While starting a business is the dream of millions, one of the most important first steps for any potential business owner is to understand and evaluate the different types of business organizations that are possible and choose the one that would most effectively help the owner realize their business goals. The five most common types of business organizations are: sole proprietorship, general partnership, limited partnership, limited liability corporation and a corporation. Each type has its advantages such as management control or limited liability; as well as its disadvantages, such as unlimited liability and high tax rates. Indeed, exposure to liability or lack thereof, remains perhaps the main consideration of owners in deciding which business is best. Nonetheless, some businesses are more suitable to certain business types. For example, it is might be more appropriate for a fruit stand to be a sole proprietorship than a corporation, or a start-up tech company to be a limited partnership rather than a general partnership. In short, there is enough diversity in the most common business types to cover every type of business.
As the table above illustrates, the owner’s liability depends on the particular type of company. For a sole proprietorship, there is no way to limit liability to the lawsuit besides settling, winning the case or changing the business structure before the case goes to trial. Under the law, the business and the owner are considered the same. The best option for an owner to limit their liability would be to change the business structure to another form that allows less exposure to the business’ obligations.
What is true for a sole proprietorship is also true for a general partnership. If there was only one partner, then liability like the sole proprietorship rest completely with the one partner. However, as mentioned, if there was more than one partner, than obligations would be shared jointly. Accordingly, one option for the future is to add more partners. But while adding more partners may spread the obligation it also decreases control, as each partner will have an equal say in the administration of the business.
Depending on the arrangement, limited partnerships may provide an owner with complete or no protection from liability (Ribstein & Kobayashi, 2001). If the owner is a general partner, then they would be jointly and severally liable to the obligations of the business along with the other general partners. Conversely, if the owner was a limited partner, they would not be personally liable for the business’ obligations but might loss whatever amount they invested or value of the resources they contributed to the business if those assets are seized by creditors for payment of the business’ debt. Accordingly, if an owner wanted to limit his liability, he would need to either already be a limited partner or change his status from general to limited. It is important to note, that while limited partners are insulated from liability for the business’ obligations, they also limited in the amount of control that they have in managing or controlling the business.
Unlike the business organizations mentioned above, the owner of a limited liability company (LLC) is, mostly, protected from any liabilities that the business may incur (Booth, 1995). Accordingly, the best option for the owner to limit his liability was satisfied when he decided to choose the LLC business structure for his business. As mentioned in the table above, however, if the owner operates the LLC in a way that is indistinguishable from it being the owner acting personally rather than as a separate company; then a court might fight that the owner is liable regardless of the fact that the business is an LLC.
Lastly, a corporation like an LLC provides its owners with almost complete protection from personal liability for the debts and obligations of the business (Well, 2008). Accordingly, regardless of the results of the lawsuit, the corporation owners’ personal assets will never be subject to seizure by creditors. Although they might suffer a loss in the value of the stocks they bought to gain ownership status. Moreover, as mentioned, if it turns out that the owners’ breach of contract was as a result of fraud or the inadequate capitalization of the corporation when it was formed, their personal assets might be subject to seizure by creditors. Accordingly, an option to limit liability for owners would be to decrease the amount of stack that they own in the company.
It seems that one of the easiest businesses to start would be a law firm. All one needs to do this is a law degree and a bar license. But what would be the best business organization for a lawyer starting their own practice? Upon consideration, the LLC seems to be the best choice. One the hone hand, it is offers the advantages of a sole proprietorship, partnership and corporation. On the other hand, it provides flexibility to grow or contract as circumstances warrant.
First, as mentioned above, one of the key advantages of the LLC is its ability to insulate the owner from personal liability for the debts and obligations of the business. So in the event that my law practice does not succeed, and I am unfortunately able to pay my bills; my creditors will only be able to seize the business’ assets. A second advantage is management control. Like a sole proprietorship, as the owner, I have full authority to make all the decisions and control the operations of the business. Moreover, I can effectively keep primary control, despite other owners that may join in the future. Indeed, perhaps the most important advantage of an LLC is its flexibility. This flexibility will be controlled by operating agreement that I must draft when I form the business (Booth, 1995). Similar to a corporation’s articles of incorporation, the LLC operating agreement is used to define the purpose, structure and procedures of the LLC and its operation. Accordingly, if estimate that in the future there will be too much work for me to do on my own, I can invite other people to join me as a partner or owner of the business. Depending on what I originally put in the operating agreement, new owners can contribute money, resources, clients or even expertise as the price of ownership. While owners will have a say in the control of the business, as mentioned, depending on what is in the operating agreement, I can retain more control as a the founder, than other owners. Conversely, management could also be outsourced to a dedicated management team such as officers in a corporation. I can also control, through the operating agreement how profits are distributed (Booth, 1995). An LLC’s tax treatment is also an advantage. An LLC, for tax purposes, is not considered to be a separate entity from its owners like a corporation. Instead, an LLC enjoys the advantages of a sole proprietorship and partnership in that the taxes “pass through” the company to the owners. This means that the corporation will be taxed under the individual tax returns of the owners who most likely have a lower tax rate than a business. In essence, the business does not pay taxes, but the owner’s do. Lastly, LLC can, depending on the operating agreement “live” indefinitely even if an owner decides to leave, dies or is incapacitated. Accordingly, this will allow me (and other eventual owners) the flexibility to make long-term plans. It is important to note that one of the disadvantages of an LLC, is that like a corporation, to form one, I will need to abide by some formalities such as registering with the state, drafting the operating agreement and paying a formation fee.
Booth, R.A. (1995). Profit-seeking, individual liberty, and the idea of the firm. Retrieved from http://openscholarship.wustl.edu/cgi/viewcontent.cgi?article=1649&context=law_lawreview
Clarkson, K.W., Miller, R.L., & Cross, F.B. (2012). Business law: Text and cases: Legal, ethical, global, and corporate environment, 12th ed. New York, NY: Cengage.
Ribstein, L.E. & Kobayashi, B.H. (2001). Choice of form and network externalities. Retrieved from http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1413&context=wmlr
Wells, H. (2008, Sep.). The rise of the close corporation and the making of corporation law. Retrieved from http://scholarship.law.berkeley.edu/cgi/viewcontent.cgi?article=1055&context=bblj