What is the Best Business Structure for My Business (Part 1)
You have the killer business idea. You have saved up your money or found the right investors. You know your industry inside and out and are confident that you will demolish the competition. But when it comes time to set up your business structure, do you know the difference between a corporation and a partnership? Or an LLC from a limited partnership?
You’ve heard the terms before – corporation, limited liability company, partnership, sole proprietorship…you know it’s some sort of business structure but that’s about the extent of your knowledge. You might know that an LLC is good for owning real estate and that an S-corporation might be good for small businesses in the service industry, but you don’t really know how or why. We won’t pretend that you’ll be an expert after one blog post, but we do hope to answer some of the questions that may have crossed your mind when it comes to the different types of business entity structures available in California along with pros and cons for each.
To give you some history, most people did business as a corporation, a sole proprietorship, or a partnership of some kind until the late 1980s. However, these traditional business forms were joined in the mid-1990s by newer forms of limited liability entities and other less common forms of business entities.
These forms of entities available in California provide varying levels of personal asset protection for the business owner, various tax advantages and disadvantages, complexity or simplicity of operation of the business, and other characteristics and choices. The best choice for you will depend on the your particular circumstances.
When you are starting your business, here are some factors you’ll want to consider when choosing your business entity:
- How easy is it to form and operate the business?
- How can I avoid personal liability for the obligations of the business?
- How can I raise operating capital?
- How will I be taxed?
- How can I set up the management and control of the business?
Keep in mind that thousands upon thousands of pages have been written about this topic – we only intend for this blog to serve as a brief introduction to a subject that is miles deep. For example, many industries will have their own regulations about business entities in addition to the state laws discussed in this post.
WHAT ARE THE COMMON BUSINESS ENTITIES AND HOW DO THEY WORK?
There are many different types of structures available for your business (for example, the real estate industry uses entities with acronyms like “REIT” or “REMIC”), but our blog series will focus on the ones that are most likely to apply to your business. Here they are:
- Sole Proprietorship
- General Partnership (GP)
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- Limited Liability Company (LLC)
- S Corporation
- C Corporation
- Professional Corporation
- B Corporation
- Close Corporation
To make things more digestible, we will focus on Sole Proprietorship, General Partnership (GP), Limited Partnership (LP), Limited Liability Partnership (LLP), Limited Liability Company (LLC) for this blog post and save our discussion on the various types of corporations available in California for another day.
WHAT IS A “SOLE PROPRIETORSHIP”
This is what happens if you go to the bank and ask to set up a business account. If it’s just you, congratulations! You are now a “sole proprietorship.” Choosing to stop here has some risk as you’ll see.
Characteristics of Sole Proprietorship:
OWNERSHIP – A sole proprietorship is owned by one individual. It not a legal entity and is the simplest form of operating a business. It operates under the name of its owner or under a fictitious name. Anyone can be a sole proprietorship.
PERSONAL LIABILITY – The owner of a sole proprietorship is personally liable for the business’s debts.
NO FILINGS OR DOCUMENTS – No required registration with any governmental agency, except maybe (1) a local or municipal government business license and (2) a fictitious business name (also called a “DBA,” for “doing business as”).
RAISING CAPITAL – No ability to raise capital by selling an interest in the business exists. You (the owner) funds business or takes out loans.
WHAT IS A “GENERAL PARTNERSHIP (GP)”
Okay, what if you went to the bank under our prior scenario and set up a bank account with a business partner? Well, then you are a general partnership! A “general partnership” (or any other type of partnership) is an entity distinct from its partners and may be formed by written, oral, or implied agreement among the partners.
Characteristics of a General Partnership:
OWNERSHIP – Generally any person or business can be a partner in a general partnership and there is no limit on the type or number of owners.
NO REQUIRED FILINGS AND DOCUMENTS – However, a general partnership may file a statement of partnership authority which may be useful for dealing with 3rd parties. A written partnership agreement is recommended.
PERSONAL LIABILITY – You are individually liable for the debts of the partnership!!
