Understanding the Different Business Formations

If you are considering starting your own business, a crucial step in that process is deciding what business formation your enterprise will be. The choice of a particular business formation will impact items like how the company is taxed and potential personal liability for company obligations. Choosing the right formation at the outset can increase the chances that your business will achieve success.

What are the Options?

Quite often, very small businesses are organized under sole proprietorships. While sole proprietorships may be suitable for businesses that are exposed to only a minimal amount of risk, they are still not ideal because they offer no protection for their owners. If the company is the target of a lawsuit, the personal assets of the owner can be used to satisfy any judgment against the company.

Another type of business formation that provides no asset protection for its owners is a general partnership. These are easy to form as they do not require any formal documentation. A potential risk of a general partnership is that a partner could use the partnership to borrow money. If that partner defaults on the loan, and the partnership cannot satisfy the debt, the other partner could be held responsible for repayment.

Alternatively, a limited partnership offers some protection. Under a limited partnership, a general partner runs and manages the daily activities of the business. The general partner can be held personally liable for the company debts. The limited partner only provides funding for the partnership, with his or her risk only being the investment made in the business. It is also possible for a business to be formed as a limited liability partnership (LLP), in which all partners have protection from personal liability.

Most people are familiar with corporations, as they are the way most of the largest businesses are organized. Corporations are considered a distinct, separate legal entity from its owners. As a result, corporations offer personal liability protection, meaning the personal assets of the owners are not, under most circumstances, at risk. However, in very rare situations, the court can use what is known as “piercing the corporate veil” and hold owner’s personally liable.

In corporations, individuals known as shareholders own the business. The shareholders elect individuals to form the board of directors and the board appoints officers to run the company. Corporations can be formed as C-corporations or S-corporations. The only difference between the two relates to how the corporation is taxed. For small businesses that intend on remaining privately owned, S-corporation status is usually preferred.

Finally, a type of business formation that is gaining in popularity is the limited liability company (LLC). LLCs are becoming more popular because they offer the personal liability protection that corporations provide, but with different tax implications. Corporations are assessed what is considered double taxation, as shareholders who receives dividends are taxed in addition to the corporation being taxed for its profits. For LLCs, company profits are “passed through” to the personal income statements of the owners. However, there are disadvantages to LLCs, such as the possibility of the LLC terminating if more than half of the capital and profit interests are sold or exchanged within a one-year period.

Help with Business Formation

The above is a very brief overview of the various types of business formations. If you would like more information or help in forming your business, contact the experienced attorneys at the Philadelphia Small Business Law Center.

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