When individuals come to me for help in selecting a legal structure for their new business, there is a standard decision process I lead them through. It begins with the following three major questions:

• “What type of business will you be engaged in?”
• “Do you plan to open a business that will require some type of liability protection?”
• “Will your customers be coming to you – or will you be going to them?”

The size, scope and type of business in which you plan to engage – whether retail, wholesale, franchise or e-commerce, to name a few – will greatly affect the legal structure you choose. These major choices fall into the categories of the sole proprietorship, partnership, C or S corporation, or Limited Liability Company (LLC). Among these categories, however, there exist more than 20 different subtypes of legal entities, each with its own pros and cons, rules and regulations.

When I ask people whether their business will require liability protection, the answer often turns from a “No” to a “Yes” when they stop to think. What about the client who steps foot into their home or office on an icy day, then slips and falls, with resulting injury? A $1 to $3 million business insurance policy is not enough protection against an individual who sues you for $20 million because he hit his head on a piece of equipment in your small business warehouse and was disabled for life.

The Sole Proprietorship
If customers are not coming to your home or to a physical place where you run your business, you may decide that you do not need to be incorporated. Instead you can operate as a sole proprietorship. The majority of small businesses in the U.S. are sole proprietorships. As the simplest structure under which you can operate a business, the sole proprietorship is not a legal entity in itself. Popular because of its ease of setup, low cost and simplicity, the sole proprietorship often operates under the name of its owner, such as “John Doe Plumbing.”

Even if the business is a mom ‘n pop venture, the Internal Revenue Service will allow the owner of a sole proprietorship to report business income and/or losses and expenses by filling out and filing a Schedule C, along with the standard Form 1040.

But what if your partner is not your spouse?

The Partnership
A partnership is a voluntary association of two or more people for the purpose of operating a business. The partnership is a structure in which each person contributes assets, labor or skills, and shares in the business profits and losses. You can form a partnership through an oral or written agreement. On their respective individual tax returns, partners must each report their share of the partnership income for the year, including gains, losses, deductions or credits.

In many unstructured partnerships, certain events may result in the termination of the partnership. When the rights and obligations of the partners have not been properly spelled out, you have a recipe for disaster. An attorney can help protect you by documenting how partnership assets are to be divided when the partnership is terminated. Before beginning a partnership, you must decide which partner is contributing what resources in the way of cash, assets, property and labor. How will profits and losses be calculated and shared? How will new partners be added? How can one partner buy out another? Who makes the decisions and how will disagreements among the partners be resolved? Ask your attorney to help you and your partner specify all aspects of the partnership.

• Personal liability is the biggest disadvantage of sole proprietorships and general partnerships

The biggest disadvantage of sole proprietorships and general partnerships is that the owner or owners remain personally liable for all the business’s debts, the actions of their fellow partners and court judgments. Creditors can bring lawsuits against the business owners, who must pay successful suits out of their own pockets after the assets of the business have been exhausted.

If the business itself can’t pay a creditor, such as a vendor or a lender, the creditor can legally go after the possessions of the business owner or any partner. Although you can, under certain conditions and in certain states, protect your home, your car and your 401(k), you can potentially lose everything else – vacation home, second vehicle, boat, investments and anything liquid such as your personal savings.

Owners of sole proprietorships or partnerships with employees have legal responsibility for the decisions made by those employees. There are a few exceptions to this personal liability. Some partnerships can be set up as a special limited liability partnership (LLP), in which only the general partner, who runs the business, has personal liability. Often the limited partners in this arrangement are passive investors whose limited liability means they can lose no more than their stake in the partnership. To create a limited partnership, you must follow the requirements of your particular state’s statutes.

Concern over personal liability may lead you to choose to incorporate your business or operate as a limited liability company (LLC). Downloading a form from the Internet and sending it in to your state authorities, however, is not the wisest course. Consult an attorney before deciding on a legal structure for your business. The highlights of the most common legal structures – the LLC and C or S corporations – are presented below.

The Limited Liability Company (LLC)
In some states, only one person is required to form an LLC. An LLC can have an unlimited number of members or owners. To sell their interest in the organization, LLC members must have the approval of the other members. In an LLC, income and losses pass through to the owners, who are taxed on their personal tax returns. Non-U.S. citizens can be shareholders of an LLC, and it can be owned by a C corporation, an S corporation, a trust, another LLC or a partnership.

The C Corporation
To form any corporation, you must file the appropriate forms with a state. Most states charge a fee for filing the corporate documents plus an annual fee as long as the corporation is in existence. A corporation is its own legal “person,” separate from its owners. This means that creditors of the corporation may seek payment only from the corporation and its business assets. A C corporation offers owners limited liability protection. There is said to be a “double tax” on C corporations, because income is taxed twice – once on the corporation’s returns and once on the shareholders’ returns. Shareholders do not report any portion of corporate income or losses on their individual returns. Income passed on to the shareholders as salary or dividends, however, is considered taxable income for them.

For income tax purposes, business owners must choose whether their corporation is to be a C or an S corporation.

The S Corporation
A Subchapter S corporation – also known simply as an S corporation – also offers owners limited liability protection. An S corporation is a “pass-through” tax entity, meaning that income or loss generated by the business is reflected on the personal income tax returns of the owners or shareholders. Unlike the C corporation, the S corporation has no possibility for double taxation.

One person can form an S corporation, but ownership is restricted to 75 shareholders. An S corporation cannot have non-U.S. citizens as shareholders. All of the shareholders must be individuals. In other words, S corporations cannot be owned by a C or another S corporation, an LLC, a partnership or many types of trusts. Shareholders may sell their interest without obtaining the approval of the other shareholders of that S corporation. The S corporation can have only one class of stock and must operate on a calendar year financial basis.

• Beware of “Piercing of the Corporate Veil” and personal liability

In an action called “piercing the corporate veil,” an aggressive plaintiff’s lawyer can still get to your personal assets even after you have incorporated your business. This can happen especially if you have failed to have the requisite forms and documents. These include, but are not limited to, items such as:

- Corporate record book
- Bylaws
- Minutes from regular meetings of the shareholders and directors
- Stock certificates
- Stock ledger
- Corporate seal (in some states)

Despite the general principle that shareholders cannot be held personally liable for the debts or liabilities of the corporation, a court of law can set aside a corporation for purposes of the litigation. This means that personal liability attaches to the shareholders and their personal assets can be reached. I advise my clients to take as many arrows out of the plaintiff’s quiver as possible to prevent a piercing of the corporate veil and exposure of their personal assets.

Author Bio

Ralph DiLeone is managing partner at The DiLeone Law Group, P.C., a law firm based in Raleigh, N.C., which provides legal services concentrating in business and estate planning matters. Established in 2000, the firm’s principal practice areas include: acquisitions and mergers, buy-sell agreements, computer software contracts, consulting agreements, corporate succession planning, employment contracts, estate planning – wills and trusts, executive compensation arrangements, financing, franchising, incorporations, independent contractor agreements, joint ventures and partnerships, license agreements, lease agreements and royalty agreements.