Choosing Your Business Entity

What kind of legal entity are you going to be? Do you know? Do you care? Should you care? Well, yes, and no. Let me explain.

I’m writing this article under the assumption that most of you who read it are starting a food business out of your kitchen, or if not literally out of your kitchen, then on a very small scale. I don’t think anyone who is raising serious capital and taking on multiple investors will be reading this blog. This article is geared toward the small-scale producer, and the small-scale producer doesn’t really need to over-think this choice in the early stages. If you’re going into this venture alone, don’t sweat over this decision at this stage. The practical reality is that being a sole proprietor and being a single member LLC will look almost identical in the early years.

What do I mean? One of the main advantages to several business entity structures is limited liability it affords the owner(s). This means that you may not be personally liable for the debts and legal snarls of the company except to the extent that you have invested in the company. The reality, however, is that you are likely to be on the hook for most of the company’s financial obligations because most lenders and vendors extending credit to you will in all likelihood ask you to sign a personal guaranty obligating you to repay the debt in the event that the company does not. They want the money the business owes them and don’t want you to hide behind your business entity structure to keep from paying the debt. So if you are alone starting a company, and you’re starting on a very small scale, it may not be worth it for you to go to the trouble of forming an entity for this purpose.

However, if you are going into business with other people, whether or not you are related or married, it is my opinion that you should hire an attorney to help you craft the details of that relationship, whether it will take the form of a partnership, LLC or corporation. The courts are full of business owners who did not work out those details with each other ahead of time and then disagree on how things should go down later on. It’s money well spent in the early stages.

Ok, so that being said, let’s review the most common options for entity structure: sole proprietorship, partnership, limited partnership, limited liability company (LLC), business corporation (C Corp), and subchapter S corporation (S Corp). It’s important to note that legal entity status is something that is created under and governed by state law. Each state will have its own laws regarding formation of a legal entity, filing requirements to maintain its status, and so on. Do your homework about what is available in your state, or better yet, consult with an accountant and attorney.

Now that we know our main options, I’ll go over what they are and the pros and cons.

Sole Proprietor: The vast majority of businesses in the United States are this form of entity. Being a sole proprietor basically means that you do nothing to create a separate legal entity for your business. You are your business, your business is you. All income is taxed to you, and all expenses are on your personal tax return. You are liable for all debts and any damages caused by your products. It’s all you, baby. A business owned by a married couple can be treated as a sole proprietorship even though there are two individuals involved.

Pros:

• There are very few, if any, expenses involved in establishing your business entity and maintaining its status. It is likely that from the state’s point of view, the only formal filing you would need to do is a trade name or “doing business as” kind of filing. This just makes sure that if your business uses a name other than your own name, the state has a record of that on file. In other words, they want to know who is behind “Acme Foods.”
• You would record your income and expenses on a Schedule C to your personal 1040, which is less complicated and less expensive than filing a partnership or corporate return. This means that the business is taxed only once (unlike a C Corp, which is taxed twice). One thing to keep in mind is that you can start out as a sole proprietor, and change to an LLC or corporation at a later date in the event that you find you need to start raising capital.

Cons:

• Exposure to liability. As I said, you are the one responsible for all financial obligations and legal liability kind of any kind.
• If you intend to sell the business, it can be a deterrent to a potential buyer that you are a sole proprietor. There are some complications that are beyond the scope of this article.

Partnership: This is where two or more people or legal entities are in business together without any formal limitation of liability of any partner. These are called “general” partnerships. State law governs how these partnerships are created and maintained as well as how liabilities and powers are allocated between the partners. However, even thought states have these laws that govern the relationship, the partners can create their own partnership agreement (and should!) which can change what would otherwise be the rules under state law. For example, in the absence of such a formal partnership agreement, each partner is liable for the financial and legal obligations of the business as a whole, even if that partner only owns a small fraction of the business. Similarly, each partner has equal power to create obligations on behalf of the business. I reiterate, however, that these so-called “default” rules can be changed by a formal written agreement between the partners.

Pros:

• One of the pros of forming a partnership is also one of its cons – it is incredibly easy to create a partnership. It’s basically the same as a sole proprietorship in that you may only need to file a trade name or “doing business as” filing to reserve the business name, and otherwise, you are in business together. So the costs of formation can be low.
• There are not as many formalities to maintain the partnership legal status as for a corporation.

Cons:

• The ease also means that partners almost always go into business together without formalizing their relationship in a partnership agreement, and then it can become very sticky to sort out the liability and responsibility issues down the road when the business is already in operation. Partnerships frequently fall apart for this very reason. Therefore, it is always advisable to have an experienced lawyer draft a formal agreement for you. In that event, however, the cost of formation will be much higher.
• Each partner will be liable for the obligations of the whole. What if one partner takes out a loan for a deal that falls flat and loses money? You guessed it, the other partner(s) will have to repay the debt.
• Filing tax returns is more complicated and hence expensive than for a sole proprietorship as there is a separate partnership return that must be completed (form 1065). If the books show a profit for the year, then that profit passes through to the partners as taxable income which they must report on their personal income tax return, even if the earnings are retained by the business for growth purposes.
• The partnership may end upon certain events, such as the death of one partner, unless there is an agreement setting forth what happens when some such event occurs. This may not be the result desired.
• It is more complicated to dissolve a partnership than to end a sole proprietorship.

