Choice of Business Entity: An Overview of Non-Tax Considerations

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By Kailey Grant

Regardless of the nature of your business or what sector of the hardwood flooring industry you work within, the choice of type of entity is an important decision with many factors to consider. The following is a summary of those considerations.

Sole Proprietorship
A sole proprietorship, which is not a legal entity but simply an unincorporated business owned by one individual, may seem like the easiest, fastest, and cheapest way to start a business. However, if you choose to operate as a sole proprietor, the assets and liabilities of the business are not separate from your personal assets and liabilities. This means you can be held personally liable for the liabilities of the business and your potential liability is limitless. Other common business structures that provide greater protection from personal liability include limited liability companies, partnerships, and corporations and there are advantages and disadvantages to each. This article provides a broad overview of these advantages and disadvantages, but does not discuss the tax implications. Please note the tax implications vary significantly between each entity and business organization and laws vary state by state. You should consult both a legal and tax adviser before the formation of your business.

Limited Liability Company (LLC)
A Limited Liability Company (LLC) is one of the most common entities utilized for small businesses. It is a form of business entity that permits the pass-through federal tax treatment of a partnership and the liability protections of a corporation. The liability of the owners of the LLC, typically called the members, is limited to the amount of capital contributed to the LLC, which shields them from personal liability in most instances. An LLC can be made up of one or more members, but two or more members are required if the LLC wants to be taxed as a partnership.

One of the greatest advantages of the LLC is its flexibility. State LLC statutes are typically made up of default provisions that apply in the absence of a limited liability company agreement or operating agreement and a few mandatory provisions that cannot be altered. While the adoption of a written operating agreement is not required, it is advisable and provides ultimate flexibility in the management structure, voting rights, allocation of profits and losses, transfer of membership interests, distributions, and liquidation and dissolution of the LLC, among other things. The governance of an LLC can be as simple or as complex as you make it.

Due to the relatively recent development of the LLC, statutory and case law is less developed than corporation and partnership law. While this provides more freedom and flexibility, it also provides less certainty. Additionally, some states require LLCs to file annual reports and pay a fee to remain in good standing. Finally, while the flexibility of an LLC’s operating agreement is an advantage, it can also be a disadvantage depending on the circumstances. A poorly drafted operating agreement can lead to ambiguities, inconsistencies, and disputes throughout the life of the LLC.

Partnership
There are a number of different forms of partnerships. The two most common kinds of partnerships are limited partnership (LP) and limited liability partnership (LLP).

An LP is comprised of two or more partners and two classes of partners; one general partner and one or more limited partners. The general partner is typically responsible for the management of the LP and may or may not make a contribution to the LP. However, the general partner has unlimited liability, which is a disadvantage of the LP. Limited partners are typically silent investors and tend to have limited control over the management of the LP. This gives the general partner great discretion, which could negatively impact the limited partners unless its authority is limited in the limited partnership agreement.

A limited partner’s liability is limited to the amount of capital contributed to the LP, similar to a member in an LLC. An LLP, on the other hand, is very similar to an LP but limits the liability of all partners. Partnerships offer flexibility similar to LLCs in that their governance can be customized pursuant to a limited partnership agreement and they are subject to fewer formalities than corporations. Additionally, partnership law is more developed than LLC law which provides more certainty.

Corporation
The two most common types of corporations are the C-Corporation (C-Corp) and S-Corporation (S-Corp). A C-Corp is owned by one or more stockholders, and there are no restrictions on the types of owners. An S-Corp may be owned by one to one hundred stockholders and with certain limited exceptions, only U.S. individuals can be stockholders.

The liability of shareholders, like members of an LLC and limited partners in a partnership, is limited to the amount of capital contributed to the corporation. Corporations are managed by a board of directors who designate officers to manage the day-to-day operations of the corporation. As a result, shareholders do not have much control over the management of the corporation, but certain major decisions are required to be approved by the shareholders. The board of directors is typically given great deference in its decisions, except in cases of fraud, conflicts of interest, or breach of fiduciary duty.

Corporations are subject to more formalities and are more regulated than LLCs and partnerships. These formalities and regulations result in more time and costs related to the formation and organization of the corporation. Furthermore, there is a well-developed body of corporate case law and statutes, particularly in the state of Delaware where a large number of corporations are incorporated, which provides greater certainty, but also less flexibility than LLCs and partnerships.

Conclusion
All three entity structures described in this article shield the business’ owners from personal liability and are generally preferable to a sole proprietorship. It is important to note, however, that there is a possibility that a court will “pierce the corporate veil,” which means subject the owners to personal liability for the liabilities of the business, in the event there is fraud, there is no real distinction between the entity and its owners, the business is not adequately capitalized and/or the business has failed to follow corporate formalities.

Kailey Grant is an Associate with the Corporate and Real Estate Departments at Barnes & Thornburg LLP in Chicago. She can be reached at kgrant@btlaw.com.

This article shall not be considered legal advice. In all cases, groups should consult their legal counsel.

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