Choice Of Entity For The Start-Up

T. Randolph Catanese, Esq. © 1999. All Rights Reserved.

The choice of entity for the start-up company will impact the company well into its immediate and long term future. The choice of entity has significant ramifications for liability, capital raising and tax purposes, to name a few critical areas. This article is the first in a series of four articles discussing entities which are available to the start-up, how these entities differ and what benefits and detriments are applicable to each.

Generally speaking, entities which would be recognized under United States law are the sole proprietorship, corporations (including S corporations), general partnerships, limited partnerships, limited liability partnerships and limited liability companies. Some entities have the same characteristics, others do not. For example, all corporations would carry with them some form of limited liability to the owner/shareholder. Whereas, a sole proprietorship and general partnership would have little, if any, limitation on personal liability to the owner/general partner. Yet, an S corporation, limited liability company, sole proprietorship and general partnership each have many of the same characteristics for purposes of income taxation to the respective owners. These kinds of issues will be discussed in greater detail in this series.

What is the sole proprietorship? A sole proprietorship arises where someone begins doing business without setting up any separate form of entity. Many times this arises where the entrepreneur starts to do business without any formalities due to lack of time or capital. The entrepreneur takes the position that the formalities will be observed once money is raised. As discussed below, for may reasons this kind of thinking may lead to later problems.

If a sole proprietorship is intended, the owner of the business will normally file a fictitious business name statement in the county where the entrepreneur resides. For example, if the entrepreneur was doing business as internetgames.com and they resided in the County of Los Angeles, they would file a fictitious business name statement with Los Angeles County stating that they are fictitiously doing business under the name internetgames.com. The fictitious business name is preceded by a publication which is circulated in the County, normally by publication which is continuously published for at least four weeks. (Many times a bank will not permit a checking account to be established under the fictitious business name without proof of a fictitious business name filing.)

One of the major limitations and deficiencies to a sole proprietorship is exposure to personal liability. If a lawsuit is brought under any theory, the individual owner is personally liable. There is no separation from the entity. Moreover, the individual may also be precluded from taking advantage of certain tax opportunities which are available to corporations. Another problem faced by the owner of a sole proprietorship is the fact that they are unable to offer any equity in their business. They limit themselves from issuing equity since a sole proprietorship has no equity to give. So, in effect, from the start a sole proprietorship is limited in raising capital. Normally, when capital formation issues arise the sole proprietor will immediately move into an entity which allows for the sale of equity interest in the business in exchange for raised capital.

Another entity which is sometimes used in start-up companies is a general partnership or limited partnership. The general partnership normally arises where two or more partners agree that they will carry on business for their common benefit equally dividing income and losses. In most states a general partnership may arise by the actions of the parties even in the absence of a written agreement. And, where no written agreement exists and a general partnership is found to exist, the law of the particular state will apply to govern any partnership disputes. Most states have adopted the Uniform Partnership Act to govern how general partnerships are to be regulated in the absence of a written agreement. General partnerships, like sole proprietorships, do not relieve the general partners of any personal liability. Even worse, one general partner may be held accountable for the actions or omissions of another general partner. That means that if one were determined to be a general partner, one would be held accountable for damages that might be caused by their partner even though they did not know about the actions and were not aware that they were taken. (At least in a sole proprietorship you know what may cause you liability.) Like a sole proprietorship, a general partnership will allow for pass-through of tax benefits directly to the partners. Unlike the sole proprietorship, a general partnership does allow for new partners to be brought in exchange for capital contributions which are recognized under state law. Nonetheless, most capital sources do not want to be treated as a general partner primarily due to open-ended liability as discussed above.

Because of the liability issues inherent to a general partnership, limited partnerships were developed. In a limited partnership, the general partner operates the partnership and has the major exposure for its operations from a liability standpoint. The limited partners can obtain equity in the partnership, but because they have no management control they have limited liability. Their liability is limited typically to the amount of their investment (capital account) or other rights to profits that they have in the partnership. Hence, the name "limited" partnership. And, like the other partnerships, tax benefits pass directly through the partnership to the various partners. Limited partnerships generally require a written agreement, but like general partnerships in the absence of a written agreement the Uniform Limited Partnership Act will control. (In many states, in the absence of a written agreement, although the parties might intend to form a limited partnership, the partnership would be treated as a general partnership since no agreement to the contrary exists.)

The sole proprietorship, general partnership and limited partnership each are progressive levels of entity formation. The sole proprietorship in many instances is the most inexpensive and easy way to move forward with a business. The general partnership usually occurs where two or more partners begin to work together with the expectation that a later corporation or entity will be formed, again, it allows for an expedited business formation. The limited partnership requires more attention and effort by all parties, including documentation, and generally speaking is not a preferred model given the needs of modern day internet and technology companies.

In the next segment of this series, corporations, including their benefits and drawbacks, will be discussed.

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