There are several ways that one can set up a business. This article discusses many of those different ways, including the six most common ways. That is, sole proprietorship, partnership, limited liability partnership, limited partnership, corporation, and limited liability company.
A sole proprietorship is a business owned by a single person who has not submitted paperwork to establish a different legal form. In other words, when a single owner opens a business, the default is a proprietorship.
A consequence of a sole proprietorship is that it is very simple to run. The owner has sole discretion about management and is not restricted by any governing rules. Additionally, taxes are quite simple. The owner simply adds the income to his/her personal taxes, likely by attaching a Schedule C to Form 1040.
The main downside of a proprietorship is that the owner is directly liable for any and all business expenses. For instance, if Joe is an electrician and purchases tools to use in the business, those tools are owned by Joe. If the business is sued, Joe might not only lose his tools, but his other personal assets, such as a car or house, may also be at risk.
Because the business and the owner are essentially the same, the legal name of the business will be the name of the owner. For example, “John H. Doe.” However, many of these businesses want to give the business a name. As such, they establish a DBA (doing business as). This simply means that they wish their business to be called something other than their legal name. However, any documents signed by the business still need to include the legal name of the business, the owner’s name.
Also known as a “general partnership,” this form of business is created when two or more owners establish a for-profit business with no other legal form. In other words, it is the multi-owner form of a proprietorship. However, because there is a partnership, there are additional rules governing the partnership. Each state has adopted a set of partnership statutes. Many have adopted either the Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act (RUPA). Although many states have adopted these standards, they are free to adjust them however they please.
Governance and Management
The main governing document of the partnership is the Partnership Agreement. This is a contract (usually written but can be oral) between the partners where they can decide who gets what and who contributes what. It also sets up the managing structure of the company. There are four main ways a partnership may establish the management:
- The partners select a managing partner who makes all business decisions (external decisions would still be made by the partner body).
- There is a committee of partners who can make the decisions.
- Each partner has an equal say in how the business is run.
- Each partner has a vote that is equal to the percentage they contribute to the partnership.
By default, the RUPA says that each pattern has an equal say. This default rule may be revised through the partnership agreement.
A major risk of a partnership is that the personal assets of each partner can be reached to satisfy a debt. In other words, just like a proprietorship, there is no liability protection for any individual partner.
As far as taxes go, the partnership is generally taxed under Subchapter K (although the partners can opt for Subchapter C or S in the partnership agreement). Usually, this means that there is no requirement to pay federal income tax. Instead, each partner evaluates their share and their losses and attaches a Schedule E to Form 1040 within their personal taxes. The partnership is still required to file a Form 1065, but this is simply to provide the IRS with information about the business growth.
Limited Liability Partnership
The legal document to establish a Limited Liability Partnership (LLP) is a statement of qualification with the Secretary of State office. LLPs are essentially identical to partnerships with one key difference, LLPs provide more protection to partners. The partnership agreement, management structure, and taxation methods are the same for both partnerships and LLPs. Additionally, governing law is essentially the same. The main difference of governing law is that states added a provision to allow LLPs to exist.
As mentioned, the main difference between an LLP and a partnership is the liability of the partners. In a partnership, the partners liability is unlimited. In a LLP, the partners are afforded full liability protection (except in Louisiana and South Carolina where they are afforded partial protection). This simply means that the assets of partners are protected from the misconduct of other partners or judgment against the business.
Think of a limited partnership (LP) as a combination of a general partnership and a LLP. There are two different types of partners in a LP: General partners and limited partners. General partners have all the management power, but they are also personally liable for business decisions. Limited partners have no management power (or vote) but they do have liability protection.
The LP is created by filing a certificate of limited partnership with the Secretary of State. Each LP is then governed by that state’s limited patnership statutes, which often mimic the Uniform Limited Partnership Act.
However, this form may be manipulated easily. A general partner could be an entity. Thus, those who would be general partners, maintain control, but none of the liability. This is a practice usually utilized by Hedge Funds.
