Entity Selection is one area where Montesino Law helps entrepreneurs protect their interests. We’ve written the following brief summary about entity selection to give potential clients an idea of the issues involved. Please note that this summary is for informational purposes only and should not be relied on as legal advice (full disclaimer available here).
Entity Selection should take into consideration the unique needs of the business. It is important to take these needs into consideration when deciding what type of business entity is right for your business. Here you will find a basic description of some of the most common forms of business entities.
The simplest and most basic form of business is the sole proprietorship. These are simply businesses owned by a single person that have no legal distinction between the owner of the business and the business itself. Sole proprietorships are the simplest type of business entity to create, yet also come with some financial hazards. To set up a sole proprietorship in Florida, one can simply go into business.
The simplicity of creating a sole proprietorship is also reflective of the taxation, duration, and lack of personal asset liability protection that accompany this type of entity. Unlike the traditional corporation, a sole proprietorship is only taxed through the personal income tax filing of the business owner. This is done by way of the business owner simply filing the business’s profits or losses as their personal income for that fiscal.
The duration, or lifespan, of a sole proprietorship is also quite simple. Sole proprietorships usually come to an end when the business owner passes away or simply ceases all business activity. A sole proprietorship, in and of itself, cannot be sold. However, the assets of the business can be sold.
Unfortunately, the simplicity of the sole proprietorship comes with the risk of liability to the owner. This risk stems from the fact that there is no legal distinction between the owner of the business and the business itself. Thus, the business owner is personally liable for any debt or legal liability incurred by the business. This liability is said to be “unlimited” because, in order to satisfy any of these outstanding debts or judgments, a creditor may go after, not only the assets of the proprietorship, but also the owner’s personal assets, even if they are unrelated to the operation of the business. This unlimited liability is often the reason why business owners opt to form separate business entities.
General and Limited Partnerships
A general partnership is similar to a sole proprietorship, but there is more than one owner of the business. Like sole proprietorships, general partnerships are easy to form. A general partnership in Florida also has the option to register with the Department of State, yet this is not a mandatory step.
Another optional, yet highly recommended, step towards partnership would be for the potential partners to form a partnership agreement. This is a contract that stipulates the important terms and conditions of the business relationship. Florida law defines a general partnership as when two or more persons carry on as co-owners of a business for profit, whether or not the persons intend to form a partnership. This means that people may form an accidental partnership, if they regularly share the profits of a business.
Much like the sole proprietorship, a partnership’s profits are not directly taxed, except through the individual tax filings of the partners. However, in contrast to a sole proprietorship, where all of the business’s profits are going to a single individual, the business’s profits are now being split by more than one owner. The partnership does not pay taxes, but must report its income by filing an IRS 1065 form and accompanying schedules that allocate the income amongst partners.
Again, like a sole proprietorship, partners in a general partnership face “unlimited” liability, meaning that “all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed”. This makes a general partnership a risky form of entity for all involved, as any of the partners can be held personally liable for all of the partnership’s obligations and not just the amount proportionate to their ownership. Furthermore, a partner’s personal assets are up for grabs when it comes time to settle a partnership obligation, including the partner’s ownership interest in the business. If a partner is held entirely liable, they can then seek contribution from the other partners if the other partners are solvent. Unfortunately, in a worst case scenario, a single partner can be stuck with the task of settling all of the partnership’s obligations out of pocket.
Limited partnerships, as opposed to general partnerships, allow for certain partners to still share in the profits of the business, yet avoid the unlimited personal liability that comes with being a general partner. Instead, limited partners face limited liability, meaning that the only money they risk entering the partnership is the money that they invest into the business. Limited partners enjoy this insulation from unlimited risk as a result of their minimal involvement in the business operations of the partnership. For example, limited partners cannot make binding decisions in representation of the business. This being the case, limited partnerships still require at least one general partner, who will face unlimited personal liability for the obligations of the business. Additionally, if limited partners do begin making significant business decisions for the partnership, their role might automatically be transformed, by law, to that of a general partner; the former limited partner’s liability would then become unlimited. These limitations make the role of a limited partner attractive only to people who wish to make business arrangements that amount to passive investments. Furthermore, a limited partner’s stake in the business can still be seized by outside creditors in order to settle personal debts.
The lifespan of general and limited partnerships usually come to an end when the partners decide to go their separate ways. However, the dissolution of a partnership is usually more complicated than the demise of a sole proprietorship and can be made more predictable by the usage of a partnership agreement. Even in partnerships consisting of more than two original partners, the exit of only one partner can trigger the end of the current partnership. This departure, called dissociation, can be either “rightful” or “wrongful”. In the event that a partner’s dissociation is determined to be wrongful, that partner will become liable to the partnership and to the other partners for any damages caused by their wrongful dissociation.
