One of the most common questions we have received at Melwani & Chan LLP is “What type of entity should I form for my new business?” As always, the answer is “It depends.” A medical clinic, restaurant, and software start-up all have vastly different requirements and their choice of entity should reflect those needs.
This guide will give a very brief description of the types of entities available and the advantages and disadvantages of each.
What types of entities are there?
Generally speaking these are the types of entities. Each one has its advantages and disadvantages.
- Sole Proprietorship
- General Partnership
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- Limited Liability Company (LLC)
- Benefit Corporation
A sole proprietorship is the simplest way of organizing a business. Essentially, it is one individual who is intertwined with their business from a legal, financial, and liability perspective.
1.) Easy of formation. There is no paperwork necessary, except possibly filing a “Doing Business As…” certificate with the state,
2.) Inexpensive—no legal or filing fees,
3.) No double taxation. In a C-corporation, profits are taxed at the corporate rate and shareholders are taxed again when the corporation distributes dividends.
1.) Unlimited liability for debts and lawsuits is the biggest disadvantage. This is especially problematic if you have assets such as a home, 401K plan, etc. and operate a business that could possibly have significant liability exposure. For example, a restaurant owner would be personally liable for slip and fall for a wet floor or food poisoning lawsuit. While I’ve occasionally heard arguments that liability insurance would cover these cases, the problem is that insurance companies do not make money by paying out money for claims. A sole proprietor leaves their fate in the hands of an insurance examiner who will thoroughly examine the claim to see if the insurance company is actually obligated to pay out on the claim.
2.) No Equity Distribution. A sole proprietorship by nature is only one individual and therefore no equity can be distributed to employees or investors.
3.) Business dies with Owner. The business dies when the owner dies, moves on, or is incapacitated.
Is two or more individuals or entities who associate together for a business purpose. It has many of the same advantages and disadvantages of the sole proprietorship.
1.) Ease of formation. No paperwork is required, except for a possible required filing of a DBA certificate.
2.) Inexpensive, a formal partnership agreement is not required (but it is wise to draft one when everyone is still on good terms) otherwise the partnership will default to the rules under state law.
3.) Transferable. It is a separate legal entity whose interests can be transferred.
4.) No double taxation. Pass through entity for taxation –meaning profits and losses are attributed directly to the individual.
1.) Unlimited liability. There is even more potential liability than a sole proprietorship, because each partner is liable for every other partner’s act within the confines of the general partnership. For example, if one partner steals a client’s money, the other honest partner will be liable for the dishonest partner.
2.) Difficult to raise money from investors, because a passive investors do not want to be faced with unlimited liability for a business that they are not involved with on a day-to-day basis.
Limited Partnership (L.P.) and Limited Liability Partnership (LLP)
The LP and LLP are similar to a general partnership in that is two or more individuals or entities coming together to conduct a business. However, the key difference is that some or all of the partners have limited liability—meaning they can only lose the amount they have invested in the business. In an LP, there is one general partner who manages the business on day-to-day basis and like a sole proprietor has unlimited liability for the debts and liabilities of the partnership. In an LLP, none of the partners are responsible for another partner’s debts, obligations, or liabilities including those resulting from malpractice or misconduct. LLPs are usually limited by state law to professional associations—lawyers, architects, doctors, etc.
1.) Limited liability, as discussed above.
2) Open to outside investors, this type of entity is more capable of attracting investment because passive investors are only liable up the amount they put in the business.
3.) No double taxation. Pass through entity for taxation.
1.) More complicated. Typically a general partner is an entity that already shields individuals from unlimited liability, for example the general partner in an LP is often a Corporation or LLC which makes the overall structure more complicated and expensive.
2.) More expensive for initial set-up, especially in New York. Typically an LP or LLP must register with the state. An written and executed partnership agreement should be drafted and executed. In addition, New York makes it expensive to set up an LP, LLP, or LLC by being one of the only states that require limited liability entities (LPs, LLPs, and LLCs) to file a “notice of publication” in two daily papers for 6 weeks. This can cost an additional $600 to $1500 depending on which county the entity is situated. **The information found in this notice of publication, can also be found for free on the NY Secretary of State website, and essentially this requirement basically exists to provide a nice fat subsidy to a select few media companies, as the 46 other states in the United States have eliminated the Notice of Publication requirement. **
3.) Limited Management. In a L.P. limited partners may not participate in management of the firm, otherwise they will be held to the liability of a general partner. L.L.P. is different, in that limited partners may participate in management.
A C-Corporation is the most common type of corporation and almost all publicly traded companies are C-Corporations. A C-Corporation is legally its own person, meaning it exists as a separate entity from its owners and will exist forever unless formally dissolved.
1.) Limited Liability for all shareholders/owners. Shareholders are only responsible for the amount of debt, liability, and obligations up to the amount of their investment.
2.) Flexible Capital Structure. A C-Corporation has the most flexibility as far as capital structure. C-Corporations, unlike LLCs or S-Corporations, can have different classes of shareholders—such as voting and non-voting stock, foreign shareholders.
3.) Best for attracting venture capital. A C-Corporation, unlike a LLC or S-Corp is not a pass-through entity for tax purposes, which means venture capital funds are allowed to invest. VC funds may be prohibited by their fund documents in LLCs and S-Corps, because they are pass-through entities and the VC fund may become liable for taxes on unrelated business income if it did invest in an LLC or S-Corp.