WHAT IS A “LIMITED PARTNERSHIP (LP)”
It’s not what you think – a “limited” partnership does not limit you in any way. In fact, if you are a “limited partner”, it is vastly preferable over a general partnership!
Characteristics of a Limited Partnership:
OWNERSHIP – A limited partnership is comprised of one or more “general” partners and one or more “limited” partners. The general partner or partners are responsible for managing the partnership and, like partners in a general partnership, are jointly and severally liable for all partnership debts and obligations. The key difference between a general partnership and a limited partnership is that the limited partners of an LP are usually not liable for those of the limited partnership. The minimum number of owners is two. It cannot consist of licensed professionals. There is no limit on type or number of owners.
GENERAL PARTNERS of a limited partnership CAN BE A COMPANY – The general partner or partners need not be a natural person; a corporation, for example, may serve as the general partner.
WHO ARE THE LIMITED PARTNERS? – Limited partners are typically passive investors who are not involved in management of the partnership and who, as a result, are generally not personally liable for the debts and obligations of the partnership beyond their capital contributions. This makes the LP a more attractive entity type for raising capital.
WHAT ARE THE FILING REQUIREMENTS FOR AN LP? – A certificate of Limited Partnership form must be filed with the Secretary of State.
USUALLY SECURITIES LAWS APPLY – LP interests are generally considered “securities” and securities laws apply. “Securities” are a topic for another blog post 🙂
In most other aspects, the limited partnership is similar to a general partnership.
THE LIMITED LIABILITY PARTNERSHIP (LLP): PARTNERSHIPS FOR PROFESSIONALS
An LLP is only available to accountants, architects, lawyers. Engineers and land surveyors are also eligible but only until January 1, 2026. Conversely, these professionals cannot set up a general partnership or a limited partnership – if they want to set up a partnership, it has to be a “limited liability partnership”.
In most respects, LLPs are similar to a limited partnership.
WHAT IS A “LIMITED LIABILITY COMPANY (LLC)”
And so we arrive at the golden ticket. For most, LLCs are the preferred way to go if they are eligible. They combine flexibility of management with maximum liability protection for its equity holders, who are called “members” instead of “partners.” Even the members who manage the business have liability protection, unlike the general partners of a limited partnership.
OWNERSHIP – LLCs are businesses with one or more owners (called members) who normally do not have personal liability for the debts and obligations of the LLC. They cannot consist of licensed professionals. There is no limit on the number or type of owners.
FLEXIBLE AND GOOD LIABILITY PROTECTION – LLC are more flexible than corporations and have more liability protection than GPs or LPs.
WHAT FILINGS AND DOCUMENTS ARE REQUIRED TO FORM AN LLC? – An LLC is created by filing the executed Articles of Organization form with the Secretary of State and payment of a filing fee, currently $70. Members enter into an operating agreement among themselves to establish operational and financial aspects of the LLC’s operation. An operating agreement may be written, oral, or implied , but a written agreement is recommended. The structure includes members and managers. The appropriate box must be checked on the form.
HOW DOES AN LLC RAISE CAPITAL? – An LLC is funded through its members’ capital contributions of cash and property, and through loans from its members and third parties. Members receive membership. Interests in manager-managed LLCs are generally “securities.” Different classes and priority returns are allowed for ownership interest. There are flexible profit allocations and voting rights. The operating agreement can provide for the above and can also address transfers of interests and termination of the company. For these reasons, LLCs are an attractive way to raise capital.
Income and expenses of a sole proprietorship, GP, LP, LLP, and LLC are generally reported as personal income and expenses on Schedule C of the owner’s federal and state income tax returns.
CONCLUSION: Your choice of business entity has far reaching consequences. Make sure you are educated and prepared before you set up your business!
(You’ll notice we did not discuss taxes. The way a business is taxed is often instrumental in choosing a business entity, but this topic is also best kept for another day.)
NEXT MONTH – STAY TUNED FOR PART TWO: CORPORATIONS.