Limited Partnership: This is another form of partnership where one or more of the partners has limited liability, in other words, a limited partner is only liable for debts and legal liability to the extent of that partner’s investment interest. This is a creation under state law, and each state’s laws regarding formation and maintenance of the limited liability status must be strictly followed.

Pros:

• It can be a very useful way to raise capital as offering limited liability to a potential investor may be an incentive for them to make the investment.
• The death, withdrawal, bankruptcy or retirement of a limited partner will not generally result in the termination of the partnership.

Cons:

• The cost of formation and maintenance is higher, as it is for a general partnership.
• State formalities must be strictly followed in order to form the limited partnership and to retain its status.
• It is possible for a limited partner to lose the limited liability status if that limited partner is deemed to have participated in the management of the business to a greater extent than is allowed under state law.
• Filing tax returns is more complicated, than for a sole proprietor, as was the case with a general partnership.
• It is more complicated to dissolve a limited partnership than to end a sole proprietorship.

Limited Liability Company (LLC): The LLC is a relatively recent creation under state law. It has only been around for thirty years or so, and some states have only recently climbed on board the LLC train. This entity provides limited liability for its “members” but allows those members to participate in the management of the business, unlike in the limited partnership.

Pros:

• Members enjoy limited liability, having liability only for debts up to the extent of their ownership interest.
  It is relatively easy to form, generally the only requirement is to file articles of organization with the state. This was a one page form when we did it in VT, for which we paid a fee of about $20 upon filing.
• There is great flexibility in management and control over the affairs of the LLC.
• If the LLC has only one member, then the income and expenses can be reported on a Schedule C on the member’s 1040 as for a sole proprietorship.
• The death, withdrawal, bankruptcy or retirement of a member may not result in the termination of the LLC, but consult with your attorney to determine what your state’s statutes provide. This issue should be addressed in an operating agreement drafted by your attorney.
• Ownership interests and rights to distributions can be divided differently, in other words, even if two members each own 50% of the business they can decide to split the distributions, for example, 60% – 40%.

Cons:

• Formation costs go up if you have an attorney prepare an operation agreement, which is always a good idea.
• It is possible for a limited partner to lose the limited liability status if that limited partner is deemed to have participated in the management of the business to a greater extent than is allowed under state law.
• If you have more than one member, you must file the 1065 tax return form as for partnerships, which is more complicated to prepare than the Schedule C for a sole proprietor.
• Some states impose a separate tax on LLCs.
• Even if the LLC retains earnings with which to grow the business, members must pay income taxes on those earnings.
• It is more complicated to dissolve a limited partnership than to end a sole proprietorship.
• You may need to convert to a corporation in the event you need to raise serious capital.

Business Corporation (C Corp): A corporation is also a creation of state law. It is a separate entity for taxation purposes, having shareholders, a board of directors, and officers for management of the business. In order to form a corporation, the founders must file articles of incorporation, a corporate charter (or the particular state’s equivalent) with the state authorities, which will detail the number of shares of stock that are authorized under the corporation, appoint an initial board of directors, and hold an initial organizational meeting of the board of directors. By-laws will generally be voted on an approved at the first organizational meeting. The by-laws can be general or very detailed. Certain formalities must be adhered to as required by state law, such as annual meetings of the board of directors, and minutes maintained of all regular and special meetings of the board of directors or shareholders.

Pros:

• Provides the most flexibility for raising capital.
• Shareholders enjoy limited liability to the extent of their investment.
• Directors and officers generally enjoy limited liability as well, although the “corporate veil” may be pierced under certain circumstances to expose individuals to legal liability.
• The entity continues until legally dissolved, regardless of the death, withdrawal, bankruptcy or retirement of any given shareholder, officer or director.
• Selling or transferring ownership interests can be more straightforward than with a partnership or LLC.
• If the corporation is for a small business, formation costs may actually be less expensive than for a partnership.

Cons:

• Generally speaking it is the most expensive form of entity to maintain. There are annual filing requirements and possibly franchise fees or taxes associated with maintaining good standing with the state.
• Earnings of the business are taxed twice. The corporation pays taxes on income (at a higher rate than that applicable to most individuals), and if there are dividends paid to the shareholders, they must pay personal income taxes on those dividends.

Subchapter S Corporation (S Corp): An S Corp is a corporation with that has made an S Corp election on form 2553 with the IRS. This means that the earnings of the corporation will flow through to the shareholders rather than be subject to the double taxation of a C Corp.

Pros:

• Pass through entity taxation. In other words, no double taxation.
• Some portion of distributions may not be subject to self employment tax.
• Shareholders enjoy limited liability to the extent of their investment.
• Directors and officers generally enjoy limited liability as well, although the “corporate veil” may be pierced under certain circumstances to expose individuals to legal liability.
• The entity continues until legally dissolved, regardless of the death, withdrawal, bankruptcy or retirement of any given shareholder, officer or director.
• Selling or transferring ownership interests can be more straightforward than with a partnership or LLC.
• If the corporation is for a small business, formation costs may actually be less expensive than for a partnership.

Cons:

• Just as expensive as a C Corp to form and maintain.
• There are a few more restrictions for raising capital than for a C Corp.