NH Legal Perspective -- Choosing a business entity: The unincorporated optionsBy PAUL REULAND
May 19. 2018 8:20PM
(First of two parts)
A critical decision for any startup is choosing the appropriate and most beneficial legal entity in which to operate. If chosen properly, the characteristics of the entity can serve as a valuable foundation in helping a business achieve its goals. If chosen improperly, it can hinder a business's growth and expose its founders to unexpected personal liability.
This article highlights some of the important distinctions between the most commonly used business entities, focusing on unincorporated entities.
When choosing a business entity, there are numerous considerations. The focus here is on three of the primary ones: limitation of liability; impact on taxation; and flexibility to raise capital for future growth.
The starting point of any analysis should be the recognition of the fundamental distinction between incorporated and unincorporated businesses: the limitation of personal liability.
Specifically, owners of an unincorporated business may find themselves personally liable for the debts and obligations of the business, whereas directors and officers of an incorporated business, absent certain misconduct, will not be held responsible for debts of the business. Though the inability of an unincorporated entity to limit personal liability is a significant drawback for some, the unincorporated form offers many attractive features, including managerial flexibility, simplified tax accounting and reduced administrative costs.
The most basic form of unincorporated business is the sole proprietorship. As its name suggests, a sole proprietorship is owned by one individual who retains complete managerial control over the business. The unparalleled control offered by this entity is often crucial to getting an early-stage idea off the ground.
As with all unincorporated entities, the owner is personally liable for the debts of the business. While this may seem risky, not all businesses engage in activities that subject them to an inordinately high level of risk. Furthermore, a business owner's personal umbrella policy may insure against some of the risks associated with operating a sole proprietorship. Despite these considerations, before beginning business operations, it is prudent to consult an experienced business attorney and insurance agent to identify the risks a particular business may face and what level of insurance coverage may be necessary.
From a tax standpoint, sole proprietorships are appealing because of their simplicity. This simplicity comes from the fact that the profits and losses generated by a sole proprietorship are reported on the owner's personal federal and state tax returns (this is frequently referred to as "pass-through" taxation). As a result, in the event of business losses, the owner of sole proprietorship may use them to offset income earned from other sources. The owner will, however, be responsible for self-employment taxes and making quarterly estimated tax payments on his or her income to the IRS.
The growth of a business, although difficult to anticipate, should also be considered when choosing an entity. The prospects of raising significant capital as a sole proprietorship are not strong. Because the owner retains absolute managerial control, outside investors have limited ability to oversee and protect their investment and, therefore, are reluctant to lend funds. As a result, sole proprietors usually rely on their personal resources or those of close family and friends.
A partnership exists when two or more people operate a business for profit. While partnerships have been in decline since the introduction of the Limited Liability Company (LLC) in 1977, they are still a commonly used business entity.
Partnerships usually exist in one of two forms - general partnerships or limited partnerships. General partnerships and limited partnerships share many of the same advantages as sole proprietorships, most notably the simplicity that comes with "pass through" taxation.
The most significant distinction between a general and limited partnership is the apportionment of control and liability. In a general partnership, the partners are jointly liable for the debts of the business and share managerial control. General partners are authorized to enter into binding contracts on behalf of the partnership and can be held vicariously liable for actions of other partners. As a result, a high level of trust between partners is essential.
Limited partnerships are comprised of both general and limited partners. General partners are personally liable for the debts of the business and maintain managerial control. Limited partners are investors only, and their liability for the debts of the business is limited to the extent of the money they have contributed. In return for limited liability, limited partners do not have any managerial control over the business.
Many people assume a partnership is always formed by an agreement; however, a partnership may arise, absent an agreement, by operation of law. In these situations, the partnership is governed by the laws of the jurisdiction in which it is operating, which may or may not conform the expectations of the partners. Therefore, the importance of a having partnership agreement in place before beginning business operations cannot be understated. A carefully drafted agreement can, among other things, prevent future disputes concerning a partner's rights and/or obligations to the businesses and assist in a smooth transition should a partner become unable or willing to continue on in the business.
Next week's column will address incorporated entities and the key legal and business distinctions between unincorporated and incorporated entities.
Paul Reuland leads the Start-Up Team initiative for Sheehen Phinney Bass & Green. He can be reached at email@example.com. NH Legal Perspective is a biweekly column sponsored by Sheehan Phinney Bass & Green PA. This column does not provide legal advice. We recommend that you consult an attorney for specific guidance on legal questions.