You’ve come up with a great idea, developed a business plan, and secured some early funding. Now what? Usually, it’s time to think about what form of business will work best for you and your business.
Entity formation is all about choosing the form of business that will help your company achieve success in the beginning and into the future. In South Carolina, there are many options, but the main business entities are sole proprietorships, partnerships, limited liability companies, and corporations.
Here is an overview of some of the considerations business owners should think about when selecting a business entity, including liability protection, taxes, filings and fees, and management flexibility, plus a look at common business structures.
Considerations When Choosing a Business Entity
Liability protection is important because owners can end up owing on the debts and obligations of the business. Without a layer of liability protection, negligent acts of employees that cause personal injury or harm to others can end up costing owners. Most companies have insurance, but if the insurance coverage is not enough or does not cover the type of negligence, then an injured party may go after the assets of the company and then the owners. Some forms of business are better at providing insulation from liability than others.
The taxation of a company can be tricky. Essentially, a company can either be taxed on an entity level or the owners can be taxed on an individual basis, also referred to as pass through taxation. There are a plethora of alternatives, but the main tax options are being taxed as a partnership (pass through), S-Corp, or C-Corp. It is always advisable to consult a tax professional for specific advice on taxation and how it affects your business.
The management and operations of each company is paramount to its success. Some business entities provide more flexibility than others regarding the management and operations of the company. Regardless of the form of business you select, one way to start your company off with the proper management tools is by drafting a quality agreement between the founding partners. This founding document can define the short- and long-term success of the business. Partnerships use partnership agreements, LLCs use operating agreements, and corporations use bylaws. Read more about Partnership Agreements: 5 Critical Considerations.
An Overview of Business Entities
Sole proprietorships are the most basic form of business. All you have to do is begin conducting business. A sole proprietorship does not require any filings or fees, and there is no formal process or state law governing its operations. The taxation is also simple because the profits of a sole proprietorship “pass through” to the owner, meaning that the income and expenses of the business go on the owner’s personal return.
Unfortunately, sole proprietorships offer no liability protection for owners, exposing owners to liability for all debts incurred and obligations of the company, including questions from the IRS. For instance, if you own a lemonade stand and your sister, who helps out sometimes, promises your business will buy $5,000 of sugar from the local grocery store, then you are personally obligated to pay for the sugar. The local grocery store will seek enforcement of the contract from the lemonade stand and seek payment from you personally. If you are like me, then your wife will not be happy to learn joint savings will have to go to settling up a bad business deal.
Additionally, sole proprietaries are usually not organized well for future growth because there are typically no founding documents. As is discussed later, being intentional about business decisions is one of the hallmarks of success in business.
Owning a sole proprietorship may seem like an attractive option because it is inexpensive to form, there are no necessary filings, the owner controls all management and business decisions, and the owner is taxed personally. However, there are not many instances in South Carolina when it would be advantageous for a company to form as a sole proprietorship because the liability exposure could be costly.
Forming a partnership works for many companies because there are so many options available and businesses can benefit from flexibility. Among the forms of partnerships are general partnerships, limited partnerships, and limited liability partnerships.
Forming a partnership is an interesting endeavor because two people can start brewing beer in their basement, sell a bottle to a neighbor, and suddenly they are in a partnership together. All that is required to form a general partnership is for two or more people to begin conducting business for a profit. Once that has occurred, whether you realize it or not, you have triggered a host of laws regulating the relationship between you and your partners. Partnerships in South Carolina are governed by the Uniform Partnership Act (UPA), which can be found at S.C. CODE ANN. 33-41-10 to 1330.
Like sole proprietorships, general partnerships are usually not advisable. While there are no filings or fees associated with a general partnership, there is a lack of sophistication most businesses need to survive. Not only are general partnerships often unintentional, which could lead to mismanagement and a host of misunderstandings between partners, but there is no liability protection. Partners in a general partnership each have control over management decisions, share profits, have a right to use partnership property, and are jointly and severally liable for the debts and obligations of the partnership. In other words, you are on the hook for what the other partners do. Usually, if you intend to form a partnership, it would benefit you to use a limited partnership or a limited liability partnership.
A limited partnership (LP) requires at lest one general partner and one limited partner. The general partner has the same rights and responsibilities as in a general partnership. A limited partner enjoys liability protection from the negligence and contractual obligations incurred by the LP, offering a more hands-off approach to participation in the business. Often a limited partner provides capital, while the general partner runs the day-to-day operations of the company.
There are simple filings and minimal fees required of a LP. Like with a general partnership, the taxation of a LP is passed though to its owners. A nice aspect of the LP is the flexibility of the management and operations.
