The Formation and Management of Business Entities

The Formation and Management of Business Entities

There is a variety of common business organization types. However, most businesses are well served by choosing a variation of one of the four major organizational forms: (1) the sole proprietorship, (2) the partnership, (3) the limited liability company, and (4) the corporation. Each has its own specific advantages and disadvantages. A core focus on the personal liability ramifications and tax implications of each type of entity should guide a new business owner in his or her selection. Contact an attorney with David, Brody & Dondershine, LLP in Reston, Virginia, for help with choosing and managing you business entity.

The Sole Proprietorship

The basic sole proprietorship is a business with one owner that is not registered with a state as a limited liability company (LLC), partnership, or corporation. Business decisions are managed by the owner. Its establishment is cheap and comparatively uncomplicated. However, the business owner and his or her assets have no protection from personal liability. Any action by the sole proprietor or an employee may create personal liability against the owner for business debts or legal judgments. The profits or losses from the business are reported on the owner's personal tax return.

Advantages and Disadvantages

• Advantage: Simple to form and run.
• Advantage: No double taxation on profits.
• Disadvantage: Only one owner responsible for all business decisions.
• Disadvantage: The owner is responsible for all business losses.

The Partnership

There are two common types of partnerships.

A general partnership is an association of two or more persons who carry on as co-owners of a business for profit. In a general partnership, each partner participates in the day-to-day management of the business and each general partner is personally liable for the entire amount of any business-related obligation. Each general partner is also usually legally bound by any valid business agreement or transaction made by any other partner. General partners report profits and losses on their personal income tax returns.

In a limited partnership there is at least one general partner who manages the business operations and at least one limited partner who may contribute capital, but does not have substantial management control. The general partner is personally liable for the business's debts and liabilities. A limited partner has limited liability, meaning that the limited partner can only be liable to the extent of his or her capital contribution. To form a limited partnership, most states require the filing of a certificate with the secretary of state. Limited partnership agreements can be very complex.

Advantages and Disadvantages

• Advantage: Few legal formalities and very flexible.
• Advantage: Limited partner may be lucrative capital investor.
• Disadvantage: General partners have unlimited personal liability for business losses and are legally responsible for the business actions of each partner.
• Disadvantage: Limited partners must take care not to exert control over the business that could open them up to general partner liability.

The Limited Liability Company

An LLC combines elements of partnerships and corporations. To create an LLC, there is most often a filing of articles with a branch of state government charged with LLC oversight. In general, this filing will be with the secretary of state's office. Most states allow the formation of an LLC with only one person. In addition to the articles, there should also be a written LLC operating agreement that sets out the LLC members' rights and responsibilities. While filing of this agreement may not be required, it should be completed to ease management of the LLC.

Similar to limited partners, the owners, called members, of the LLC only risk loosing money that has been invested in the LLC. Only LLC assets are used to pay the LLC's debts. Therefore, with certain exceptions, the members of the LLC are protected from personal liability. As in a partnership, LLC owners report profits and losses on their personal income tax returns. Therefore, the LLC is not a separate taxable entity.

Advantages and Disadvantages:

• Advantage: Owners only risk loosing money invested in the LLC.
• Advantage: Flexibility in rules of management.
• Disadvantage: Can be complex to set up and manage.
• Disadvantage: LLC is not a separate legal entity for tax purposes.

The Corporation

A corporation is a legal and tax entity that is separate from the people who own, control, and manage it. A corporation is a legal person. Effectively, this means that the corporation can enter into contracts, take on debt, and pay taxes apart from its owners. Therefore, with some exceptions, the owners of the corporation are personally protected from the corporation's liabilities and creditors. Generally, an owner only stands to lose what he or she invested in the corporation.

Each state has its own procedure for establishing a new corporation, but most states require the filing of articles of incorporation with the secretary of state. Other matters at start-up usually include drafting corporate bylaws, holding the initial meeting of the board of directors, and issuing ownership stock.

Advantages and Disadvantages:

• Advantage: Owners have limited liability.
• Advantage: Corporation is a separate taxable entity.
• Disadvantage: Costly and complicated to set up.
• Disadvantage: Complex management responsibilities.

Conclusion

Choosing the correct business form is an important step in the set-up of a new business. Contact an attorney with David, Brody & Dondershine, LLP in Reston, Virginia, for help with choosing and managing the form of your business.

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