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Partnership, S-Corp, or LLC? How to Choose a Business Entity

I periodically give a SCORE workshop called Legal Issues for Startups, where I get lots and lots of questions about what sort of business entity to form — Should I be incorporated?  If so, where — Nevada or California or both?  Should I be an LLC or an S-Corp?  And what is an S-Corp anyway?  How about just being in a partnership?  Anything wrong with that?*

The answers to these questions boil down to two basic issues:  liability and taxes.  As a lawyer, I regularly advise my clients about the liability issues, but always recommend they check with a qualified accountant to get specific tax advice before making a final decision.**

Here’s how the liability issues work:  A corporation (or LLC)  is a separate legal entity that exists independently of its owners (who may buy and sell shares or otherwise change over time).  The debts of the corporation belong to the corporation and, provided the owners are careful about maintaining corporate formalities, their personal assets are protected and cannot be used to satisfy corporate debts.  In a sole proprietorship or partnership, on the other hand, the business debts are also personal debts, and there is no protection of personal assets when the business can’t pay.

Now, in practical terms, this may not matter too much if you are the sole owner of  a small business where you have signed personal guarantees for credit and where there isn’t much risk of being sued (e.g., certain types of consulting services).  In those situations, it may not be worth the cost and hassle of forming a corporation or LLC.  I generally recommend those clients get good insurance instead — including professional liability insurance if possible.

But if you own your business with a partner — be careful!!! 

Most people don’t realize that even if you divide up responsibility with your partner on a 50-50 basis, the partners are each “jointly and severally liable” to third parties for the partnership debts.  This means that either partner could be forced to pay  100% of the partnership debts out of his or her personal assets, if the other partner was unwilling or unable to contribute his share.  And, unless your partnership agreement says otherwise, each partner can legally bind the partnership to a debt without the other partner’s consent.  So, not only could you be held 100% liable, but you could be held liable for a debt you never even knew existed.  From a liability standpoint, partnerships can be very risky for a small business.  I generally recommend that all small business partners should consider forming a corporation or an LLC (though check with your accountant about possible tax consequences of conversion first!).

As for the difference in liability protection between a corporation and an LLC, I believe that the corporate form is probably stronger.  That’s because corporations have been around for hundreds of years and there are a lot of court cases testing the ability of creditors to “pierce the corporate veil” and use the owner’s personal assets to satisfy debts.  These cases are decided by the extent to which corporate owners have consistently treated the corporation as a separate legal entity (maintaining adequate working capital in a separate bank account, not commingling funds, keeping accurate corporate books and records, holding required board and shareholder meetings, etc.), rather than simply as an alternate bank account for their own personal transactions.

On the other hand, LLC’s are fairly new, and there are not yet a lot of cases deciding whether and when a creditor can “pierce the corporate veil” to reach the assets of the owners.  With an LLC, there are very few corporate formalities to follow (which is why it is so popular) — no board meetings, no minutes, no officers and directors.  This means it is easier for owners to ignore the fact that they’ve set up a separate legal entity (e.g., by commingling funds or drawing money out of the business at random).  It’s also harder for owners to prove that they’ve maintained a separate legal entity.  So the liability protection may be less clear.

Bottom line, I often recommend to clients — particularly those in high-risk industries, like restaurants and food preparation — that they form a corporation rather than an LLC.  Sure, it’s a bit more complicated and there are more paperwork headaches, but some of that comes with the territory of running a business. And the extra protection may be well worth the additional paper.

*[To take these questions in reverse order — yes, there are potentially a lot of things wrong with being in a partnership (especially if you don’t have a good written agreement) because of joint and several liability; an S-Corp is a tax classification that allows corporate revenues to be taxed on an individual or partnership basis (“pass through” taxation), unlike a C-Corp where the corporation pays taxes on its income and the owner pays taxes on dividends (the so-called “double taxation” problem);  S-corps may have advantages over LLC’s from the standpoint of liability protection, though this is mostly a tax question that should be decided with the help of an accountant; you should incorporate in California if you are doing business and generating  income in California, because you will probably be taxed on it here regardless; and you should form a corporation if you intend to attract outside investors, or if you are in a business that puts you at risk for being sued, or your accountant tells you there are tax advantages to doing so.]

** As discussed in my workshops, in general, there are a couple of general tax advantages to forming an S-Corp over and LLC in California.  First, S-Corp owners can take part of their compensation as salary and part as distribution of earnings, which means they can avoid paying payroll taxes on the distribution portion (provided the salary is “reasonable”).  This is not possible with an LLC, since there are no shareholders and  no mechanism for making a shareholder distribution (though LLC’s can elect to be taxed as S-Corps, which is a complication I won’t attempt to address here).   Second, S-Corps pay California franchise taxes on the basis of net income, whereas LLC’s pay franchise taxes on the basis of gross revenues.   In a year when an LLC doesn’t make any profit, it may therefore still find itself liable for the minimum $800 franchise tax, and possibly more, based on the amount of revenue received.  For these reasons, as well as the potentially greater liability protection, I think the  S-Corp  is generally preferable over the LLC.

2 Comments Post a comment
  1. susi hughes #

    This summary of business entity possibilities is very helpful. Do you have comments or perhaps other blogs (did not see in your archives) pertaining to sole proprietorships working with independent contractors as an alternative business structure?

    April 25, 2011
  2. Susi: Thanks for your comment! You make a good point — sole proprietorships can keep things simple by contracting for services (rather than taking on employees), and that way avoid payroll taxes, unemployment insurance and workers’ comp obligations. But the issue of whether someone working for you is legally considered an employee vs. an independent contractor can be tricky — it really depends on how much control you have over the way they perform the job. And small business owners often get in trouble by treating workers as employees, but then thinking they can convert them to contractors just by issuing 1099’s. I haven’t written about this yet, but this is a good topic for a future blog post — coming soon, I promise!

    April 26, 2011

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