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;
- corporations; and
- limited liability companies (“LLCs”).
This article (Part 1 of 2) will focus on the first two (sole proprietorships and partnerships). Part 2 will address corporations and LLCs.
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.
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.
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.
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.