Modern economics has allowed us the capacity to do many amazing things, but certainly one of the most interesting and useful is the creation of the legal entity. How come? Because a legal entity is like an alter ego, a sort of Frankenstein creation that is both person and not-person; it is simultaneously you and not-you, or not-just-you. By definition, a legal entity is an association, corporation, partnership, proprietorship, trust or individual that has legal standing in the eyes of the law; as such, it has the legal capacity to enter into agreements or contracts, assume obligations, incur or pay debts, sue and be sued in its own right, and to be held responsible for its own actions. So it can take the actions of a person and assume the responsibilities of a person, but it is not a person, or more precisely, it is not you, the eager entrepreneur.
Now, why would you want to do this? You have your business plan, and you’re ready to get out there and start making money. Why stop and consider the possibilities of setting up a legal entity? According to Andrew Howell, estate planning and asset protection specialist for The Wealth Factory, there are three very important considerations to keep in mind: estate planning, asset protection and tax issues. Depending on which legal entity you choose to adopt, these three factors will change accordingly, sometimes to your benefit, sometimes not. In this two-part series, we will take a look at your options and map out which choices make the most sense for you.
Legal Entity: The Sole Proprietorship
This is the simplest and most direct form of business model, though, in truth, it cannot really be considered a separate legal entity. In this scenario, there is only one owner, so you have total control over all business decisions and you do not have to share your profits with anyone else. You don’t even need special legal documents to claim you are a business; you can just open up shop and begin. Great, right? But what about the potential downsides?
The sole proprietorship offers no asset protection, no estate planning benefits and no tax benefits. The owner is liable for all debts and liabilities. The business does not file a separate tax return; instead, the owner must file a Schedule C to be included with his or her individual return. While the assets of the business, including its name, can be sold, it is not possible to transfer a sole proprietorship to someone else. One of the biggest downsides of the sole proprietorship is that is offers no legal distinction between your company assets and your personal assets. Therefore, if someone decides to sue your company for an alleged wrongdoing, you might lose more than just your company assets; you could lose your personal assets as well.
Legal Entity: The Partnership
The next step up from Sole Proprietorship is a partnership. There are a couple of different varieties of partnership, and each affects our key factors a little differently. At its most basic level, a partnership is, as the name implies, a business entity consisting of two or more owners. Partnerships are not taxed as separate entities, so all profits and losses must be recorded on the individuals’ tax returns. The four distinct types of partnership are: a general partnership, a limited partnership (Ltd.), a joint venture and a limited liability partnership (LLP).
A general partnership, in most respects, is similar to a sole proprietorship except that you have two owners rather than one. Each partner is equally responsible for all liability. Unless otherwise specified, each partner also has equal management rights. Changing partners or the death of a partner dissolves a general partnership. A joint venture is like a general partnership, but it only exists for the duration of a single business project. For example, if a pair of businesswomen wanted to establish a shopping center, they might enter into a joint venture. Once the project was complete, they could sell, and the joint-venture partnership would dissolve.
A limited partnership exists between one or more general partners and one or more limited partners. In this agreement, the general partners agree to take on unlimited liability, but the limited partners are only responsible for liability to the extent of their investment so long as they remain passive investors and do not become involved in the day-to-day operations of the business. Limited partnerships are also known as silent partnerships, since the limited partner has no voice in the managerial aspects of the company. Limited partnerships do allow for the transfer of interest and general partners can be replaced in this agreement, giving it a bit more flexibility than some of the other partnership agreements.
A limited liability partnership is a particular form of partnership that protects the liability of each member of the partnership from the actions or debts of other partners. In such an agreement, each partner has unlimited liability for their own acts, but not for the debts of the partnership or for the liabilities of the other partners beyond the extent of their interest in the partnership. This form of partnership is very common among professionals, such as accountants or lawyers, who may want some of the legal and tax benefits of a partnership, but who do not want to be on the hook for every action of their partners. Limited liability partnerships can have provisions for withdrawing from the partnership or adding a new partner without changing the existing agreements. The partnership does offer asset protection, but the partners are not required to pay a self-employment tax.
Both limited partnerships and limited liability partnerships require filing forms with the state when entering into the agreement. We recommend that you and your prospective partners consult with an experienced attorney and together draft a Partnership Agreement for your company, regardless of which sort of partnership you choose. An attorney can help guide you through the many options and scenarios you must agree on, including management responsibilities and rights, profit sharing, responsibility for expansion, the withdrawal or addition of another partner, and a multitude of other issues.
In the next installment of this series, we will discuss the last form of a legal entity, the corporation, and detail the different options you have if you choose to incorporate.