The answer to the question, of course, depends on a number of factors. There are four business entity types:
- Sole Proprietorship
- Partnership
- Limited Liability Company
- Corporation
I would like to discuss the ease of formation and the liability of owners of each type in this post and in my next post, I’ll discuss the tax issues and management and control issues of each type.
EASE OF FORMATION
Sole Proprietorship
The simplest business entity to form is the sole proprietorship because there are no formal requirements for formation: meaning, there are no forms or papers to file with the state. All one need do is hang out a sign and wait for the customers to appear. There may however, be requirements on a local level for a business license or fictitious business name.
Partnerships
The next in ease of formation is a partnership. A partnership is formed when two or more persons (or entities) get together to operate a business. There are several different types of partnerships that can be formed: general, limited and limited liability.
The general partnership is the easiest to form. In a general partnership, all partners are entitled to manage the business. As with a sole proprietorship, there are no legal requirements for formation aside from the agreement of the partners. That is, there is no legal requirement that the partners register with a state agency or enter into a written agreement (although it is recommended).
A limited partnership is one in which at least one of the partners wishes to be a limited (or silent) partner and the other partner or partners manage the business. The managing partner is referred to as the general partner.
Formation of a limited partnership generally requires the creation and filing of a written partnership agreement and a Certificate of Limited Partnership with the appropriate state agency (usually the Secretary of State). Many states also require filing of a formal public notice in a local newspaper. This filing provides notice to prospective customers and creditors of the limited liability status of the limited partners.
A limited liability partnership is a new entity type and may not be recognized in all states or may be limited to only certain professions. Basically, creation of a limited liability partnership provides limited liability for each partner from the acts, errors, omissions or negligence of the other partners but not themselves. However, it does not provide limited liability for general debts and obligations of the company.
Formation requirements for a limited liability partnership vary from state to state but generally include registration with the appropriate state agency, appointment of an agent for service of process and may require creation of a written partnership agreement.
Limited Liability Company
Formation of a limited liability company involves the creation and filing of Articles of Organization with the appropriate state agency. Each state has detailed rules on what must be contained in the Articles of Organization. A few states require the creation and filing of an operating agreement which provides the outline of how the LLC will be run. Also, some states require public notice advertising similar to that for a limited partnership.
Corporation
A corporation (sometimes called a C corporation) is the most complicated business entity to form. Formation typically involves the creation and filing of Articles of Incorporation and in some states, also bylaws. In addition, many states require the filing of a Statement of Information. And every corporation must identify an agent for service of process and file the appropriate form with the state.
An S corporation is not a separate type of entity. Every S corporation started out as a C corporation. The S signifies only different tax treatment for the corporation. The shareholders of a C corporation elect to become an S corporation by filing the appropriate forms with the IRS. The S designation then allows the corporation to be taxed differently by allowing the income and deductions of the company to flow through to the shareholders. The corporation still has to abide by the formation requirements of the state. There are, however, strict formalities that must be adhered to for qualification and maintenance of the S tax status.
LIABILITY OF OWNERS
Sole Proprietorship
As the name implies, a sole proprietor is solely and personally responsible for all of the debts, liabilities and obligations of the business. The business is not a separate entity so any lawsuits filed will be in the name of the proprietor. That means that the business owner’s personal assets have no protection from the creditors of the business.
In addition, if a sole proprietor decides to hire agents or employees, he is also liable for the actions of these persons committed while engaged in business activities.
Partnerships
Most states now consider a partnership to have some characteristics of a separate legal entity and therefore, they can sue or be sued in the partnership name.
In a general partnership, each owner is subject to personal liability and is therefore, jointly and individually liable for the debts, liabilities and obligations of the business. This means that a creditor can seek recovery from any one or all of the partners as they see fit. In the case of a new incoming partner, he or she would have no personal liability for partnership obligations that existed before their admission into the partnership.
A limited partnership has at least one general partner and at least one limited partner. All general partners have full personal liability for all of the debts, liabilities and obligations of the partnership. Limited partners are generally not personally liable for these debts beyond their capital contributions. That means that their personal assets, other than the cash or property that they contributed to the business, are not at risk. However, this limited liability protection can be lost if a limited partner becomes actively involved in the management of the partnership. Every state has different rules regarding what constitutes “actively involved.”
In a limited liability partnership, each partner is entitled to limited liability for the acts, omissions, negligence or incompetence of the other partners but not for their own. This means that one partner cannot be sued personally for the misdeeds of another partner but they can be sued for their own. All partners are jointly and individually liable for all of the general debts, liabilities and obligations of the partnership up to the amount of their capital contributions and the partnership as a whole remains liable for all its debts and obligations.
Limited Liability Company
In a limited liability company, members typically have no personal liability for the debts, liabilities and obligations of the company. However, there are circumstances under which a member could be held personally liable. These circumstances can be triggered when any one member or all of the members fail to act like a limited liability company in key respects. These key issues include commingling of funds, undercapitalization of the entity or the granting of a personal guarantee.
Corporation
Because a corporation is recognized as a separate legal entity, it is responsible for its own debts. The corporate structure is intended to protect shareholders, officers and directors from being personally responsible for the debts, liabilities and obligations of the business. However, as with the limited liability company, there are circumstances under which a shareholder, officer or director could be held personally liable. The legal concept is referred to as “piercing the corporate veil” and requires evidence of abuse of the corporate structure. Some of the circumstances that can trigger a piercing of the corporate veil include:
- Failure to follow corporation formalities
- Commingling of corporate and personal assets
- Undercapitalization of the corporation; and
- Use of the corporate entity to perpetrate fraud
The fact that a plaintiff could be able to pierce the corporate veil and hold one or more individuals personally liable does not mean that the veil will be pierced as to any other shareholder, officer or director.
Remember, however, that regardless of the type of entity that you choose, a person will always be held personally liable for any damages they cause as a result of their own willful or negligent acts or omissions as well as for any liabilities they personally guarantee.
Part II will be about the tax issues and governmental reporting requirements for each of the entity types. In the meantime, please post any questions or comments that you may have.