In this two-part article, we look at the question of selecting the form to organize a business.
One question that a business owner needs to decide at some point is in what form the business entity is going to take. For ordinary for-profit businesses, the law in most states offers four major forms and a few minor forms, each of which has its own benefits and costs. There are three factors that the owner should consider before deciding how to proceed: flexibility of management, protection of personal assets, and tax effects.
In this part, we discuss two major forms that put all of the owner’s assets up for potential payment of any resulting claims against the business. On the other hand, there are tax and flexibility reasons that may benefit the owner in return.
The simplest form of ownership is the sole proprietorship. In this form, the owner simply runs the business under his or her own name (or a business name, which in most states can and should be registered to discourage duplication by competitors).
The sole proprietorship offers maximum flexibility. There are no requirements how decisions are made or when meetings need to be held.
Sole proprietorships also allow for simplicity of tax treatment: the profits or losses are simply taxed as the owner earns them.
The main disadvantage of a sole proprietorship is that all of the owner’s assets are at risk to pay losses.
If you have more than one owner, you can get most of the same effects of a sole proprietorship by forming a partnership. In fact, if you don’t set up a different form, you probably will end up with a partnership created by your actions. In Oregon, for example, there are many cases in which the courts found two or more people to have created a partnership by acting as one – including the divorce case involving the founders of Leathers Fuels.
Partnerships are generally managed according to an agreement reached by the partners. This can be as simple as “you provide the money, I provide the labor, and we split the profits,” and as complicated as a written contract dealing with such issues as how to make decisions, how to divide profit and loss, what business the partnership will or will not do, when and how partners can be removed, and so forth. In general, partners should act fairly with each other, including allowing the partnership first chance at opportunities within the scope of the business. It’s more or less the business equivalent of getting married, except that it’s easier to get out of a partnership. Generally, if a majority want out, or the agreement expires, or a court finds that it’s fair to close up shop, the partnership can be ended, and the result is that the partners pay off the bills and divide what’s left. It is possible that the partners agree that some of the remaining partners can carry on the business, but usually that requires a buyout.
Partnerships are the most flexible arrangement when there is more than one owner. The agreement and legal rules based on fairness are the primary controls on how decisions are made (usually majority or unanimity) and whether meetings need to be held. Most partnerships assume that the partners will remain in close contact and work together. For this reason, with the exception of professional services, most partnerships are small operations.
Partnerships also are treated simply for tax purposes. Generally, the partnership files an annual return, paying no taxes itself, and each partner’s share of the profit or loss is reported on the partner’s returns.
There are two major disadvantages to a partnership. First, if there is a major disagreement, it can tear the partnership apart very easily, and if anyone leaves under conditions that the agreement doesn’t allow, that partner may be shut out of closing down the business. Second, all of the partners’ assets are placed at risk. For this reason, if there is a question as to any of the partners’ or employees’ honesty, the other partners should think carefully before joining, and the partnership may want to consider buying insurance specifically to protect against this.
Two variations on the partnership have confusingly similar names but different functions.
The limited partnership is primarily used for investments. There is at least one general partner, who manages the partnership and puts all of his or her assets at risk, and at least one limited partner, who risks only their investment but generally does not get involved in management.
The limited liability partnership (LLP) tends to be used for professional businesses (doctors, lawyers, etc.), and most states allow LLPs only in professional fields. As the name implies, the partners in an LLP generally put only their investments at risk.
In Part Two of this article, we’ll discuss two major forms of business organization that limit the investors’ risk to their investments: the corporation and the limited liability company.