Depending upon the manner of a partner’s exit, a partnership may be forced to complete its current obligations and then close up shop permanently. In other instances, the partnership may continue to do business after the exit of a partner, yet the old partnership is deemed to be legally dissolved, giving way to a new legal relationship excluding the departed partner. Additionally, a partnership may avoid being dissolved through an agreed buy back of the exiting partner’s interest in the business.
Traditional corporations are a complex form of business entity requiring, by law, formalities in order to retain corporate status. Traditional corporations are generally appropriate for large businesses that have many owners, yet, occasionally, it also makes sense for a smaller business to incorporate.
When choosing to incorporate, a business must first choose which state it wishes to incorporate in, as each state has different corporate laws and regulations. This decision also has implications for taxation and possible venues of future litigation. Once a state of incorporation is chosen, the company must choose a name and file articles of incorporation with the Department of State.
After the articles of incorporation are filed with the state, the named directors of the corporation must hold a board of directors meeting and adopt bylaws. Bylaws are of the utmost importance as they often include rules for the appointment of corporate officers, the authorization of issuance of shares of stock, and other important business matters.
Incorporation comes with many pros and cons. The main benefits of incorporating are limited personal liability and the ability to easily raise capital through sale of shares. Corporations are completely separate legal entities from their owners. This being the case, an individual shareholder is nearly always shielded from personal liability for the actions of the business (assuming that the corporate formalities have been complied with). Thus, usually, a shareholder is only risking the money he puts into the business. However, a shareholder’s creditor may receive a judgment authorizing the seizure of a shareholder’s shares in order to settle that shareholder’s personal debts.
Additionally, the ability to issue and sell shares of the business to other parties allows the corporation to raise quick money in ways that other business entities cannot. This allows corporations to be flexible enough to take on many owners or to buy out existing shareholders in order to limit the amount of owners. Furthermore, corporations can use this ability to offer prospective employees stock options and other benefits.
Along with the benefits of incorporating come a major downside, double taxation. Double taxation means that both the corporation’s profits are taxed and then the shareholders’ individual portions of the profit are taxed again through personal income tax filings. This is a major disadvantage for small businesses and is usually the reason why it does not make sense for small businesses to choose this type of entity.
After filing articles of incorporation with the state, a business may elect to become an S corporation by filing as an S corporation with the IRS. An S corporation comes with the same limited liability for its owners as traditional corporate shareholders enjoy. However, an S corporation is not subject to double taxation, meaning that it is only taxed through the personal income tax filings of its owners. Additionally, S corporations come with certain employment tax breaks.
This type of entity is usually a good fit for midsized businesses. This is because the seemingly “best of both worlds” features of an S corporation come with several regulations and restrictions that other entities do not face. The most notable of these restrictions are that S corporations have a maximum number of shareholders allowed, which traditional corporations do not, and S corporations may not have shareholders that are not U.S. citizens or other business entities, making them unsuitable for foreign investors.
Limited Liability Companies
Limited liability companies (LLCs) are often a good choice for small businesses, especially in Florida, for several reasons. Owners of an LLC are referred to as members. Members of an LLC enjoy the same limited personal liability that shareholders of corporations enjoy, while also receiving the benefit of single taxation.
To create an LLC, the founders must file articles of organization with the state, similar to the process by which corporations are founded. The members of the LLC may then draft an operating agreement (this is analogous to the bylaws of a corporation).
When compared to all of the other types of entities previously discussed, members of multimember LLCs receive one safeguard that is unique and powerful, protection of their business interest from personal creditors.
In Florida, and several other “debtor friendly” states, when a member of a multimember LLC is sued, his ownership stake in the LLC cannot be taken away to satisfy a debt. This is because Florida law explicitly provides that “a charging order is the sole and exclusive remedy by which a judgment creditor of a member or member’s transferee may satisfy a judgment from the judgment debtor’s interest in a limited liability company or rights to distributions from the limited liability company.” A charging order is a lien upon a debtor’s business interest, which requires the LLC to pay the creditor all of the distributions that would usually be paid to the debtor/business owner. However, LLCs are not required to make distributions to the owners and can, instead, elect to keep profits and losses within the company as assets of the business itself. Thus, a charging order is largely ineffectual, as a multimember LLC, in which the debtor in question has influence, can elect to halt distributions indefinitely. This extraordinary asset protection, extreme flexibility, and the fact that members of LLCs need not be U.S. citizens, make LLCs an attractive choice for small businesses.
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