Choice of Business Entity (Part 2)
In Part 1, we explored doing business as a sole proprietor or in a partnership. A problem with those types of business entities was that they did not shield the sole proprietor or the general partner from the claims of creditors of the business. This installment will briefly discuss the operation of a business through a corporation or a limited liability company, two forms which, if established and operated correctly, can provide the owners with limited liability.
In a corporation, the owners (“shareholders”) generally have limited liability for the corporation’s conduct of the business. This liability is “limited” to the shareholder’s investment in the corporation. This is applicable, even if there is only one shareholder. While generally the liability is limited, the corporation must observe all the corporate formalities, such as having regular meetings of its directors and shareholders, documenting all action taken (leasing property, setting up a bank account, paying compensation and dividends to the shareholders), and owning or leasing its own property, and treat the business as a separate entity. If they fail to do so, creditors may be able to “pierce the corporate veil” and assert the liability of the corporation against the shareholders.
In a limited liability company (”LLC”) as in a corporation, the owners (“members”) generally have limited liability for the LLC’s conduct of the business. Unlike a corporation, an LLC does not have to observe formalities, such as conducting meetings and documenting the actions of the LLC. However, the members must treat the LLC as a separate entity with its own assets, including bank accounts, and liabilities.
Note that other issues may arise when selecting your choice of entity. A corporation may be either a “C-corporation” or an “S-corporation.” An LLC can be ignored for income tax purposes if there is only one member; if there is more than one member, it may be treated as a partnership. If the member(s) otherwise elect, an LLC could be treated as a corporation (C-corporation, or S-corporation). No matter what the income tax election or consequences, the income tax treatment has no effect on liability issues.
This article and Part 1 have each addressed, in general terms, the types of business entities available to the business owner. No decision should be made without considering all of the issues. Please feel free to contact us with any questions you have regarding this or any other legal issues confronting your business.
If you are starting a business or have any questions regarding the legal alternatives available to your business, please contact:
312-368-0100 or msaunders@lgattorneys.com.
Choice of Business Entity (Part 1)
Congratulations, you have decided to start a new business. You are going to become an “entrepreneur”, a business owner. You have put together your business plan, located potential business premises, talked with your advisors, and are ready to get started.
You have talked with an attorney and an accountant and they have advised you to form a “business entity”. Now you have to decide which one is right for you. So, what are your choices? Following are just a few options:
Sole Proprietorship. You could own and operate the business and not form a separate entity. This is generally the “simplest” legal way of owning and operating a business. Other than obtaining the required business licenses, all you need to do is to put an “open for business” sign up and you are ready to go. The business is owned by only one individual and “dies” when the owner either stops doing business or dies. The individual owner has unlimited liability for all obligations of the business.
Partnership. If you have decided to go into business with other owners, you could form a partnership. There are two kinds of partnerships: general partnerships and limited partnerships.
In a general partnership, you and your partners will have unlimited liability for acts and obligations of the business, including those incurred by any of the partners in the business. If you have no agreement, the partnership will be governed solely by the laws regarding partnerships in your state. Without an agreement, if one partner dies or withdraws, the partnership terminates.
In a limited partnership, there must be at least one general partner who manages the affairs of the partnership and who will be liable for all the acts and obligations of the partnership. The “limited partners” may not participate in the management of the partnership and are treated as investors. They will not generally be liable for the acts and obligations of the partnership. The partnership must file a Certificate of Limited Partnership in the state in which it wishes to organize.
In proprietorships and general partnerships, there can be serious legal consequences to the individual(s) who operate the business. As pointed out, a sole proprietor, while “King” of the business, has unlimited liability for the obligations of the business. General partners are entitled to their share of the business income, but also have unlimited liability. Limited partners may not participate in management, but have limited liability.
So, what can a business owner do to limit his or her liability?
[To be continued, in Part 2, where we will discuss Corporations and LLCs, two of the more preferred ways of operating a business in order to minimize personal liability].
If you are starting a business and have any questions, please contact:
312-368-0100 or msaunders@lgattorneys.com.