One of the first steps in to starting a business or reorganizing an existing business is to determine which type of legal entity is the best fit for your business. In order to make that determination, it’s imperative that you have a basic understanding of the key characteristics of each type of entity. Most businesses fall within one of the five following categories: sole proprietorship, general partnership, limited partnership, corporation, and limited liability company.
A sole proprietorship is the most common type of business structure. In a sole proprietorship, all the businesses’ assets are owned by a single person. As such, the business really has no separate legal identity apart from the individual owner. The owner alone assumes all of the benefits and burdens associated with owning and operating a business. Simplicity is the obvious benefit to a sole proprietorship, but simplicity comes at the price of unlimited exposure to the businesses’ liabilities.
A general partnership is very similar to a sole proprietorship in that the enterprise itself really has no legal existence separate from its owners. The key distinction between a sole proprietorship and a general partnership is the existence of more than one owner. A general partnership is so simple to create that two people could form a general partnership without it being their specific intent to do so. Anytime you have two or more people come together and associate themselves for the purpose of carry on a business for profit as owners, a general partnership can be said to exist.
While a general partnership is still a relatively simple business structure compared to other types of business entities, anytime you have shared ownership of a business enterprise, you have a situation fraught with potential internal conflict. Some of that conflict may be resolved by the application of our laws that are generally applicable to all general partnerships, but you should never assume that the legal defaults are right for your business or that they are comprehensive. There is no substitute for a written partnership agreement. It doesn’t necessarily have to be long or overly complex, but at a minimum, a basic understanding of each partner’s rights and responsibilities should be reduced to a writing that all partners understand. People say vows when they get married. Partners are parties to a business marriage of sorts and they should make some vows to each other.
Similar to a sole proprietorship, the underlying owners of the business conducted as a general partnership are generally liable for its debts and obligations. This is another area where conflict can rear its head because your partner may take an action or refrain from taking an action that winds up creating personal liability for you. Again think of a partnership like a marriage and imagine a situation where your spouse engages in some spending that you don’t agree with.
Moving on to limited partnerships, we start getting into the more complex, state-chartered entities. That is, these types of entities are granted life, so to speak, by a state based upon an application submitted by or for its owners. In addition, we also begin to see a separation of ownership and management.
A limited partnership is very similar to a general partnership in that it is, at its core, an association of two or more persons for the purpose of carrying on a business for profit as owners. The most obvious distinction between a general partnership and a limited partnership pertains to the classification of limited partners and general partners. Every limited partnership must have at least one general partner. The general partner, like a sole proprietor or partner in a general partnership, is generally liable for the debts and obligations of the business. However, in exchange for this burden, the general partner alone is vested with the right to control most aspects of the partnership’s business, particularly those pertaining to day-to-day affairs.
By contrast, limited partners in a limited partnership are not generally liable for the business’ debts and obligations. As a general rule, their liability is limited to their investment in the limited partnership. This limited liability comes at the expense of sacrificing the ability to engage directly in the control of the limited partnership’s business. Limited partners may have a voice in certain major decisions, and limited partners may, among other things, serve as employees of the limited partnership, all without sacrificing their liability protection. However, the line separating what does and does not constitute participation in the control of the business is a very fine one, and it often requires a fact-specific and subjective determination to see where that light might fall.
The most common limited partnership structure will have a limited liability company or corporation designated as the general partner. These types of entities are ideal candidates for the position of general partner because they themselves provide a liability shield to their underlying owners. It is also common for the limited partners to have control or ownership of the general partner. In this manner, the limited partners can exercise their ability to directly control the general partner and thereby indirectly participate in the control of the limited partnership’s business. People sometimes refer to wearing different “hats” for one capacity or another, e.g. I cannot do this in my limited partner hat, but I can put on my hat that says “President of X Corp, General Partner of Y Limited Partnership” and take that action. Extreme caution must be observed, particularly when third parties are involved, so that there is no confusion over which hat a person is wearing when they take a particular action.
