Which Business Structure is Right for You?

The following is a true story with the names changed to protect the innocent.

I was once introduced to a prospective client who owned an environmental services company; he cleaned out tank cars. Serious work. When I asked him what kind of entity his company was, he said, “a DBA.” After picking my jaw up off the floor, I realized he was serious. Because he was not operating through an entity, the owner could be sued for (and be personally liable) for any claim against his company. He was undertaking an extremely dangerous business venture while placing all of his personal assets at risk. The fact that the business owner didn’t understand the enormity of his exposure was depressing. Following is an overview of the most common business structures.

Which entity is best for your business depends on many factors, and the decision can have a significant impact on both profitability and asset protection afforded to its owners.

Sole Proprietorship

A sole proprietorship is the simplest and least regulated of all business structures. For legal and tax purposes, the sole proprietorship’s owner and the business are one and the same. The liabilities of the business are personal to the owner, and the business terminates when the owner dies. On the other hand, all of the profits are also personal to the owner, and the sole owner has full control of the business.

General Partnership

A general partnership consists of two or more persons who agree to share profits and losses. It is simple to establish and maintain; no formal, written document is required in order to create a partnership. If no formal agreement is signed, the partnership will be subject to state laws governing partnerships. However, to clarify the rights and responsibilities of each partner, and to be certain of the tax status of the partnership, it is important to have a written partnership agreement.

Each partner’s personal assets are at risk. Any partner may obligate the partnership, and each individual partner is liable for all of the debts of the partnership. General partners also face potential personal legal liability for the negligence of another partner.

Limited Partnership

A limited partnership is similar to a general partnership but has two types of partners: general partners and limited partners. General partners have broad powers to obligate the partnership (as in a general partnership) and are personally liable for the debts of the partnership. If there is more than one general partner, each of them is liable for the acts of the remaining general partners. Limited partners, however, are “limited” to their contribution of capital to the business and must not become actively involved in running the company. As with a general partnership, limited partnerships are flow-through tax entities.

Limited Liability Company (LLC)

A Limited Liability Company (LLC) is a hybrid type of business structure. An LLC consists of one or more owners (“members”) who actively manage the company’s business affairs. An LLC contains elements of both a traditional partnership and a corporation, offering the liability protection of a corporation, with the tax structure of a sole proprietorship (if it has only one member) or a partnership (if the LLC has two or more members). It is important to note that in certain states, single-member LLCs are not afforded limited liability protection.

Series LLC

A Series LLC is the newest form of entity in Texas, created by statute in 2009. It effectively acts like a holding company with sub-companies by providing for different “series” within one LLC. The series in the LLC can be different classes of members or assets. Each series provides liability protection for each distinct series, so that the overall assets of all the series are protected from liabilities of the other series.

The Series LLC is growing in popularity for real estate investment because it allows individual properties or buildings to be segregated within one entity. Traditionally, to gain the same structure, an investor would have had to form multiple entities.

Corporation

Corporations are more complex than either a sole proprietorship or partnership and are subject to more state regulations regarding their formation and operation. There are two basic types of corporations: C-corporations and S-corporations. There are significant differences in the tax treatment of these two types of corporations; however, they are both generally organized and operated in a similar manner.

Technical formalities must be strictly observed in order to reap the benefits of corporate existence. For this reason, there is an additional burden of detailed recordkeeping. Corporate decisions must be documented in writing. Corporate meetings, both at the shareholder and director levels, must be formally documented.

Corporations limit the owners’ personal liability for company debts. Depending on your situation, there may be significant tax advantages to incorporating.

If you or your company would like a free consultation on these or any issues, contact me at mmurrah @mktxlaw.com.