The Legal Form of Your Business
Posted: 8/21/2006 15:30:49

THE LEGAL FORM OF YOUR BUSINESS
By William D. Harazin, Attorney at Law
(C) Copyright 1995

Ordinarily, the last thing on the minds of would be entrepreneurs is the legal form of the new business venture. The entrepreneurs’ primary object is to take an idea and as quickly as possible turn it into a profit generating business. The details will be worked out later. Unfortunately for too many start-up companies, failing to give due consideration to the form of the business may prove unfortunate in the future. Without any thought to the legal form, the business will, by default, usually take the form of a sole proprietorship, or partnership depending on the number of individual owners involved. This choice by default may or may not serve the owner(s) needs.

In deciding which legal form is best for your situation, the focus is generally on the issues of liability and taxes. However, other factors may also come into play depending on the circumstances including financing, central management, continuity, estate planning and administration. For the purposes of this article, the focus will be on the available options and the issue of liability.

From a legal standpoint, there are several different legal forms available to the entrepreneur, including a Sole Proprietorship, a Partnership, a Corporation, a Chapter S Corporation, a Limited Liability Corporation (often referred to as an “LLC”), and a Limited Partnership. These all have their own special advantages and disadvantages, and a decision as to form should be based on the individual circumstances and the needs of the owner(s).

1. A Sole Proprietorship is the simplest legal form that a business can take. It involves one individual, who owns the entire business to make a profit. It requires few formalities and carries with it the most risk to the individual in that there is unlimited liability. This form also lacks continuity because it comes to an end upon the death of the owner, and it will be taxed at the owner’s individual rates.
2. A Partnership is a legal entity much like a sole proprietorship in its simplicity and vulnerability except that it involves two or more owners who come together for the purpose of making a profit. For the purposes of this discussion the sole proprietorship and the partnership will be treated as the same due to their similarities with respect to liability and taxes.

3. A Corporation is a more formalized legal entity, which is considered in the eyes of the law to be a separate legal entity, separate and apart from the individual owner(s). It offers more protection to the individual owners in the form of limited liability, but requires more formalities. In addition, Corporations have different tax rates than individuals. It is often said that a corporate characteristic is “double taxation” in that the corporate profits, after being taxed at the corporate tax rate, are than taxed again when such profits are then distributed to the individual owners (shareholders) in the form of dividends

4. A Chapter S Corporation is not really a separate legal entity, but rather a tax vehicle for small and uncomplicated businesses. From a legal standpoint, other than the tax consequences, it is virtually no different from a regular corporation. The difference is in the taxation of the Chapter S Corporation in that it will generally be taxed like a sole proprietorship or a partnership, while retaining its corporate attribute of limited liability. In order to take advantage of the favorable tax treatment, the chapter S corporation can have no more 35 shareholders, have only one class of stock and satisfy certain other requirements reflecting its small business status.

5. A Limited Liability Corporation (LLC) is the new legal entity on the block. Relatively unknown just a few short years ago, most states now allow, in some form or another, the formation of the LLC. The LLC is made up of two or more shareholders protected by limited liability, though taxed generally as a Partnership. Simply put an LLC is like a Chapter S Corporation without its limitations.

6. A Limited Partnership is a business form in which one or more of the partners are general partners with unlimited liability and the remaining partners are limited partners with limited liability. The general partners are the managers and the limited partners, in order to maintain their limited liability, must have little authority over the running of the business. The Limited Partnership also requires a higher degree of formality, and provides for taxation similar to that of partnerships.

In light of the high risk of failure in starting any business, limited liability is a highly desired attribute in the choice of a business form. The Corporation, the Chapter S Corporation, and the Limited Liability Corporation provide limited liability to the individual owners and in the case of Limited Partnerships to the limited partners. However, the individual owners of other business forms, such as the sole proprietorship, the partnership and in the case of limited partnerships, the general partners, have unlimited liability with respect to their business and personal assets.

The concept of limited liability can be explained as follows: An individual is said to have unlimited liability when all of one’s assets, both business and personal, are at risk or exposed to others for the collection of a debt regardless of how the debt might arise. Depending on the legal form chosen, an individual starting a business, may risk not only the investment in the business and its assets, but also his own individual and personal assets. When an individual business owner risks only the investment in the business and the business assets, and not his own individual assets, he is said to have limited liability.

The liability may come from several different sources. It may be a simple debt, such as when the business borrows money, or it may come from the business’ breach of a contract or broken promise to others. It may also arise from the wrongful or negligent conduct of the business or its employees resulting in personal injury or property damage to another. The parties seeking compensation by imposing liability may be customers, suppliers, partners, employees or unrelated third parties who have been injured by the acts of the business. The liability may be small or range into the millions of dollars.

The exposure to liability will be an important factor in the choice of a business form, and will generally depend on the type of business and the potential for harm. An industrial chemical company requiring substantial investment carries much more potential for harm and exposure to liability, than a business requiring little investment that consults on the colors of butterflies. In the first instance, the issue of liability would be of utmost importance. Whereas, in the second instance, other factors might outweigh the liability issue in choosing a business form. Furthermore, certain risks may be adequately protected against through insurance, indemnification or methods other than the choice of form. In any event, any time the exposure to liability may be eliminated or diminished at a relatively minor cost one should consider doing so.

Despite the fact that Corporations, Chapter S Corporations, Limited Liability Corporations and to some extent Limited Partnerships, provide limited liability to the individual owners, such limited liability is not absolute. The limited liability protection provided by these business forms may be lost or extended in certain circumstances. Three typical instances wherein limited liability may be lost or extended are through guarantees, tortious conduct or piercing the corporate veil.

Although lenders and suppliers may be willing to extend credit to new “limited liability” business entities, when they do, they are generally sophisticated enough to require the individual owners to either co-sign or guarantee such grant of credit. Much like a teen buying a car on credit, the car salesperson will be more than happy to sell and finance the car to the teen. However, since the teen lacks a credit track record, the salesperson would require mom and dad to co-sign or guarantee the loan. In the event the teen defaults on the loan, the parents are still liable. The new corporation or other limited liability form is like the teen. It is without a credit history and if it defaults, the lender will still have recourse against the individual owners and their personal assets if they take the affirmative act of co-signing or guaranteeing the loan. By doing so they have extended their individual liability.

An individual may lose its limited liability protection provided by the corporation or other limited liability form, if through tortious or negligent conduct, the individual injures another individual or damages such individual’s property. Any individual, who tortiously or negligently harms another, will be responsible and liable for such injuries and damage. This is true regardless of whether the individual was acting for himself or the business. One who commits tortious acts, cannot hide behind the business form’s cloak of limited liability. However, in the event the tortious conduct is committed by an employee, and not the individual owner, the employee and the business entity may be liable, but the individual owner will retain the limited liability protection.

As a separate legal entity, the corporation and other limited liability forms, must maintain their separateness from the individual owners and perform certain corporate formalities. If the individual owners fail to maintain the separateness, and/or fail to perform the corporate formalities, the corporation may be considered the individual owner’s alter ego. In such a case, for liability purposes, the “corporate veil” will be pierced or disregarded. The corporation and the individual will be treated as one and the same, and the individual thereby loses the limited liability protection provided by the corporation or other limited liability forms.

A word to the wise. Certain business forms provide substantial, though not absolute protection in the form of limited liability. As such, some thought should be put into the choice of legal form for a business in order to fit the needs of the business and the individual owners