While it is by no means the only important legal decision to be made when buying or starting a business, would-be entrepreneurs tend to focus on what sort of legal entity that company should be - corporation, partnership, limited liability company, etc. The basic options are fairly clear:
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If you will be the only owner, either a corporation or a limited liability company (sometimes called an LLC) are possibilities. An individual can also operate his or her business without forming either, becoming a sole proprietorship by default.
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A business with multiple owners can be a general or limited partnership, a corporation, or a limited liability company. If no conscious decision is made, a business with two or more owners will automatically be a general partnership.
There are still other more esoteric options, but these are the basic entities available. Making the proper choice among these options requires both a fundamental comprehension of the characteristics of each and an ability to understand how you want to handle and respond to the inevitable challenges ahead for the business. In today's post, I will highlight the basic characteristics of these various entities. In my next post, I will discuss some of the factors to consider when making the choice between them.
Sole Proprietorship Disadvantages. For businesses owned by a single individual, remaining a sole proprietorship has a number of drawbacks. Unless the business is very small and very new, and perhaps even then, operating a business as a sole proprietorship is generally not the best choice. The legal costs of incorporating a business or forming an LLC with a single owner are relatively small (less than $1000) and a more formal business structure can enhance a company's credibility with both vendors and customers, thus leading to growth. At the same time, incorporation or forming an LLC can also offer protection from personal liability for company debts to vendors, for accidents not covered by insurance, and from other creditors if the business ever becomes unable to pay. In addition, transferring ownership of the company, especially for anyone hoping to eventually sell out to investors, is greatly simplified with a corporation or LLC.
If you choose to remain a sole proprietorship "for now", you should still open a separate business checking account to help you keep track of business revenue and especially expenses. In addition, this will help you form good habits regarding keeping business and personal financial affairs separate that will serve you well as your business matures and does require more formal structure.
Corporations as an Option. Corporations are the most established choice for those wanting the benefits of limited liability for their business. In Ohio, corporations are governed by the provisions of Chapter 1701 of the Ohio Revised Code. Corporations are rather easy to form, although contrary to some popular belief, it does require some additional steps beyond merely filing a 2-page Articles of Incorporation with the Secretary of State. Corporations formed in Ohio have Articles of Incorporation and are governed by a Code of Regulations which is analogous to what is sometimes called Bylaws in other states.
Corporations are managed by officers such as a President and Treasurer who answer to directors who are in turn elected by shareholders, with the exception of "close corporations" in which the shareholders act as the directors. While in smaller privately held owner-operated corporations these may all be the same people, technically shareholders - unless they are in a "close corporation" which has affirmatively made such a choice - do not participate in the management of the company's day-today business and financial affairs.
Ownership in the corporation is conferred by the issuance of shares of stock evidenced by stock certificates; in Ohio, technically you have shares - not stock -- in a corporation. Everything from voting influence to the amount of dividends received is directly dependent upon the number of shares one has relative to other shareholders; if one holds 35% of the stock, one has 35% of the voting power and the right to receive 35% of whatever dividends are being distributed. (This can be made modified and become more complicated in corporations with "preferred" stock or other classes of stock.) Ownership can also be diluted if additional shares are issued to others.
By statute, corporations are generally required to observe many formalities and do considerable recordkeeping in order for shareholders to enjoy the benefits of limited liability. Directors and officers must be appointed, even if they are also already in the role of shareholder. Shareholder and director meetings must be held periodically and minutes of those meetings maintained. Ledgers reflecting share ownership allocations must be kept up to date at all times.
To dispense with the necessity of complying with some of the statutory record-keeping and other requirements, shareholders of an Ohio corporation can enter into a written Close Corporation Agreement complying with Ohio Rev. Code §1701.591 if they make an affirmative decision to do so. This agreement can also include provisions sometimes found in a Buy-Sell Agreement dealing with circumstances and conditions under which ownership can be transferred or owners wishing to sever their ties to the business can receive the benefit of their investment.
S-Corp or C-Corp. Businesses considering the corporation form must further choose between being an S-Corporation or a C-Corporation. This is primarily a taxation decision, but the choice does carry certain consequences with it. S-Corps can later convert to C-corps fairly easily, but generally C-corps cannot convert to S-corps later without tax consequences.
S-corporations are designed for smaller businesses. Under federal law, they are restricted to 100 shareholders who must be individuals (or their estate planning trust) who are either U.S. citizens or permanent resident aliens; partnerships, LLCs, or other corporations cannot be shareholders of an S-corporation. In addition, if there will be more than one class of stock or owners will otherwise have differing rights to manage or receive distributions, S-corps are off limits. Entitlement to dividends and voting rights must directly correlate to the corresponding ownership interest.
