The structure of the business or business type is one of the most important decisions to be made in starting a new venture. There are varying factors that all have legal and financial implications. Those factors can include:
- Legal restrictions
- Liabilities assumed by members
- Type of business operation
- Earnings distribution
- Capital needs
- Number of employees
- Tax advantages or disadvantages
- Length of business operation
Types of entities span from sole proprietorships to corporations, with many variations in between. The main types of entities include sole proprietorship, partnerships and corporations. However, there are many variations of each.
Sole Proprietorship is the easiest and least costly formation and business type. With this said, all benefits and liabilities are borne by the owner. There is no corporate protection, which can prove to be detrimental, depending on the type of business activities and possibilities for disasters.
In Partnerships, there are multiple owners that share in the profits of the business. However, partners of this type of entity are personally liable for the other partner's business actions, as well as their own, which can outweigh any benefit of the costly formation, depending on the nature of the business. Where there is such a relationship between two or more people, a partnership agreement is a MUST. It is not required to form a partnership (it can be oral or even through just performing work with each other for a common profit) but it helps solve disputes fairly and under the original intentions of each partner.
A good partnership agreement should include the type of business, equity of each partner, division of profits, losses and liabilities, duration, provisions for dissolution, dispute resolution clause, and other regulatory language for the events of death, break up or voting ties.
For Corporations, no operating agreement is required, but it is highly recommended for similar reasons stated above. There are “C” corporations, which are comprised of shareholders, directors and officers. This is the more complex of business types. These entities are subject to more government regulation and are held to higher compliance rules. Further, this type of entity is subject to double taxation. There are higher corporate protections from liabilities, but not all lawsuits. There are also “S” corporations which have single taxation, but certain requirements and qualifications must be met and appropriately filed with the state and IRS.
The most popular type of formal entity is an LLC. Limited Liability Companies combines select corporate a partnership characteristics, while still maintaining status as a legal entity distinct from its owners. There is limited liability to the owners. They risk their investment into the LLC, but are not held personally liable without proof of actual fraud or other veil piercing willful acts.
As you can see, there are a lot of decisions and agreements to made before starting a business. Many people make the mistake of ignoring the possibility of disaster in the planning stages and therefore find themselves unequipped to handle business breakups or hard times. For these reasons, we suggest that no matter the type of entity you start, you seek legal counsel as the the ramifications of entity type and agreements.