Article written based on California Law
As small business owners are well aware, we live in a time where anyone who feels that they have been wronged files a lawsuit. Now, more than ever, it is important that small businesses examine their options to determine the correct type of business entity in which to operate. Choosing the right type of business type can save your home and other personal assets being at risk if you are named in a business-related lawsuit.
Most individual owners of small businesses operate what is called a sole proprietorship. For example: George, a printer, opens George’s Print Shop. This is the cheapest way to operate with no special state filing requirements to start the business. The major problem with operating as a sole proprietorship is, of course, the personal vulnerability of the owner’s assets.
Running as a sole proprietorship means that George, the owner, is personally liable for any and all debts and claims made against George’s Print Shop. Personal liability is something to be steadfastly avoided if possible. It is better to do avoid the potential for personal liability before any lawsuits have been filed against a business.
A partnership is where two or more people operate a business in concert with a common goal, e.g. George and Fred, open George and Fred’s Print Shop. The partnership differs from the sole proprietorship in that there is more than one person that owns and is responsible for the business.
There are tax advantages to using a partnership in that income and losses of the partnership are generally passed through to the partners’ tax returns directly. However, a partnership carries the same potential for personal liability of each partner as a sole proprietorship, i.e., personal assets are at risk.
An additional potential problem is that each partner can bind the partnership and other partner(s) to contracts. Thus, a partnership carries the risk that your partner can put your personal assets at risk. If the print shop fails, both George and Fred’s personal assets are at risk for creditors to use to satisfy debts owed by George and Fred’s Print Shop. It is very important before entering into a partnership that you know AND trust your partner(s).
Another type of partnership is called a “limited partnership”. A limited partnership has at least one “general partner” with full personal liability for all partnership debts. However, the limited partnership also has “limited partners” who have liability and participation in the business limited to their investment in the partnership.
A Corporation is a separate entity such as George and Fred’s Print Shop, Inc. Use of a corporation limits the liability of all of the owners (stockholders) of the corporation. Provided the corporation is set up correctly and initially has adequate capitalization and maintains the separateness of the corporate entity there is no personal liability for the stockholders.
Formation of a corporation is not nearly as simple as with a partnership. There are specific filings that must be made with the State and certain corporate formalities that must be maintained in order to preserve the corporate status and limited liability. Additionally, a corporation is more expensive since yearly fees and taxes must be paid.
The major advantage to the corporate entity is, of course, its limited liability. With a limited partnership, only the general partner would still be liable for the damages to the injured party. In a corporation, generally only the corporation is liable, not the officers, directors or shareholders.
Limited Liability Company (LLC)
An LLC is a hybrid type of entity that has characteristics of both partnerships and corporations. An LLC has the “pass through” income and loss treatment of partnerships. However, an LLC also has liability limitations of corporations. An LLC can have fewer formal requirements such as regular meetings. However, the LLC, like the corporation has to pay yearly fees and taxes to the State making it more expensive than a partnership or sole proprietorship.
The LLC and small closely held corporations are typically two entities that have similar characteristics that should seriously be considered by the small business owner. Knowing what type of entity to choose to do business under is a very important decision for the small business owner. Most small businesses should consult with an attorney before making the decision on how to operate. However, speaking with an attorney to discuss the available options is very important.