If a written partnership agreement is important for a general partnership, it is even more important for a limited partnership. The greater necessity is in part due to the separation of powers between the general partners and the limited partners. As stated above, the introduction of another owner into the relationship creates a real hotbed for conflict, but when you start to separate ownership from management, as you do with a limited partnership, the potential for conflict is even greater. A general partner has an immense amount of power relative to that of the limited partners and careful consideration must be given to the limits of that power.
The corporation is probably the most well known type of legal entity. Corporations dominate the list of the most influential and wealthy business enterprises. Many of us that would never otherwise invest in equity securities own shares in publicly traded corporations. In our consumption of TV and movies we are frequently exposed to internal corporate power struggles and phrases like “hostile takeover”, “golden parachute”, “poison pill”, and “white knight”. For these and other reasons, the average person is probably most familiar with the corporate form than any other form of business entity. However, when it comes to selecting a business entity, this does not mean that the average person is suited for a corporation.
Corporations are, generally speaking, highly structured, inflexible, and burdened with technical procedure and formality. Much of this perception is a product of the relatively large size of the corporations that we encounter in our daily lives and not because the corporate form in and of itself would create that impression regardless of the size of the enterprise. That said, the corporate form is designed and uniquely suited to accommodate a relatively large and diverse pool of constituents. The clear and complete separation of ownership from management and the limited liability afforded to shareholders, can facilitate the acquisition of a vast amount of capital through investor volume.
In the classic corporate model, a business is broken up into tiny, normally indistinguishable, pieces called “shares”. The corporation then sells these pieces of itself to investors who become shareholders. The shareholders then elect a board of directors, which responsible for overseeing the corporation’s business. In order to facilitate their oversight obligations, the board of directors elect officers who are specifically responsible for one or more defined areas of management. You can see how that even with this simple explanation, a corporation can be perceived as cumbersome.
A corporation, like any other business entity, can be customized to suit the specific needs of its principals and to adapt to unique aspects of the industry in which the corporation does business. For example, it is possible to have a corporation without directors and instead vest management directly in the shareholders. You may also think of a corporation as a balloon. When you first blow it up, it’s just a balloon. However, a person can take that balloon, and trough a series of twists and turns, turn it into a dog, a giraffe, or some other animal.
There does come a point in customizing any legal entity or business relationship when you have to wonder, “Why we can’t just have some type of entity to please everyone?”. State legislatures have heard the call, and behold, the limited liability company has arrived. This type of business entity has become immensely popular with business owners and their attorneys due, in large part, to its ability to be as complex or as simple as anyone would like and all while preserving the concept of limited liability to its owners.
The limited liability company possesses many of the favored characteristics of a corporation and those of a partnership, all while avoiding many of the disadvantages that often accompanied those entities. For example, like a corporation, a limited liability company sells pieces of itself, or “membership interests”, to its investors in exchange for contributions to capital. Management in a limited liability company may be vested directly in its owners (called “members”), similar to partners in a general partnership, or management may be vested in one or more managers, similar to a corporation’s board of directors. Thus, a limited liability company has appeal to both small and medium-sized businesses.
The internal affairs of a limited liability company are governed primarily by an agreement called an “operating agreement” or “company agreement”. These agreements are often very similar to partnership agreements and address important issues such as allocation and distribution of profits and losses, management rights, restrictions upon transfer of ownership, and agreements concerning additional capital contributions. Again, its not that you couldn’t accomplish many of the same things with a corporation or limited partnership, but the initial framework of a limited liability company as created by state legislatures simply lends itself to a greater degree of flexibility.
While an in-depth discussion of the federal income tax considerations applicable to business entity selection is beyond the scope of this article, it is worth noting that limited liability companies are also extremely flexible when it comes to selecting any entity that meets your tax objectives. A limited liability company can conceivably be taxed as a “disregarded entity” (basically, as a sole proprietorship and reported on an individuals 1040 Schedule C), as partnership, or as a corporation.