OVERVIEW
One of the most important decisions an entrepreneur will make is deciding how to structure the business. Should the company be operated as a sole-proprietorship or partnership? Or should the owner form a legal entity, such as a limited liability company or corporation? It’s not a decision that should be taken lightly.
Selecting the right business form for a new venture requires not only an understanding of the strengths and weaknesses inherent in each of the different business structures available, but also an understanding of complicated issues related to the expected financial growth and operational control of the new company. For example, do the owners intend upon exercising direct control over the day-to-day affairs of the business, or are there passive owners who have other jobs and won’t be involved in growing the new company? Does the new business anticipate having a lot of employees to whom various benefits will be offered? Does the new company intend upon seeking venture capital to help finance its creation and growth? Do the owners want to protect their personal assets from losses or liabilities associated with the new business? The answers to those questions, as well as several other important ones, are important considerations when choosing the proper business form.
Most companies in California fit into one of these four organizational business structures:
- sole proprietorships;
- partnerships;
- corporations; and
- limited liability companies (“LLCs”).
SOLE PROPRIETORSHIPS
The most basic organizational structure for a business is the sole proprietorship. A sole proprietorship has no legal existence apart from its owner (i.e., it’s not considered a separate entity) and it’s primarily characterized by the following traits:
- it consists of one owner (also referred to as a “proprietor”);
- the owner maintains absolute control over all aspects of the business;
- the business involves very little in terms of “corporate” regulation;
- the owner personally owns all of the company’s profits and assets;
- the owner is personally responsible for all of the company’s debts, obligations, and liabilities; and
- the business automatically terminates upon the death of the owner.
PARTNERSHIPS
At their simplest level, partnerships are similar to sole proprietorships, except that they involve at least two owners rather than just one. While typically more complicated than sole-proprietorships, they are generally less complex than corporations or LLCs. And although there are a few distinct specialized categories of partnerships, this article only addresses the two most common types of partnerships: the general partnership and the limited partnership.
General Partnerships
A general partnership is created by an oral or written agreement amongst two or more owners and is typically characterized by the following traits:
- all of the partners personally share control over all aspects of the business, subject to limitations imposed by an agreement;
- all of the partners personally share, in some agreed upon proportion, in the profits of the business;
- all of the partners personally share, in some agreed upon proportion, in the losses, debts, and liabilities of the company;
- all of the partners have fiduciary duties to each other;
- does not require filing with the Secretary of State, but may do so; and
- it automatically terminates upon the death of a partner unless an agreement amongst the partners states that upon such an occurrence, the partnership will continue.
Limited Partnerships
A limited partnership is a bit more complicated than a general partnership. It too is governed by an oral or written agreement amongst the partners. But it’s the differences that are key. First, limited partnerships are statutory creations, and thus can only be formed by filing a Certificate of Limited Partnership with the Secretary of State. Second, limited partnerships are characterized by two distinct classes of partner: the general partner(s) and the limited partner(s).
The general partners of a limited partnership share the same characteristics as the partners in a general partnership described above (e.g., control the day-to-day operations of the business, have personal liability for the debts and obligations of the limited partnership, etc.).
In contrast, the limited partners of a limited partnership are typically passive investors who contributed cash or some other asset(s) to the partnership. Limited partners have no personal liability for the debts or obligations of the limited partnership—i.e., their maximum liability is the value of their investment in the company—and exercise no control over the day-to-day operations of the business. And, in contrast to the general partners, the death of a limited partner has no effect on the limited partnership, as the interests of the limited partners can be transferred or bequeathed to a limited partner’s heirs.
CORPORATIONS
Corporations are perhaps the most well known and widely used type of business form. This makes sense because a corporation, as a business structure, has been around for a very long time. While there are different types of corporations (e.g., professional, public, non-profit, statutory close corporations, etc.), this article is aimed only at offering a broad overview regarding what a corporation actually is, and therefore this article will only discuss the two most common “types” of corporations: C corporations and S corporations.
For the most part, corporations are:
- formed by filing certain documents with the Secretary of State (e.g., Articles of Incorporation);
- perpetual in duration (don’t automatically terminate upon the death of a shareholder);
- governed by state law (including requiring compliance with certain corporate formalities relating to filing annual statements of information with the Secretary of State, holding director elections, keeping minutes of shareholder/director meetings, etc.);
- owned by shareholders;
- managed by a board of directors (who are elected by the shareholders);
- operated on a day-to-day basis by officers (e.g., President, CFO, Secretary, etc.) selected by the directors;
- governed by a shareholder/buy-sell agreement; and
- offer limited liability to the shareholders (i.e., shareholders’ assets are shielded from creditors of the corporation).
A lot of people are confused about the difference between directors and officers because in the vast majority of corporations, they are the same people. For example, in a corporation with, say, between one and five shareholders, most, if not all, of the shareholders will not only serve on the company’s board of directors, but it is very likely that each of them will serve as the company’s President, CFO, Secretary, or in some other official capacity. It’s important to not get confused between a director and an officer. Officers run the day-to-day operations of the company, but they serve at the pleasure of the board of directors; they are not elected by the shareholders.
A lot of people are also confused regarding the difference between a “regular” (i.e., C) corporation and an S corporation. While the differences are vast, and can get quite complicated, for purposes of this article, all you need to know is that an S corporation is a tax designation offered under the federal tax code. An S corporation is, broadly speaking, a blend of the regular corporation and the more relaxed LLC (discussed below). S corporations must meet certain criteria (e.g., limitation on number of shareholders, residency requirements, etc.), and unlike C corporations, which are taxed as entities (with the corporation itself paying taxes on revenues, and the shareholders then paying taxes on distributions they receive), shareholders of S corporations are taxed like partnerships or members of LLCs—i.e., net revenues of the company are “passed through” as income to the members in proportion to the shares held regardless of whether or not the shareholders actually receive any distributions. [When to choose a C corporation or S corporation, or the specific tax and non-tax related requirements/options, are topics for another article.]
What matters most is that corporations are governed by directors, managed by officers, and provide the owners (the shareholders) with limited liability from the debts/obligations of the corporation.
LLCs
Compared to corporations, LLCs are relatively new (as business organizations go), having been created just a few decades ago. Simply put, LLCs blend the simplicity and flexibility of the partnership with the limited liability of the corporation.
LLCs in California are governed by the California Revised Uniform Limited Liability Company Act, and are typically:
- formed by filing certain documents with the Secretary of State (e.g., Articles of Organization);
- governed by state law, including imposing certain default provisions, many of which can only be overridden by a written operating agreement between the members;
- owned by the members;
- managed by the members (although some LLCs are designated manager-managed, meaning that either only some of the members manage the day-to-day operations of the business, or that the members select non-member, professional managers to do so);
- operated on a day-to-day basis by the members (but not always, such as if the LLC is designated as a manager-managed LLC);
- governed by an operating agreement; and
- offer limited liability to the members (i.e., members’ assets are shielded from creditors of the LLC).
LLCs require fewer corporate formalities than do corporations (e.g., no elections required, no annual meetings required, no minutes required, and statements of information only due every two years rather than annually), and are considered more flexible. Again, as with corporations, there are distinct tax advantages and disadvantages that are beyond the scope of this article.
What matters most is that LLCs are simple, flexible, typically managed by the members themselves, and provide the members with limited liability from the debts/obligations of the LLC.