A corporation is created by filing articles of incorporation with the Secretary of State. The owners of a corporation are called “shareholders.” These shareholders elect a “board of directors” who then have managing authority of the business.
To establish this structure, the corporation must file a charter and bylaws. The charter outlines the company name, type of stock (preferred or common), rights of stock, and the office of a registered agent within the state of incorporation. The bylaws function similar to a partnership agreement. That is, it outlines outlines rules, meeting requirements for votes, qualifications, appointment of officers, etc.
A shareholder has limited liability. In all states, this is a full limitation. Thus, if a corporation fails, the shareholder will lose what they had personally invested into the company, but will not lose their personal assets.
Each state has passed laws governing corporations. Most states utilize the Model Business Corporation Act (MBCA). However, there are a few states that do not utilize the MBCA, that are very important to corporations. For instance, Delaware is non-MBCA, but more than half of all publicly traded companies are incorporated in Delaware. Thus, it is important to always check the statutes within the state of incorporation.
Often, you may hear of two different types of corporations C-Corps and S-Corps. This is simply referring to which Subchapter of the IRC the corporation elects to file taxes. A C-Corp files its taxes as a separate entity. This means that it is subject to federal income tax, then taxed again when it distributes money to the shareholders. An S-Corp utilizes a similar method to an LP, where it does not file federal income taxes, and then passes the profits to the shareholders to file directly on their individual tax returns.
Limited Liability Company
Also known as LLCs, Limited Liability Corporations are created by submitted articles of organization. Owners of LLCs are called members and there are two main types of management systems: member management or manager management. Member-management functions in the same was as a general partnership, where each member has a vote. Manager management operates in the same way as a corporation, where the members elect a board of managers who have the authority to make business decisions. The governing document (where this system is established) is called the operating agreement.
If the LLC has more than one member member, the IRC treats the LLC as a general partnership. That is, they are taxed under Subchapter K. If the LLC has only one member, it is taxed the same as a proprietorship. Thus, a single-member LLC owner simply has to note the income on their individual tax returns.
Other Business Forms
Although the above is the most common types of business forms (crazy to think that there were once only 3), there are several other types of business forms. They are:
- Professional Entities: professional limited liability partnerships, professional limited liability company, and professional corporations. These must be licensed professionals to have this entity form associated (law, medicine, etc.)
- Close Corporation: small corporations, but few take this route.
- Nonprofit corporations
- Benefit corporation: corporations where they not only consider the welfare of the shareholders, but also the welfare of the public.
- Benefit limited liability company
- Low-profit limited liability company: the goal is not to gain a profit, but to pursue a social benefit.
- Business trust: managed by trustees
- Joint venture: when multiple entities combine resources to explore a separate business opportunity or venture.
Internal Affairs Doctrine
This doctrine simply states that the law governing the entity will be that where the entity is incorporated. So, if the parties live in Iowa, but are incorporated in Delaware, then Delaware corporate law will govern.
Please note that this only applies for the internal affairs of the corporation. This does not apply when determining which law to use for contract, torts, or other malpractice.
Default v. Mandatory Rules
Most of the rules within the RUPA and MBCA are default. That is, they are the binding rules unless if the entity’s governing documents alter the rules. There are only a few rules that cannot be altered. For example, the only mandatory rules in the RUPA are found in § 103(b).
This also plays a role into how majority share owners and minority share owners feel about the rules. For instance, default rules generally favor majority share owners (default rules basically give majority owners most if not all the decision making power). Thus, those who strive to alter the rules are typically minority share owners.
Private v. Public Companies
The main difference between a public and private company is that public companies have their shares traded as stock on a public exchange market. This benefits the companies because it means that the stock assets can become much more liquid. Although the majority of public companies are large, there are a few large private companies.
A large consequence of a public company is that there are a lot of owners (each stock holder ultimately is an owner of a small piece of the company). Typically, private companies have few owners that own a larger share of the company.
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.