Business Formation

When starting a business, you have many different options. One of the most important things you should consider is the legal form your business is going to take.

There are a few common arrangements that business-owners use; which one is right for you depends on your particular circumstances. It's important to consider these options, because they can have significant consequences for taxes, and the liability (or lack thereof) of the owners of the business for the actions of the business.

Sole Proprietorship

This is the simplest business arrangement, and common for a very small business. The business has only one owner, and the business is not a separate legal entity from the owner. This means that the debts and liabilities of the business are also the debts and liabilities of the owner.

A sole proprietorship is usually created without any legal formalities. It simply involves a person selling their products or services.

This type of arrangement is very easy to set up, but it creates risks — if the business fails, the owner is entirely on the hook for all its debts. Also, any money generated by the business is taxable against the business owner as personal income.

General Partnership

Like a sole proprietorship, a general partnership can be set up without any formalities. However, it takes at least 2 people (up to an unlimited number) to establish a general partnership.

Essentially, 2 people agree to co-own a business, and make decisions concerning how the business is to be managed. Generally, it's a good idea to put the partners' respective duties in writing before the business actually gets off the ground to avoid conflicts. Like a sole proprietorship, the owners (partners) are liable for the debts and civil liabilities of the business, commonly called joint and several liability. This means that any one partner can be held liable for the entirety of their business's debt. However, if one partner is held liable and made to pay for all of the debt, they can then sue the other partners for their share of the debt.

Limited Liability Partnerships

This is a different type of partnership, in which some or all of the partners have strictly limited individual liability for the debts of the business.

This arrangement exhibits attributes of both a partnership and a corporation. It is like a corporation in that the partnership is a separate legal entity from any of the partners. However, it resembles a partnership in that the owners (partners) have the right to directly manage the business. The owners (shareholders) of a corporation have no such right.

Corporations

A corporation is often (though certainly not always) used to set up a larger business than the other methods discussed above. A corporation is a legal entity entirely distinct from any of its owners. Generally, a corporation is owned by many people, who buy and sell shares of the corporation. A corporation has many of the same legal rights and responsibilities as an actual person. This is known as corporate personhood.

For example, the income generated by a corporation is taxed, not against the owners or managers, but against the corporation itself. If a corporation, through its managers or employees, engages in an illegal act, the corporation is liable, and the owners and managers are not. Typically, even the highest-level managers of a corporation are simply paid a salary, rather than directly benefiting or suffering from the corporation's profits or losses.

In some cases, a corporate officer can be held liable for the unlawful conduct of a corporation. When this happens, it's referred to as "piercing the corporate veil." Generally, this can only be done under certain conditions, usually when the assets of the owners and the corporation are extremely intermingled, and when the defendant clearly used the doctrine of corporate personhood as a shield, to avoid personal liability for some kind of fraud or other wrongful act.