Four Types of Small Businesses and Their Operations. Sole Proprietorships. Partnerships. Corporations. Limited Liability Companies (LLCs).

June 23, 2010 by · Leave a Comment
Filed under: Entrepreneurship 

There are many different ways to organize a business—from sole proprietorships to subchapter S corporations. Over the years we have found that many small business owners do not know what type of business organization they are operating under. Often they think their business is a corporation because they use the word company in the business’s name. Sometimes they know a lawyer or accountant took care of the legal formalities when the business was formed years ago, but they do not know exactly what was done and have not worried about it since.
Since the nature of a business can have a great effect on what type of bankruptcy you or the company can file, it is worthwhile to take a minute to read over this section.

Sole Proprietorships

The most common business form in the United States is the sole proprietorship. All forms of business, from the corner lemonade stand to multimillion dollar companies, can exist as sole proprietorships. Unlike a corporation or a limited liability company (LLC), nothing needs to be filed with the government in order to bring a sole proprietorship into existence. A sole proprietorship is formed the instant a person begins operating a business without a partner or filing to change the business’s status.
A sole proprietorship is the legal term for an individual operating a business without special status (such as corporate status). A sole proprietorship is merely an extension of the person who is operating the business. The business’s debts are considered to be personal debts of the entrepreneur while the business’s assets can be reached in order to satisfy the individual’s personal debts. There is no legal distinction between the person and the business.
The most prevalent misconception surrounding sole proprietorships is that once the business’s assets are sold off, the business’s creditors cannot go after the individual’s property. This is wrong. Because the sole proprietorship and the entrepreneur are considered one and the same, a debt against one is treated as a debt against the other. The entrepreneur must incorporate or seek some other form of legal protection in order to protect his or her personal property.

Partnerships
A partnership is formed when two or more individuals agree to operate a business without filing for special status.
Partnerships are very easy to form. A partnership is usually formed once an agreement is made about how to split profits.
This agreement can be written or oral.
Once a partnership is formed, all partners are personally responsible for all the business’s debts. A creditor can usually sue a partner for the full amount of a debt once the partnership’s assets have been exhausted. A partnership offers no protection to its members’ assets. Much like a sole proprietorship, a partnership is simply an extension of its members’ estates. It is not a separate legal entity.
The great danger in a partnership is that one partner can create a debt that holds the other partner or partners accountable even if the others did not know about the debt in the first place.

Corporations
Corporations are the most common form of special legal business status in the United States. Filing for corporate status shields shareholders from liability on corporate debts. The corporation is treated like a separate entity that is responsible for its own debts. Once the corporation’s assets are exhausted, barring any agreements to the contrary, creditors have no further recourse against the shareholders.

Filing for corporate status is a relatively simple procedure. A lawyer can help you legally incorporate your business and follow your state’s guidelines as to how to maintain corporate status. Every state requires a corporation to meet minimal operational guidelines such as maintaining corporate procedures (i.e., electing a board of directors and holding corporate meetings) and avoiding commingling of corporate and individual assets. Failure to follow these corporate formalities results in the loss of the corporate shield. Although not overly complicated, corporate formalities are required in order to maintain the corporate shield and provide protection for the shareholders.
The small business owner, however, faces an even greater hurdle to preserving corporate protection than just following proper corporate procedures. Creditors know that once a corporation’s assets are dissolved, barring any further agreements, they will be unable to get at the entrepreneur’s personal assets. Since most small business corporations have no assets, creditors will want to have another way to protect themselves financially. This means that creditors will almost always require the entrepreneur to personally guarantee the debt. In this way, if the corporation fails and lacks the assets to fully pay all of its debts, creditors can then go after the individual behind the corporation.
Be careful when signing contracts on a corporation’s behalf. Most small business contracts are written by creditors who have lawyers working for them. Contracts are almost always written in a way that if the corporation fails, the entrepreneur is then personally liable. Unless you sign the contract “John Doe, on behalf of Corporation, Inc.” or something similar, you are more than likely also personally liable for the debt. It is very common for small business owners to insist that it is only the corporation that is liable on a debt and not them personally, and then come to find out once they actually read the contract that they are in fact personally liable.
Some people believe that forming an S corporation will provide further protection as to corporate debt or obligations as a grantor. This is not true. The S corporation is merely a tax device to modify income tax payments; it has no effect on corporate debts.
In theory, a corporation is a good means for a business owner to protect his or her personal property from liability on business debts. In reality, a small business owner will have problems maintaining corporate protection. Even if all corporate formalities are followed, creditors are loath to lend money to a small corporation without a personal guarantee on the loan.

Limited Liability Companies
Not too long ago, limited liability companies (LLCs) did not exist. However, by 1997, every state in the country had formally recognized such business entities. The rapid growth in LLCs’ popularity is due to the fact that LLCs offer the same protection as corporations, but there is no double-taxation problem. An LLC is treated the same as a sole proprietorship or partnership for tax purposes while providing an individual with a corporate shield.
The small business entrepreneur, however, must still be careful to limit his or her personal liability when signing contracts. Some states may also require certain formalities for LLCs, although there tend to be fewer formalities for LLCs than for corporations. LLCs fill a void in U.S. business structures, giving the security of the corporate shield without the problems of double taxation or corporate formalities. A local attorney should be able to explain your state’s LLC requirements and help you comply with them.

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