Advantages and Disadvantages of Different Business Entities

July 9, 2012


Introduction

What are the advantages and disadvantages of a sole proprietorship, partnership, corporation, and LLC? This article explains.

For partnerships, we distinguish a general partnership from a limited partnership. For corporations, we compare and contrast a C corporation from an S corporation.

Sole Proprietorship

A sole proprietorship may be one of the simplest ways to start a business. Essentially, the owner is the business.

Advantages of a Sole Proprietorship:

  • Owner receives all profits.
  • Easier to start up and lower cost because there are no required filing fees.
  • Few documents are required at start up.
  • Owner is free to make own decisions concerning the business operations.
  • Owner pays only personal income taxes on the profits.

Disadvantages of a Sole Proprietorship:

  • Owner alone is responsible for all liabilities incurred by the business; if the business does not have enough assets to pay back business debts, creditors can take the personal assets of the owner.
  • Owner’s ability to raise capital is limited to personal funds and the funds from people who are willing to give the owner loans, which can limit the size of the business.
  • The business may come to an end at the owner’s death, it does not continue unless transferred to heirs, but when it is transferred to family or heirs a new sole proprietorship is created.

Partnerships

There are two forms of partnerships, general partnerships and limited partnerships. There are three essential elements to a general partnership:

  1. a sharing of profits and losses,
  2. a joint ownership of the business, and
  3. an equal right in the management of the business.

In a limited partnership there is one general partner and one or more limited partners. The general partner assumes the responsibility for the management of the business and the limited partner contributes only assets to the business, while having no role in the company’s management.

Advantages of a General Partnership:

  • Businesses as partnerships do not have to pay income tax; each partner files the profits or losses of the business on his or her own personal income tax return. This way the business does not get taxed separately.
  • Easy to establish.
  • There is an increased ability to raise funds when there is more than one owner
  • Wider pool of knowledge, skills, and contacts.
  • Improved management with more than one owner.

Disadvantages of a General Partnership:

  • Partners are jointly and severally liable for the actions of other partnership obligations including contracts, torts, and breaches of trust. Joint and several liability means that if a third party were to sue the partners, the third party can sue any one of the partners without suing all of them. If a partner has been sued but cannot pay the third party the full amount, the third party may collect the money from the remaining partners.
  • Each partner is individually liable for the debts and obligations of the business; if the business does not have enough assets to pay back business debts, creditors can take the personal assets of the partners.
  • A partner cannot transfer interest in the business without the unanimous consent of the partners.
  • Partnerships can potentially be unstable because of the danger of dissolution if one partner wants to withdrawal from the business or dies.

Advantages of a Limited Partnership:

  • Being a limited partner puts a limitation on liability with respect both to potential lawsuits and money; the limited partner is only going to be liable for the amount of capital it contributed to the business; a business creditor cannot come after the limited partner’s personal assets.
  • Easier to attract investors because limited partners have limited liability to the business debts.
  • Profits and losses pass through the business to the partners, who are taxed on their own personal income tax returns.
  • Limited partners get to share in the profits and losses without having to participate in the business itself.

Disadvantages of a Limited Partnership:

  • If the limited partner becomes active in the business he or she may have general-partner personal liability.
  • General partner is personally fully liable for the debts of the business.
  • Certificate of Limited Partnership must be filed with the state before the partnership comes into existence, which includes state filing fees.

C Corporation

A corporation is a separate legal and tax entity created by individuals (shareholders) who offer money, property or both for the corporation’s capital stock. The corporation remains separate from those who manage and control the operations of the business.

Advantages of a C Corporation:

  • There is a pooling of capital from many investors so it is easier to get the business up and running.
  • Shareholders are not personally liable for the debts of the corporation. If the corporation fails, shareholders may lose their investments in the corporation, but are not personally responsible for the corporation’s debts.

Disadvantages of a C Corporation:

  • Have to file Articles of Incorporation with the Minnesota Secretary of State and a filing fee.
  • Double taxation. The profits of the corporation are taxed as they are earned at a corporate level, and the profit is also taxed to the shareholders when it is distributed out as dividends.
  • Shareholders that control and own a significant amount, or majority, of the corporation’s voting stock have a dominant voice in the management of the business in comparison to shareholders that do not own as much stock.

S Corporation

A business may elect to be an S Corporation (S Corp) in order to avoid income taxes at the corporate level, like the C Corp, while at the same time retaining the advantage of limited liability that corporations enjoy.

Advantages of an S Corporation:

  • Income is taxed only at the shareholder level, not at the corporate level, which means that an S Corp avoids double taxation that C Corps face.
  • Shareholders are not personally liable for the debts of the corporation. If the corporation fails, shareholders may lose their investments in the corporation, but are not personally responsible for the corporation’s debts.

Disadvantages of an S Corporation:

  • Have to file Articles of Incorporation with the Minnesota Secretary of State and a filing fee.
  • Shareholders that control and own a significant amount of (or a majority of) the corporation’s voting stock have a dominant voice in the management of the business in comparison to shareholders that do not own as much stock.

Limited Liability Companies

LLCs are viewed as a hybrid between a partnership and a corporation because it offers the limited liability of a corporation but has the tax advantages of a partnership.

Advantages of an LLC:

  • Profits pass through the LLC and taxes are paid personally by the members (owners) of the company.
  • Liability of the members is limited to the amount of their investments.
  • Members are allowed to participate fully in management of the company.
  • Corporations and partnerships can be LLC members.
  • No limit on the number of members for an LLC.
  • An LLC can have just one member.
  • Offers a large amount of flexibility; members decide how to operate various business aspects through the operating agreement.

Disadvantages of an LLC:

  • Increased complexity in business formation; an LLC may be classified as a sole-proprietorship, a partnership, or a corporation for tax purposes.

Beware of Choosing Wrong

If you make the wrong choice, you can fix it. But there are two problems. First, the fix will not be retroactive. Second, the fix may be more expensive than hiring an attorney to do it correctly from the beginning.

It is “penny wise pound foolish” to pick a business entity without professional help.

Conclusion

In addition, this article highlights the major advantages and disadvantages of each entity type, but no article can cover all the details. If it did, it would be a “book,” not an “article.” This means details are missing. In your circumstances, the missing details could be a big deal. An experienced attorney can ask about your business plans, identify what is important to you, and talk through important factors so you can select a business entity together.

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