In his book, Essentials of Corporate and Capital Formation, David H. Fater identifies the corporate structures traditionally used by entrepreneurs and helps them understand which is best for their particular situation. According to Fater, the principal factors for selecting a corporate structure are: risk tolerance, tax implication, need for capital and exit strategy.
A sole proprietorship is a good choice for individuals starting a business that will remain small, does not have exposure to liability, and does not justify the costs associated with incorporating and ongoing corporate requirements.
Here are the key defining points of a proprietorship:
- no formal requirements
- all decisions are totally in the hands of the owner
- all profits and losses are reported directly to the owner's income tax return
- start-up costs are minimal
- unlimited liability to business and personal assets
- lacks continuity; ends when the owner becomes disabled, retires, or dies
- difficult to raise capital for
- requires owner attention to all business needs
Evolving from the proprietorship, partnerships are highly adaptable and vary in complexity, as partners may be individuals, groups, companies, and even corporations. A partnership is typically the result of a contract with no formal documents. A partnership is identified by the following characteristics:
- intention of parties
- sharing of profits and losses
- joint administration and control of operations
- capital investment by partners
- common ownership of property
In determining whether a partnership is the appropriate corporate structure for your enterprise, consider the following:
- Partners are personally liable for torts committed by the partnership and its agents (except in limited partnerships).
- State property law defines ownership and determines changes in partnership structure when a partner dies.
- A partnership is not a state or federally taxable entity; partners pay income in proportion to their share in the profits.
- A partnership does not incur tax on profits before profits are distributed to the partners.
- Partners may be exposed to greater personal liability versus shareholders of a corporation.
- There is no shield from liabilities or other risks; liabilities and/or risks are shared jointly and severally by the partners.
- Profits and losses go directly to the partners' individual tax returns, which may not be advantageous if the company is very profitable, as partners may not have both the cash necessary to pay these liabilities and the capital needed for growth.
The limited partnership (LP) evolved out of the need to limit owner liability. There are three differences between partnerships and limited partnerships:
- LPs are created by statute versus partner intention
- LPs may be able to override partnership agreements
- taxes are treated differently; while an LP typically has pass-through taxation, it must meet specific criteria to avoid being taxed as a corporation
Here are the particulars:
- LPs have two or more persons, with a minimum of one general and one limited partner. The general partner has unlimited personal liability, while the limited partner's liability is limited to his/her investment in the company.
- LPs require document filing with the state.
- LPs are frequently used as vehicles for raising money.
- LPs file taxes as a separate entity.
- The GP has authority to bind all other partners in any/all contracts entered into for purposes related to the ordinary case of the LP's business; in other cases, the GP must have authorization from all the other partners.
- LPs have liability only to the extent of their registered investment and no management authority.
- GPs pay LPs a return on investment (similar to a dividend) as defined in the partnership agreement.
- LPs in the U.S. are most common in the film and real estate industries, or in businesses with a project focus; private equity firms almost exclusively use LPs for their investment funds.
- LPs may be useful in "labor-capital" partnerships in which a partner(s) provides the capital or resources and the other partner(s) provides the labor.
- LPs are attractive to those interested in providing shares to many individuals without the additional tax liability of a corporation.
- In some states, an LP may become a limited liability partnership (LLP), in which GPs are responsible for business debts, and shielded from acts of malpractice or other wrongdoing by other partners in the normal course of business. LPs may be attractive for businesses that require capital and have a defined exit strategy.
Read more about corporate structure here.