LLCs, LLPs, and Corporations
Today’s episode is a crash course in the differences among sole proprietorships, LLCs, LLPs and corporations.
First, a disclaimer: Although I am an attorney, the legal information in this podcast is not intended to be a substitute for seeking personalized legal advice from an attorney licensed to practice in your jurisdiction. Further, I do not intend to create an attorney-client relationship with any listener.
Today’s episode is a crash course in the differences among sole proprietorships, LLCs, LLPs and corporations. Geoff wrote:
Are LLCs really able to limit a person’s liability? It seems like it is too easy, and I always worry when things seem like they are too easy to be real. Is there really a meaningful benefit to using these structures?
The short answer, Geoff, is that LLCs really are able to limit a person’s liability, and there are several meaningful benefits to forming an LLC. To fully understand the pros and cons of an LLC, it is necessary to understand how an LLC is different from an LLP and a corporation.
Many Americans share the dream of creating their own businesses. You get to be your own boss, directly reap the rewards of your toils, and contribute to your community. Let’s use a bakery as an example. If you have some savvy with your stand mixer, you might envision opening a small bakery out of your kitchen. But your bakeshop business can take one of several forms.
The simplest is the sole proprietorship. Basically, a sole proprietorship is a business you create, you fully own and for which you are fully responsible. You do not have to get approval for the bakery from the government before you start. (You must still follow health and safety laws, still report any income for tax purposes, etc.) A major advantage to the sole proprietorship is that you are the boss and get to keep all profits. Typically, you are personally taxed on profits as your income. But, the major downside is that you are fully responsible for any debts incurred by the business, and you are open to unlimited liability. Another downside is that your business dies when you do.
Limited Liability Partnership
To limit this liability, there are several options from which to choose. The first is the Limited Liability Partnership, also known as an LLP. An LLP is a legal entity that you create with one or more business partners. You can do so by simply signing an agreement among the partners that sets forth how profits are shared, how liability is shouldered, and how decisions will be made. Most often, an LLP will divide all these benefits and burdens equally. Profits and liabilities are shared among the partners, and partners can still be personally liable for injuries. So, this offers more protection to you than a sole proprietorship because the liability is shared among partners. But, the protection is not great. Each partner is taxed once for his share of the income. A partnership will often dissolve when one partner dies, leaves, or attempts to pass his interest in the partnership to someone else. Last, some states, including California and New York, only permit certain state-licensed professionals such as attorneys and accountants to form LLPs.
A corporation is the most complicated type of business entity. To form a corporation, you must file for approval with your state’s Secretary of State and pay a fee. The owners of a corporation are the shareholders, who elect a board of directors who make management decisions. Running a corporation is complicated; you must maintain the board of directors, have annual meetings, and keep annual reporting. The main benefit to the corporation is limited liability. If a corporation incurs liabilities, then the corporation is responsible. In most cases, the shareholders are not personally liable for losses; only the corporation is. One main drawback to a corporation is double taxation, which is a taxation principle referring to income taxes that are paid twice on the same source of earned income. Any money earned by the corporation is taxed first as corporate income. Then, if you are paid a salary because you work for the corporation, or if the corporation pays you a dividend as a shareholder, you must again pay tax on that income. So, the money earned by the corporation will be taxed twice before you get it. One last advantage is that you can easily transfer your ownership in the corporation by selling your shares, and the corporation will survive despite this change in ownership.
Limited Liability Corporation
A limited liability corporation, or LLC, is a modern hybrid of an LLP and a corporation. To form an LLC, you must file with the Secretary of State and pay a fee. The owners of an LLC are called members, and the members will have an agreement that sets forth who manages the day-to-day affairs of the LLC. LLCs enjoy both the primary benefit of an LLP, single taxation, and the primary benefit of a corporation, limited liability. So, the profits earned by the LLC are passed directly through to the members, who are taxed only once. Also, if an LLC incurs liability, the members are not normally subject to personal liability. It really is the best of both worlds. An LLC can be created where the LLC survives or dissolves when one member transfers his interest. It depends on how the LLC agreement is drafted.
So, those are the four main business entities available. Please tune in next week to learn more about how the pros and cons of each entity would apply to opening your bakeshop.
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