Limited liability partnerships (LLP) offer partners liability protection, meaning partners are generally not liable for the negligence of other partners. Like an LP, an LLP requires the partners to file with the Secretary of State and pay a filing fee. The taxation of an LLP also passes through to the partners, as with the other forms of partnerships.
The distinguishing feature differentiating an LP from an LLP is the LLP does not have limited partners. All the partners are theoretically the same, unless the partnership agreement states otherwise.
As with any entity, it is always smart to draft an agreement between the partners, here called a partnership agreement. Depending on the type of partnership and the partnership agreement, partnerships can offer limited liability protection and flexible company management.
Limited Liability Companies
Limited liability companies (LLC) have been the most prevalent form of business over the past couple decades in South Carolina. Forming as an LLC offers owners the ability to operate the company without rigid rules associated with a corporation while affording great liability protection and flexible tax options. LLCs are often thought of as a hybrid between a partnership and corporation.
The owners or shareholders of an LLC are called members. As with forming a LP, LLP, or corporation, LLCs require a simple filing with the Secretary of State and a filing fee. There are two basic types of LLCs: member-managed and manager-managed. The default rules governing LLCs are found in the South Carolina Uniform Limited Liability Company Act of 1996, S.C. CODE ANN. 33-44-101 to 1208. These laws serve as the default rules on LLCs unless the operating agreement specifies otherwise.
One of the distinguishing features of an LLC is the ability to enjoy liability protection because the LLC is treated as its own separate entity, different from its members. Therefore, an LLC affords its members a layer of liability protection insulating them from the negligence of employees and the debts or contractual obligations of the company. In many instances, the liability protection afforded by an LLC is stronger than that of a partnership.
LLCs enjoy flexibility regarding taxation, allowing the owners to choose whether it will be taxed as a pass-through entity, S-Corp, or at the entity level as a C-Corp. Again, consult a tax professional on how each choice would specifically affect your business.
The operating agreement of an LLC can be a great tool because it affords flexibility, allowing the members to agree to terms different from the default laws found in the South Carolina Limited Liability Company Act. An operating agreement can be customized to fit the particular needs of the company including, but not limited to, defining management rights of the members, member equity and shares, distributions, dissolution, disassociation, buy-out provisions, transfer of interest, and a number of other important ownership considerations.
A good operating agreement can also help govern the company in many other management decisions. For instance, the default rules dictate that an LLC will be member-managed, which means it will operate like a partnership, giving all the members the ability to serve as agents of the company and make management decisions. Alternatively, by drafting the proper operating agreement, a company could choose to be manager-managed, allowing for the election of managers so the LLC would act more like a corporation.
Corporations have stood the test of time for good reason: they offer great liability protection for shareholders while providing a sophisticated form of governance that offers comfort to outside investors. Moreover, the case law is so well established it is easy to set expectations about how to operate.
Like an LLC, a corporation is a legal entity separate from the owners or shareholders. Unlike an LLC, a corporation offers less flexibility in its operations. Corporations require some fees and specific yearly filings. As the South Carolina Business Corporations Act of 1988 calls for, corporations require specific corporate formalities. Accordingly, South Carolina law dictates corporations must file Articles of Incorporation signed by an attorney and create bylaws, which set out an agreement on how the company will operate.
From the outset, the Articles of Incorporation state how stock is held and the classes of stock to be issued, as well as voting rights for shareholders and the distribution of dividends. The bylaws of a corporation serve as the constitution of the company, addressing everything from shareholders rights to stock options to the management of the company and dissolution. Anyone who owns equity in a corporation is a shareholder and each investor’s shares are issued as stock in the company. Typically, shareholders of a corporation play a passive role in the management of the company, serving as investors. Shareholders do, however, elect directors to serve as agents and establish the management of the company. Directors then hire managers and make other management related decisions.
Additionally, corporations must hold annual shareholder meetings, make specific yearly filings, and provide readily available information to shareholders. For some of these reasons, corporations create a comfortable environment for outside investors.
Corporations are usually taxed at the corporate level as a C-Corporation, meaning the corporation is taxed and the shareholders are not. However, if the corporation makes a distribution, then the shareholders will pay taxes on the distributions they receive. This “double taxation” is avoidable by filing as an S-Corporation, which means the corporation will not be taxed at the entity level and only the shareholders will be taxed according to their individual profits. Corporate taxes can be a complicated matter and every company is different, so consult a tax professional for specific questions related to your company.
Which Type of Business is Right For You?
Owners should be intentional about entity formation, not default to whatever a buddy recommends. The different forms of business in South Carolina each provide unique benefits, so understand which form works best for the success of your company. For further information regarding entity formation and which form of business you should consider, contact an attorney to address the issues raised above and many other valuable considerations.
John Henderson is an attorney with the Henderson & Henderson law firm. His practice focuses on business law with a particular interest in startups.