By Jennifer Reuting, author of Limited Liability Companies for Dummies™
First of all, what is a sole proprietorship? That's simple! A sole proprietorship automatically exists whenever you are engaging in business by and for yourself, without the protection of an LLC, Corporation or Limited Partnership. Your kids selling lemonade on the street is a sole-proprietorship.
Sole proprietorships are so easy to start-up that you could be in one and not even know it! If you ever do contract work for a company and you are not on the payroll, you are a sole-proprietor. Or, if you sell your crafts at a local flea market, you are a sole-proprietor. In some states, only a business license is required and, being a sole-proprietorship, there are no other legal formalities. Being a sole-proprietor is easy.
However, all roses have thorns and although the sole proprietorship is simple to set up, it doesn't even come close to comparing to an LLC or a Corporation. Unlike an incorporated entity, when you are operating as a sole-proprietorship, your personal assets are completely at risk from being seized by a judgment or other creditor. There is an old saying… "You aren't in business until you've been sued" and when you are operating as a sole-proprietor you are practically setting your most precious assets on the curb. And, as far as healthcare goes…as a non-incorporated entity, you can't even offer insurance to yourself, your family or your employees!
Want to raise money or acquire a loan for your new business? Fat chance! Normally, in order to raise money, you sell shares of your company. Unlike LLCs or Corporations, sole proprietorships don't have shares to sell. Remember, in a sole proprietorship, your business is YOU. So, unless you're desirous of cutting yourself up into little pieces, this probably isn't the way to go.
Once a sole proprietorship brings on its first partner, a general partnership is formed. No filings need to be made and no paperwork needs to be completed. You can bring on partners with only a handshake and a smile and they are official.
Think business is going to be any easier when you have someone to share the ups and downs with? Think again. General partnerships (commonly just called "Partnerships") can be even more dangerous than sole-proprietorships when it comes to liability. In general partnerships, each partner is equally responsible for all judgments, taxes and debts of the business. This means, that not only do you bear the same responsibility that you would in a sole-proprietorship, but you are also responsible for any wrongdoing or debts acquired by your partners!
Think of Limited Partnerships as a hybrid between the General Partnership and the Limited Liability Company. The Limited Partnership provides liability protection to the silent partners in the business (called "limited partners") but not the operating partners in the business (called "general partners"). The limited partners receive profit distributions, but do not take an active role in the day-to-day operations of the business. Because of this liability protection, all that the limited partners have to lose is the total amount that they have invested in the company. However, the general partners in the business, who manage the day-to-day operations, still are completely at risk.
Now, the mother of all partnerships is the Limited Liability Company ("LLC"). Unless you have never been involved in business, or just recently moved to the U.S., I'm sure you've heard of it. Unlike the Limited Partnership, which has liability protection for only some of the partners, the Limited Liability Company protects everyone - the members, the managers and even your Aunt Peggy, if she decides to work for you. Short of some wild criminal offense, you can pretty much rest assured that yours and your partners' personal property will remain safe and sound and in your possession.
The only possible drawbacks of an LLC is that it is still a partnership. Which means that, for the most part, you need a partner. Even if your state does allow single-member LLCs (LLCs with only one owner) you should still have a partner for liability purposes - which I discuss in further detail in the book, Limited Liability Companies for Dummies. And to all of the cheapskates out there who's throats tighten at the thought of sharing their pie, you don't have to give away too much - one or two percent should do it. Surely you have a friend, family member or charity that you like that much, right?
A lot of people compare LLCs to Corporations, but they are indeed very different. Not only are they taxed differently (this goes for S-Corporations also) but LLCs have a second level of liability protection that even Corporations don't have. This is called Charging Order Protection. This second level of protection keeps your LLC safe in the event that you get sued. For instance, say you back into someone in the shopping center parking lot. A savvy victim would be itching to take your personal assets, including your business interests. Well, as long as your business interests take the form of membership shares in an LLC, as opposed to stock in a corporation, your company will be safe and sound!
The next step up from an LLC is a Corporation. Corporations are different in the sense that they are a completely unique entity upon themselves. Meaning, they are separate from you in every way. Creating a Corporation is almost like creating another person.
Because Corporations are legally separate entities and they also have a much different tax structure. They pay their own separate taxes at a corporate tax rate instead of a personal tax rate. This tax is assessed on the profits (the money that is left over at the end of the year) as opposed to the business's gross income.
In addition to the separate tax structure, Corporations have an unlimited life, free transferability of ownership (unlike LLCs, where it's harder to transfer your membership shares) and tax benefits that allow for many more deductions. A corporation also has complete flexibility in ownership and management structures. These benefits make corporations an ideal choice for businesses intent on going public but, with all of the recordkeeping requirements, can also create paperwork havoc for small businesses.
An S-Corporation is subject to the same filing requirements (e.g. "paperwork havoc") as a regular Corporation (also sometimes called a "C-Corporation), however has a pass-through tax status that is similar to a partnership, though filed on a different addendum to your personal return. This makes life a little bit easier by avoiding the need to calculate corporate taxes and file a corporate tax return. It is also great if you have a lot of business losses that you wish to deduct from some of your personal income.
Designating a corporation as an S-Corporation is easy. It is just a matter of filing a Small Business S-Election (form 2253) within three months of formation.
A word of caution — S-Corporations have severe ownership limitations. Non-U.S. citizens and other entities cannot own shares in an S-Corporation and the number of shareholders is limited to 100. Also, all shares are equal, meaning that the officers of the company cannot place limitations on any set of shares, like they can in an LLC.
Mike received a sizeable inheritance and has decided to start a taxicab company in New York City. Although the competition was fierce, after a couple of months he is up to seven taxis in his fleet and the money is rolling in. Then, one day, one of his drivers calls him from the road - he's been in an accident. Mike learns that a new driver he hired wasn't paying attention and seriously injured a man crossing the street. Mike fired the driver and sent his condolences to the man in the hospital and even went so far as to offer to pay his hospital bills, yet the victim wasn't consoled by his efforts. Two weeks later, Mike is served with a lawsuit.
Upon finding out the man might never walk again, Mike's attorneys decided to settle out of court. The sum was vast, but Mike didn't have any choice. Because Mike had not formed a corporation or LLC, not only did the judgment force him to liquidate his entire business, but he also had to sell his home and give up a substantial amount of his children's' college fund. Mike was devastated - especially when he learned that had he formed an LLC, only the business would have been lost and his home and family's financial future would have remained intact. He was especially surprised to learn that had he placed each vehicle into a different LLC, only the car that hit the victim would have been able to be seized and Mike would still have his business and six cars in his fleet.