1.) Double taxation—as noted above, because C-Corporations are not pass through entities, they will be taxed once on corporate profit and the dividends to shareholders will be taxed again.
2.) Lots of Record Keeping—maintaining the limited liability shield requires the corporation to be very diligent in their record keeping—filing the articles of incorporation, adopting by-laws, electing a Board of Directors and having documented annual meetings. All of this must be documented otherwise shareholders may lose their limited liability. The record keeping process can also be expensive to maintain.
An S-Corporation is formed by making an election to the IRS that the corporation chooses to be taxed under Sub-chapter S of the Internal Revenue Code. Unlike a C-Corporation it is a pass-through entity for tax purposes. S-Corporations are useful for members who need limited liability and pass through taxation.
1.) Limited Liability for shareholders.
2.) Pass-through taxation—meaning profits and losses can pass to the shareholders as individuals.
3.) Easy to convert to a C-Corporation. Converting an S-Corporation to a C-Corporation is easier than converting an LLC for legal and tax reasons.
1.) Limitation on type and number of shareholders. An S-Corp can only have 100 shareholders and all shareholders must be U.S. Citizens or residents.
2.) Only one class of stock is allowed—An S-Corporation can not have preferred stock, certain options, warrants, and convertible notes which makes it harder to raise capital.
3.) Lots of Record Keeping—same as a C-Corporation.
Limited Liability Company (LLC)
LLCs are relatively recent legal creation and combine the limited liability of a C-Corporation with the pass-through taxation of a Partnership. LLCs are one of the most flexible entities available in regards to number and types of shareholders. They well suited to businesses such as consulting firms, real estate projects, certain investment funds, and other business that will not be seeking venture capital.
1) Anyone can be a shareholder—unlike an S-Corporation, LLCs allow for Corporations to be members.
2.) Any member can manage. Any member of an LLC can participate in management and maintain their limited liability status.
3.) Flexibility and Less Formalities—the members of an LLC can allocate profits and losses as they see fit. It can also operate in a fashion similar to corporation with elections and meetings or it can operate like a sole proprietorship and have very little formal operating requirements.
4.) Taxation. LLCs can select to be taxed as a partnership, S-Corp, or a C-Corporation.
1) Complex from a tax and accounting perspective—Unlike C-Corporations, each member of an LLC may be required to file a tax return in multiple states. Also an LLC may be required to withhold taxes on certain income to foreign members, regardless of whether distributions are made.
2.) Harder to convert an LLC to a C-Corporation, as opposed to converting an S-Corporation to a C-Corporation. Depending on the nature of the company, changing an LLC to a C-Corporation may trigger tax issues when transferring assets from an LLC. This may make an LLC less attractive (or even ineligible) to certain investors such as venture capital firms and institutional investors.
3.) Limited types of capital structure—although members can make distributions as they see fit, there is no formal mechanism in place such as preferred shares or convertible notes to differentiate who gets what.
4.) More expensive for the initial set-up, especially in New York. A written operating agreement should be entered into by the members, and in some states such as New York, an agreement is required. Also, in New York, LLCs are subject to the Notice of Publication requirement, which makes LLCs more expensive that other types of entities to set up, see above under Disadvantages for LPs and LLPs.
“Benefit Corporation” can legally pursue a “double-bottom line” of social justice and profits Normally, a corporation’s directors and officers are held to have a fiduciary duty to the shareholders, meaning that pursuing interests outside of profit seeking can open directors and officers to shareholders lawsuits.
1.) Legally pursue a “double-bottom line” of social justice and profits without breaching fiduciary duty to shareholders to only seek profit.
2.) By allowing Benefit Corporations to exist, directors and officers have legal protection to engage in activities that promote a social good, such as using environmentally friendly materials, even though it may hurt their financial performance.
1.) Benefit Corporation structure is relatively untested in terms of legal issues. For example, what happens if the B-corporation or one of its officers doesn’t meet its social obligations or fails to adequately deal with compliance and disclosure.
2.) Heavy administrative burden than traditional C-corporations and LLCs.
3.) Investors are uncomfortable with Benefit Corporations as opposed to investing in C-corporations or LLCs.
NOTE: Certified Benefit Corporation (not an official legal entity)
A Certified Benefit Corporation is NOT the same thing as being a legally formed Benefit Corporation. A Certified Benefit Corporation is a regular C-Corporation that meets certain standards, such as fair treatment of its workers, promoted by the non-profit group “B-Lab.” While being a Certified by B-Lab can assist a company in meeting certain standards, the certification process by itself will not provide directors and officers with the legal protections of a Benefit Corporation formed under the laws of the state in which it is located. It is closer to having coffee certified as “Fair Trade.” There a are a few well known C-Corporations that are Certified Benefit Corporations such as Patagonia, Etsy, and Warby Parker.
The process to become a Certified Benefit Corporation is to be reviewed bi-annually by the Non-profit B-Labs and pay a sliding scale fee based on revenue.
DISCLAIMER: **The information appearing in this article does not constitute legal advice or opinion. This article is for informational purposes only. Melwani & Chan LLP only provides advice and opinion upon engagement with respect to specific factual situations.**