The start to a meaningful conversation with clients about business structure entails understanding the nature of their business so you can assess the risk factors and potential liability that may impact the owners, professionals, employees, and customers. Of course, the subjects of tax, situs, goals, objectives, economics, and business structure cannot be overlooked, and must be factored into the analysis. It is always best to communicate and coordinate with the clients’ team of advisers to ensure a collaborative approach to the analysis of the appropriate alternatives.
With a clear understanding of what the owners’ goals, objectives, and family economic realities are, the business structure options can be narrowed down. When considering a sole proprietorship, general partnership, limited partnership, C corporation, S corporation, or limited liability company (LLC), a comprehensive analysis of all the options is a first step. The most popular form of business is the sole proprietorship. The owner gets unilateral decision-making, control, and right to all profits, but the downside is the unlimited personal liability for anything the proprietor does or fails to do with the business.
A general partnership, by definition, must have two or more owners, though they need not be equal. A big advantage is the pooling of capital – both knowledge and financial. The disadvantage is liability exposure for anything and everything each and every one of the owners does or fails to do. Proprietorships and general partnerships are the simplest forms of business with the least formality, but the unlimited personal liability exposure associated with them makes them hard to justify.
Limited partnerships consist of one or more general partners, together with one or more limited partners. The general partners make all the decisions and manage the business. The limited partners are investors with no say whatsoever. The trade-off is that the general partners have unlimited liability exposure, but the limited partners have none beyond their investment.
Corporations provide liability protection to all of its owners. For the most part, S corporations or C corporations are the same when it comes to liability exposure; the distinction is related to the tax code, the eligibility criteria, and the S election at the federal and/or state levels. Shareholders/owners elect a board of directors which appoints officers who are charged with day-to-day management and operation of the business. Corporations can have as few as one shareholder or an unlimited number. Corporations are undoubtedly the most formal of any of the entity options. Pennsylvania statutes require corporations to advertise their existence, issue stock certificates to their shareholders, have a corporate seal, and conduct annual meetings of the shareholders and directors.
The LLC has been the most popular choice of entity recently. Pennsylvania began recognizing this form of entity in 1994, but it took until 1998 until the legislature eliminated its taxability at corporate rates. Since that time, LLCs have grown exponentially as the entity of choice for closely held, privately owned, and family businesses. Its popularity is undoubtedly a result of the flexibility and limited formality requirements. Unlike corporations, LLCs are not required to advertise, issue stock certificates, have a corporate seal, or have annual meetings. They can issue an unlimited series of equity with disproportionate financial benefits if they choose. This contrasts distinctly with the limitations on S corporations, which can only issue one series of stock (though they can offer both voting and nonvoting in such series).
Any entity that offers liability protection requires formal statutory formation and observance of the requisite formalities. It is essential to always use the formal name of the entity, including its designation as a limited partnership, corporation, or LLC, as the case may be. Likewise, one can never comingle the money of a formal entity with that of the owner(s) or any other entity. Respecting the statutory formalities, coupled with reasonable business integrity/ethics, should keep individual owners safe.
Liability exposure and/or the risk of double taxation often narrows the field of options down to LLCs and corporations eligible to elect subchapter S status at the federal and state levels. The ultimate selection needs to specifically take into consideration all of the relevant facts and circumstances associated with the business and its owners.
A final piece of advice is that anytime a business has two or more owners, there should be a written agreement defining and describing the rules of engagement. While not a statutory requirement, it is undoubtedly the most practical requirement to keep the peace among the owners. Proper planning can help protect your clients, including cautioning them on matters such as sharing equity. It is quite easy to give it away, but it is often torture to reclaim it.
Bernard M. Lesavoy, JD, is founding partner of the law firm Lesavoy Butz & Seitz LLC in Allentown. He can be reached at email@example.com.