C-corporations, by contrast, tend to be larger more mature companies. Many, if not most, of America's best known companies are C-Corporations. There are no limitations in a C-corporation as to the number or type of shareholders; LLCs, S-corporations, C-corporations, partnerships, and foreign nationals or companies can all be shareholders of a C-corp. Nor are there any restrictions on the number of classes of shareholders or the types of voting and economic rights shareholders can be given. However, because profits of a C-corp are taxed twice (once as corporate income and once as dividends) and losses must remain at the corporate level rather than being utilized by shareholders, C-corps are generally not appropriate for small and medium sized privately held businesses, especially ones just starting out or ones that are sometimes referred to as "lifestyle" companies.
General and Limited Partnerships Both Largely Obsolete. Partnerships provide some level of limited liability and come in two flavors - general partnerships and limited partnerships. Because of the flexibility of the LLC structure, partnerships have largely been replaced by LLCs as a business form. Consequently, both limited and general partnerships are now obsolete choices except in some very specific and unusual circumstances such as certain estate planning situations.
In a general partnership, all partners participate in the management of the business venture and each is liable for the partnership's debts in proportion to their respective partnership interest (e.g. if three people are equal partners, they are each liable for one-third of the partnership's debt if the partnership has insufficient assets; if A has a 50% partnership interest while B and C each have a 25% partnership interest, A would have liability for 50% of the partnership debt if the partnership has insufficient assets). In a limited partnership, there is a general partner who is responsible for the day-to-day management of the partnership's business and who is likewise liable for the debts of the partnership in the assets of the partnership are insufficient. A limited partnership also has limited partners who must not participate in the management of the partnership's business and are protected from personal liability for partnership debts in return.
Limited Liability Company. The impetus for the emergence of the LLC alternative was the desire of owners to participate directly in management of a business as in a general partnership while retaining the protection from personal liability found in corporations. An LLC has members instead of shareholders and, if desired, managers instead of officers and directors. Instead of shares, members hold Membership Interests which in some cases are also called membership units.
Basically, an LLC is a cross between a partnership and a corporation, allowing owners to have the best of both. Instead of a partnership agreement or a Code of Regulations (or bylaws), LLCs have Operating Agreements. A Limited Liability Company, also known as a LLC, can be structured to include all of the informal decision-making, tax advantages and other benefits of either a General Partnership or a Limited Partnership. In addition, LLC Members do not have to forgo participation in managing the business (as they would need to do in a partnership) to enjoy the limited liability protection against company obligations to suppliers, vendors, and other creditors which is normally associated with corporations.
LLCs are a fairly new entity, first appearing in 1977 in Wyoming, but are now available in all states. Some states such as Delaware also have statutes permitting certain specialized versions. In Ohio, LLCs have only been an available option since 1994 and prior to 1997, Ohio law did not permit one member LLCs. Chapter 1705 of the Ohio Revised Code governs limited liability companies formed in Ohio and provides certain default provisions which will govern if not otherwise determined by the members of the LLC. LLCs can be structured like a limited or a general partnership, or even a corporation with respect to the management of the business. Under the IRS Check-the-Box Regulations adopted in 1997, LLCs can choose to be taxed as either (1) a partnership or sole proprietorship as applicable; or (2) a corporation.
Virtually unlimited flexibility is the hallmark of a limited liability company; essentially, virtually any business arrangement among owners can be easily accommodated. There are also fewer statutory recordkeeping requirements than are imposed on corporations. In addition, allocations and distributions of profits and losses, as well as management and voting rights, need not mirror and conform to the relative ownership interests held in the company. Typically, however, member-managed LLCs tend to duplicate the essence of a partnership, involving participation by all owners in management without giving up limited liability protection. Alternatively, a manager-managed LLC business operations may more closely resemble a limited partnership or corporation with day-to-day management being reserved for the manager(s).
Choice Narrowed to LLC or Corporation. Given the disadvantages of operating a sole proprietorship and the general obsolescence of the partnership alternative, the real choice for most business owners comes down to incorporating the business or organizing it as an LLC. Whether the corporation structure or the LLC alternative is better for a particular business depends on a number of factors. Those factors include the number and type(s) of owners and under what conditions, if any, there will be other owners. In addition, subjective complexities such as whether distinctions in the owners' respective equity and management rights are necessary or appropriate are important.
What really matters, regardless of the legal form chosen, is deciding more personal questions which will arise in every business. What will be the responsibilities of each owner with respect to the business? If a decision has to come to a vote, will each owner have one vote or will votes be by the level of ownership interest or some other formula? Will different kinds of decisions be decided by different kinds of votes, and if so, what will that be? How will profits (and losses) be allocated among owners? What happens if owners want to leave the business; how (and under what circumstances) will transfers of ownership be allowed?
For more details on all of these choices, view my PowerPoint seminar presentation The Legal Side of Getting a Business Up and Running.
For other perspectives focused on other states, see
