When starting a new business or embarking on a new business venture, there are many factors an entrepreneur needs to consider beyond the business’s purpose. An entrepreneur must choose the best entity structure for their business to achieve its goals.
The general entity structures are sole proprietorships, general partnerships, limited partnerships, corporations, and limited liability companies. There is no one best entity type; each has its pros and cons that need to be evaluated when choosing the best path for you.
Sole Proprietorship
A sole proprietorship is a business owned and run by a single individual; once more, adding managing members changes the company’s status from a sole proprietorship. It is a business association. The sole proprietor can have employees, but they make all the management decisions, meaning they reap all the benefits from the business.
Additionally, Sole proprietorships are easy to form; a sole proprietorship can be formed by simply starting to work. This limited management form and ease of formation may be a benefit to new business owners, but there are some high risks associated with a sole proprietorship. Specifically, a sole proprietor bears all the risk if the business goes south, and there are no protections for the sole proprietor’s assets.
Pro’s:
- Easy Formation
- Sole profit sharing
- You get to make all the managing decisions.
Con’s
- Risk is on the sole proprietor.
- No protection of personal assets
- Maybe a lack of guidance, as founding documents are not required.
Partnership
General partnerships consist of 2 or more co-owners who will share in decision-making for the partnership and invest capital. Like a sole proprietorship, they can be formed informally by two people simply starting to work towards shared goals for the business for profit. However, it is beneficial to file a partnership agreement with the state. Every partner has the right to participate in the management of the business.
Losses are shared equally by the partners, and they will share the partnership’s profit equally. For taxation purposes, partnerships are taxed on a pass-through basis, meaning the business assets are only taxed once, but the taxes are paid on a partner’s individual tax return. Partners may be able to dissolve the partnership, leading to the winding up of partnership affairs, which can be a harsh process and may result in legal disputes.
Pro’s
- Pass-through taxation
- It can be formed easily
- Default is equal profit sharing
Con’s
- Partners share in losses.
- Partners have to pay taxes on partnership profits, regardless of distributions.
- Partners may be able to dissolve the partnership, leading to a messy wind-up.
Limited Partnership
Like partnerships, a limited partnership requires a partnership of at least two partners. However, Limited Partnerships have stricter formation requirements to implement that limited liability structure not afforded in general partnerships.
In a Limited Partnership, some participants will have personal liability, and limited partners will have limited liability. Limited Liability often comes with limited management rights; sometimes, limited partners have no voting rights. From a tax perspective, limited partnerships are subject to single taxation.
Pro’s
- Some partners will have limited liability.
- Subject to single taxation.
Con’s
- Stricter formation requirements.
- Potentially limited management control.
Corporations
Corporations are typically large business entities. They are heavily regulated by statute and have strict formation requirements. Members of a corporation have limited liability, and their personal assets are protected from corporate debts.
Additionally, it is easy to transfer ownership interests, and the entity type is stable. From a taxation perspective, corporations are subject to double taxation, meaning both the entity and owners pay taxes on the business profit.
Pro’s
- Stable entity structure
- Shareholder personal assets are protected.
- Easy to transfer ownership interests without disrupting the entity.
Con’s
- It may not be effective for small businesses.
- Heavily regulated by statute.
- Strict formation requirements.
- Are subject to double taxation.
Limited Liability Companies
Limited Liability companies are formed by filing articles of organization with the state. In a limited liability company, all members and managers are granted limited liability by statute, even if they have control of the business. This means they are not personally liable for the entity. Limited Liability Companies offer a significant amount of flexibility in structuring the industry and appear to value the freedom of contract.
Limited liability companies can be either member-managed or manager-managed. Additionally, unlike corporations, Limited Liability Companies are subject to single taxation. However, if a member leaves wrongfully, they often have no right to a buyout. They still retain financial rights and the right to distributions, but no longer have voting rights or information rights. Before filing an LLC, contact a Colorado LLC Lawyer.
Pro’s
- Limited liability for all Members and Managers.
- Large amounts of flexibility through freedom of contract.
- Single taxation
Con’s
- It may be expensive to file.
- Income may be subject to self-employment taxes.
- Restriction on transferability of membership interests.
What one business owner considers a benefit may be a disadvantage for another.
Additionally, many default rules for each entity type can be altered through a carefully drafted formation document or operating agreement.
A skilled Colorado business attorney can help determine which entity best suits your business needs.
They can also help you carefully draft agreements to tailor that entity type to meet all your expectations and business goals.
