Most startups and small business owners have some inkling of the fact the very next step after forming an idea, is forming a business. The benefits are many, and can include more favorable taxation, greater credibility in the business sphere, and, perhaps most importantly, the all-important separation of personal assets from business liabilities and debts.
The aim of this post will be to present the three most common limited liability entity options and explain their benefits and function in as user-friendly a form as possible. Keep in mind that the black letter law of business organizations does vary by state, so this post will attempt to just lay the universal groundwork.
WHAT IS LIMITED LIABILITY?
When a private individual owes a creditor, even if the debt is not secured by collateral, the creditor has the ability to sue the debtor to collect on the debt. The court can then attach the debtor’s property in settlement of the debt, and transfer that property to the creditor. So what does that mean in the business context? Well, if you’re doing business under your own name, or as an entity that doesn’t offer limited liability protection, that means that you could be sued to collect on your business expenses. Your bank account, your car, and even your home could be at risk.
Limited liability protection can help protect you, by limiting what your business’s creditors can collect to just the assets of the business. In other words, as the business owner, you can lose what you put into the business, and any profit that the business generates, but you won’t lose the shirt on your back, or anything else that you do not explicitly transfer from personal ownership to the business. Keep in mind that limited liability means “limited” liability – members are not necessarily shielded from intentional wrongful acts, including those of their employees.
All businesses are not created equal, however. Not all business structures offer limited liability protection, and those that do all require some amount of formalities to be adhered to. The purpose of this article is to outline each type of limited liability entity, as well as lay out which ones actually offer you the protection you will need.
LIMITED LIABILITY COMPANY (LLC)
Probably the most common form of limited liability business organization for a small business is the LLC. An LLC attempts to combine the limited liability protection of a corporation, with the ease and freedom of operation of a general partnership. The owners of an LLC are known as “members” and depending on state law, the members can consist of a single individual, two or more individuals, or even other LLCs.
Advantages of an LLC include:
- Limited Liability: Members are protected from personal liability for business decisions or actions of the LLC.
- Less Recordkeeping: An LLC’s operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork, start-up costs are lower, and there are generally no mandatory record keeping requirements.
- Operational Control: Unlike with a corporation, very few of the rules regulating the operation of an LLC are up to state statute, with greater freedom given to the founding members, and the rules that are laid down in the Articles of Organization, and Operating Agreement. With no shareholders to be responsible to, the members are free to run the LLC more or less as they see fit. Of special importance is the fact that there are fewer restrictions on profit sharing within an LLC, so members distribute profits however the agree. Members might contribute different proportions of capital and sweat equity. Consequently, it’s up to the members themselves to decide who has earned what percentage of the profits or losses.
- Pass Through Taxation: An LLC is not taxed as a separate business entity in the way that a C-Corporation would be. Instead, members are taxed on their share of LLC income as personal income. This means that personal profits from an LLC are not “double taxed.”
In short, an LLC is a good choice of business organization form for a small business that the owners wish to be able to structure exert full control over.
Technically, speaking, an S-Corporation is just a privately held corporation whose shareholders have all signed Form 2553 with the IRS to alter the way the corporation is taxed under Subchapter S of the Internal Revenue Code. This allows for Pass Through Taxation, which means that the shareholders are taxed on profits and losses individually, without the entity being taxed individually.
As a Corporation, S-Corporations come with an increased level of necessary formality, such as scheduled director and shareholder meetings, minutes from those meetings, and proper maintenance of records of adoption and updates to by-laws, and stock transfers.
Advantages of an S-Corporation include:
- Limited Liability Protection: Shareholders are protected from personal liability for business decisions or actions of the S-Corporation.
- Tax Savings: Whereas the members of an LLC pay employment tax on the entire net income of the LLC, only the wages of S corp shareholders that are also employees are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all. However, any shareholder that does work for the corporation must be paid reasonable compensation, otherwise their distributions may be reclassified by the IRS as wages.
- Business Expense Tax Credits: Some expenses that shareholder/employees incur can be written off as business expenses. However, for employees that own 2% or more of the total shares, benefits are deemed taxable income.
- Independent Life:. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.
- Pass Through Taxation: An S-Corporation is is not taxed as a separate business entity in the way that a C-Corporation would be. Instead, shareholders are taxed on their share of corporate income as personal income. This means that personal profits from an S-Corporation are not “double taxed.”
In short, an S-Corporation is a good choice for a larger, and more established business that is ready and able to comply with all necessary corporate formalities, but wants to retain the advantages of pass-through taxation.
A limited partnership is a special kind of partnership composed of two types of partners; namely, General Partners and Limited Partners.
General Partners are responsible for managing the business, and are jointly and severally liable for the liabilities of the business. This means that General Partners do not have limited liability protection and each General Partner could potentially be liable for the debts of the business with their personal assets.
Limited Partners, also known as “Silent Partners” do have limited liability protection, however they may not participate in the management or day to day business operations of the Limited Partnership. They are essentially investors, similar in some ways to the shareholders in a corporation, in that they are part-owners of the business entity, but they do not have any management power.
Advantages of a Limited Partnership include:
- Limited Liability Protection: The Limited Partnership structure offers liability protection up to the amount of the investment for the company’s Limited Partners.
- Full oversight: The General Partners have complete management control of the Limited Partnership. This can make the Limited Partnership very nimble, and able to quickly change business strategy, without the need for voting, or other formalities.
- Investment potential: Limited partnerships can generate capital injections without altering the management structure by adding more limited partners. As the limited partners do not participate in management, a successful Limited Partnership can be an enticing investment opportunity for certain wealthy individuals or financial funds that do not have the time or inclination to actively manage the operation of their investments.
- Pass Through Taxation: A Limited Partnership is not taxed as a separate business entity in the way that a C-Corporation would be. Instead, members are taxed on their share of Limited Partnership income as personal income. This means that personal profits from a Limited Partnership are not “double taxed.”
In short, a Limited Partnership is a good choice of business organization for a business that would want to retain autonomy as it attracts investment. In order to attract such investment however, the business would need to be sufficiently profitable. Limited Partnerships are a common form of business organization for professional services firms such as accounting, law, and consulting firms.