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BUSINESS ENTITY TYPES: A Basic Discussion

March 29, 2021

One of the first decisions an entrepreneur must make before getting into business is what type of business entity they want to create.  There are four business entities, and each has its advantages and disadvantages.  The largest consideration for most business owners is to limit personal liability.  While each entrepreneur and business idea are unique and worthy of a more detailed discussion here is a short discussion of the four types of business entities.

Sole proprietorship:  A sole proprietorship is the default business entity if you choose not to file, elect, or register another entity with the state where you are operating.  As a sole proprietor you typically would not be required to file any state filing fees (normally required at formation and annually thereafter).  Revenues typically flow directly into your personal bank account.  However, as a sole proprietor, you remain personally liable for any harm done, whether by accident or not, as a result of operating your sole proprietor business.  Because sole proprietors are personally liable for their actions, this is generally not a recommended business structure.  There are rarely any instances where being a sole proprietorship is worth risking your personal assets (home, car, investments, etc).

Corporations:  Corporations are entities owned by one or more shareholders.  The shareholders can, and often are, also employee or officers of the corporation – especially for smaller entrepreneurial companies.  Each shareholder will own equity (shares) in the corporation and be entitled to certain financial benefits, such as distributions (sharing in the profits).  Further, depending on the by-laws for the corporation, shareholders will have rights and privileges in how the company is operated.  The greatest benefit to shareholders is that so long as the corporation follows certain procedural requirements the shareholders are not personally liable for the actions of the corporation. Liability is therefore limited to the assets (bank accounts, property, etc) of the corporation.  Corporations are governed by the filed Articles of Incorporation and the approved By-Laws which each shareholder is bound by. One additional consideration for corporations is taxation.  The Internal Revenue Service (IRS) has classified two types of corporations for taxation purposes: C corporations and S corporations. Regardless of the election (C or S), each corporation must file its own tax documents each year (or quarter). However, C corporations will pay their own taxes, while S corporation tax liability “passes through” to the shareholders.  You should note, S corporations and C corporations are not different business entities; they are tax elections for IRS purposes only. 

Professional Services Corporations are a variant of Corporations and are used for professional licensed services such as doctors, dentists, lawyers, accountants, and architects.  Professional Service Corporation ownership is usually always limited to those individuals who are licensed by the state to perform that service. For example, only lawyers can be shareholders in a law firm which is created as a professional corporation.

Limited Liability Company: Limited liability companies are similar to corporations in that they limit liability to the assets of the company. Owners are called “Members” and ownership is held through “units” instead of shares like with a corporation.  Limited liability companies are governed by the filed Articles of Organization and the approved Operating Agreement. While there are formalities to a limited liability company which must be followed, the formalities are a little less burdensome and the members can opt to run the company in a manner as simple as they like (more like a sole proprietor) or as complex as they like (like a large corporation). The degree of complexity and procedures required to be followed are determined in the Operating Agreement.  

One other unique facet of a limited liability company are the two varying management styles: member-managed or manager-managed. A member-managed limited liability company is fully operated and managed by the owners, which may be an easy way to do business with a small group of owners (generally 1-3).  A manager-managed limited liability company appoints 1 or more individuals to operate and manage the daily business affairs of the company.  This makes daily decision making easier and faster when the number of owners grows.  Manager-managed companies also make it easier for continued investment from other individuals.  In both instances, Members retain certain controls to ensure their investment is protected and the manager(s) run the company in the desired fashion.

Much like corporations, some states allow for professional service limited liability companies  (“PLLCs”. PLLCs also limit ownership to those individuals professionally licensed for that particular service.  In all other aspects, PLLCs operate just like regular limited liability companies.

The IRS does not recognize limited liability companies as a taxable entity, so the Members will have to elect for the company to be taxed as a sole proprietor, partnership, or corporation (C or S).

Partnerships: Partnerships are entities formed by two or more individuals where each individual is a “partner” and an owner.  Partners can be personally liable for the affairs of the business and therefore should have a great deal of trust with each other and their competencies. 

Partnerships can be either general partnerships or limited partnerships. In a general  partnership all members are “general partners” and are liable for the acts of the partnership. A

limited partnership consists of both “limited partners” and general partners.  In a limited partnership, limited partners are only liable to the extent of their investment in the partnership, but the general partner(s) remain fully liable for operations of the partnership.  General partners remain involved in the day-to-day management of the partnership while limited partners are generally limited in involvement to capital contributions and rights to share in profits. It is this lack of involvement which supports the limitation of liability of limited partners.

Partnerships are required to file their own tax documents, but the profits are “passed through” to the individual partners based on their respective ownership.  

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