One of the most important steps in the early business formation process is deciding the best legal form for a business to take. The legal structure chosen for a company influences many aspects of how it is run (e.g., how taxes are assessed, how taxes are paid, how decisions for the company are made, who is liable for the business’s debts, available exit strategies, etc.). Individuals looking to form a business have their choice of several different legal entity structures. The most popular structures include partnerships, limited liability companies (LLCs), and corporations, each of which has its own rules, obligations, advantages, and disadvantages. The choice of business entity should be tailored to the nature of the business that the founders intend to establish, the stage of the company, and its projected growth.
Business Formation: Partnerships
The simplest legal structure for a new company is to form a partnership. A partnership joins together two principal owners. Partnerships sometimes include formal, written agreements. However, partnerships do not require any written agreement or filing fees to be established. Unlike corporations, partnerships are not subject to corporate income tax.
The main drawback of a partnership is that partners are not protected from personal liability for the partnership’s debts. Another potential downside is that the lack of structure and accountability can cause problems once the partnership is up and running. Partnerships are considered “pass-through” tax entities, which means the members of the partnership must report business profits and losses on their personal tax returns. Partners must pay tax on their entire share of the business’s income, including their retained earnings and benefits. Partnerships also may become problematic when partners disagree on key business issues (e.g., financial goals, leadership styles, work ethic, etc.). Once a business is established as a partnership, the partners may find the lack of structure causes problems in the event of partnership disputes, because no formal process for decision making or dispute resolution has been established upfront. Many of these issues may be addressed with a well-drafted partnership agreement.
Business Formation: LLCs
LLCs are business structures that combine the liability protections of corporations with the pass-through taxation of a partnership. LLCs are more complex to set up than partnerships and have additional costs associated with their formation. Nevertheless, they may be more appealing to small business owners because the LLC protects owners from personal liability for debts and judgments against the business.
Like partnerships, LLCs are pass-through entities in which owners must pay taxes on their share of business income on personal tax returns. The LLC structure makes sense for companies that are at particular risk of being sued by customers, or that are at risk of accruing a great deal of debt. There are also circumstances in which individuals with substantial personal assets may form an LLC to protect themselves against business creditors.
The structure of an LLC provides for some flexibility in how the business is managed. Unlike partnerships, which may be formed without any decision-making process in place, LLCs must be created with some rules and procedures in place. In contrast to corporations, which must include standard business formalities (e.g., board meetings, record keeping, and other procedures), the management of an LLC is up to the members to decide.
Business Formation: Corporations
Corporations share some characteristics with LLCs in that the corporation owners’ liability is limited for business debts and judgments against the business. The main difference between a corporation and other entities is that it is considered an independent entity from the individuals who own it. The corporation is treated as separate when it comes to both legal and tax issues, and the owners of a corporation do not report corporate earnings on their personal tax returns. Instead, the corporation is subject to its own tax. The owners of a corporation (its shareholders) only pay income tax on the money they take out of the corporation (e.g., salaries, bonuses, dividends, etc.). Certain smaller businesses may incorporate but enjoy the pass-through tax liability of LLCs and partnerships if they meet certain requirements.
Like the LLC, the corporation structure appeals to companies that are likely to be sued or are likely to accrue a great deal of business debts. It is an ideal entity for investors because of the lack of unexpected tax or legal liability, and because ownership of the corporation can be transferred easily. However, corporations are complicated to form and maintain, include a host of associated fees and taxes, and must include regular corporate functions (e.g., board meetings, record-keeping, audits, etc.).
Business Formation: How We Can Help
The business formation attorneys at Payne & Fears have the experience and knowledge to choose and create the business entity best suited to the operations and projected growth of a company. Our business attorneys can help entrepreneurs evaluate and select the best structure for their business based on several factors (e.g., taxation implications, the stage of development of the company and future growth plans, operational control options, and personal liability concerns). We have decades of experience helping clients sort through the pros and cons of different business structures and guiding them through the business formation process from beginning to end.
For more information on our business formation work, please contact Richard K. Zepfel.