporation, but generally the same people remain in control.

IV. Opportunities To Raise Funds

S Corporations can sell stock to raise funds, but the rules are quite tricky.  Only certain people are authorized to own part of the company, and if shares are transferred to someone who is ineligible then the IRS can cancel the S status of the Corporation and impose severe tax penalties.  If choosing to go the route of an S Corporation it is advisable to consult a licensed attorney with a background in tax law.

V. Exit Strategies

Exiting an S Corporation is a matter of selling your share of the company.  Unfortunately, the IRS’ rules on transferring any share of the company also apply in this situation.  Therefore it is advisable to contact an attorney to make sure everything is in order during the transfer so that S status for the Corporation is not lost.

VI. Formation

To form an S Corporation, one must first chose a state to incorporate in and file Articles of Incorporation.  Second, a Board of Directors must be appointed.  In this case, it is likely to be the same people that formed the Corporation in the first place since S Corporations are generally smaller, closely held Corporations.  Third, the Board of Directors must write the Corporate Bylaws.  Fourth, stock must be issued to all the initial owners.  This step is also trickier because the people who get issued stock must be statutorily allowed to own it, because if they are not allowed to then the Corporation can lose its S status and be forced to pay a hefty tax penalty.  Fifth, any licenses that the business needs must be obtained.  Finally, the S Corporation has to be registered as such with the state and the IRS in order to gain the preferred tax treatment of being an S Corporation.

Limited Liability Company

A Limited Liability Company, or LLC, is a hybrid version of all of the other organizations discussed above.  It provides favorable tax status, with limited liability and greater management flexibility.  It is another organization that is a “creature of statute”, meaning it is expressly created by a state statute and has to operate within the bounds of that statute.

I. Tax Treatment

An LLC has the same beneficial tax treatment that is given to Partnerships, Pass-through Taxation.  As explained above, Pass-through Taxation is where the profits of the business are only taxed once as the owner’s income tax.  This allows the business owner to save money because his business is not taxed separately alongside his own income taxes.

II. Owner’s Liability Exposure

As an LLC, all owners get the benefit of limited liability exposure.  This means that creditors to the debts of the business cannot go after the personal assets of the owners, except possibly in certain cases such as a negligence filing against the business.  This is beneficial because it means the owners personal assets are safe should the business fail.

III. Management/Governance of Business

LLC’s are almost always governed by an Operating Agreement.  An Operating Agreement is a mix between a Partnership Agreement and Corporate Bylaws.  This allows the owners of the business much more flexibility in how they manage the business than they would get if they had formed a Corporation, because the statutory rules and restrictions for Corporate Bylaws are much more in depth.

IV. Opportunities To Raise Funds

The opportunities to raise funds are a little more limited in an LLC, just as they are in a Partnership.  Generally, money is raised by the owners themselves.  However, there are other fundraising options such as selling shares of stock in the company.  Unfortunately, if an LLC sells shares of stock to the public then it loses its Pass-through Tax status and is taxed the same as a Corporation.

V. Exit Strategies

Exiting an LLC is rather easy as well.  As with Corporations, all that is needed is for the owner to sell his share of the business.  This effectively ends the owner’s involvement with the company.

VI. Formation

The first steps to forming an LLC are picking a name and filing Articles of Organization.  Articles of Organization are to be filed with the appropriate government agency.  There is also a fee that must be paid to the same agency.  An Operating Agreement that details how the LLC will be run must also be formed.  Some states require that you publish a notice in the paper that you intend to form an LLC.  Finally, the business owner must get all the licenses and permits needed for their business.

How Do You Choose?

The decision of how to organize your business is a tough one that can have long lasting ramifications, including whether or not your business survives.  Each of the six attributes I have listed above must be carefully considered and weighed against the others under the lens of the purpose of your business.  Enlisting the help of a competent attorney who is seasoned in these types of matters can be invaluable to the future success of a business.

Sources

 

Business Structures in a Nutshell

By Joseph Shade and David Epstein

West Group, 2003

 

www.entreprenuer.com 


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Julianne Gern

1000 E. University Ave

Knight Hall 128

Laramie, WY 82071

Phone: (307) 766-3296

Email: sls@uwyo.edu

1000 E. University Ave. Laramie, WY 82071
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