There are a number of important considerations to keep in mind when selecting the best business entity for yourself or your clients. These considerations can be distinguished into two smaller groups, Tax Implications and Non-Tax Implications. In this article, we will discuss the Non-Tax Implications of selecting a business entity.

A closely held business may be organized as a sole proprietorship, a general partnership (GP), a limited partnership(LP), a limited liability company(LLC), a limited liability partnership, and an “S” corporation or a “C” corporation. Deciding which entity works best for you requires consideration of a number of factors. These factors include limitation of liability, transferability of interest, continuity of existence, management and control, financing and raising of capital, securities laws and costs of formation and operation of entity. Please note, because limited liability partnerships are only used for professionals such as attorneys, architects and accountants, we will not discuss their features in detail. Your attorney can give you more information about these entities if they are applicable to your needs.

A sole proprietorship is the easiest entity to form, because it is the default entity. If you have not selected an alternate form, you are operating as a sole proprietorship. You may, however, need to file business licenses and fictitious name statements. GPs should have a written partnership agreement, but it is not required. LPs require filing of forms with the state and a written agreement between the parties, as do LLCs. In California, there is an $800 annual tax on LPs and LLCs. Corporations must file Articles of Incorporation with the state, draft by-laws, written minutes of the first meeting, and issue stock certificates. The election between “S” corporations and “C” corporations, which dictates how taxes will be paid, can be made when you obtain the Tax ID number for the Corporation and by filing additional forms with the IRS.

One of the most important factors to consider is limitation of liability. In a sole proprietorship the owner of the business is personally liable for all debts of the business. Should the business fail or face litigation, the owner may lose personal assets such as a house or money in personal bank accounts. Similarly in a GP, all partners are personally liable for business debts.

An LP involves one or more limited partners and one or more general partners. Limited partners are passive and have limited liability, where as general partners are actively engaged in management and control of the business, and have unlimited personal liability for the obligations of the partnership.

For this reason, sole proprietorships and GPs are greatly discouraged. Additionally, even LPs still involve the possibility of personal liability. There is almost no reason to operate as a sole proprietorship or general partnership and allow personal liability when other entities limit liability and are fairly simple and cost-effective to organize.

Both corporations and LLCs limit personal liability of the individual shareholder (in a corporation) or member (in an LLC). Shareholders and Members have no personal liability for the debts of the business. The extent of their liability is their interest in the business only.

Another consideration to make is transferability of interest. In a sole proprietorship, the death of the sole proprietor dissolves the business. Likewise in a GP, the death or withdrawal of a general partner typically dissolves the partnership unless the partnership agreement provides otherwise. Transfers also typically require full consent of all partners.

In both LPs and LLCs, a transfer of the economic interest (like the right to receive distributions of profit from the business) does not transfer voting rights or management rights. This is helpful from the standpoint of creditor protection, because it limits the creditors to only receiving distributions. They would not be able to gain control of the company and vote to dissolve it, for example, which they could do in a corporation, where transferring shares is traditionally very easy (subject to any restrictions in the shareholder’s agreement or under securities laws).

The death or withdrawal of a member will typically dissolve the sole proprietorship, GP and LLC, unless remaining members vote to continue the business. A corporation is an autonomous entity and exists indefinitely without regard to the death or withdrawal of shareholders, officers or directors.

A sole proprietor makes all of the decisions of the company. General partners generally have equal rights to manage and conduct partnership business, and each partner also has veto power. A written partnership agreement can provide for different levels of voting control based on partnership interest. The partners can also appoint a managing partner to operate the business on a day to day basis.

LPs are managed by the general partner. The limited partners (remember, passive) cannot participate in management of the business without risking the loss of their limited liability.

LLCs are managed by the members, unless the written Articles of Organization provide management by an appointed manager. LLCs provide great management flexibility. They can adopt a strict corporate format with officers and a board of managers, or they can centralize their structure similar to an LP with a manager acting like a general partner, and the members having no right to remove the manager.

Corporations have strict management and control requirements. The shareholders elect directors, who in turn elect officers. The directors generally guide policy and authorize corporate actions that go beyond day to day business. The officers manage day to day operations and their actions are approved by the directors. Corporations are required to have annual shareholders meetings (unless waived) and must keep excellent records of meeting minutes. They may also hold special meetings and conduct business via written resolutions adopted with unanimous consent.

Generally, it is very impractical and difficult for a sole proprietor to raise outside money. Obtaining a loan is the only method.

A GP may accept contributions from the partners. Most passive investors would not want to invest in a GP, because they would be subject to unlimited personal liability.

An LP may accept contributions from limited partners (typically passive investors), but they will have no say in the management of the business. Most LP interests are considered to be securities, and therefore the LP will have to comply with Federal and State securities laws.

LLCs may accept capital contributions from members and passive investors, who are given a member interest in the LLC. If no pre-existing relationship with the investor exists, or if the investor-member will not be involved in the management of the LLC, then Federal and State securities laws may apply.

Corporations may raise money from passive investors by issuing shares. However, any issuance of corporate stock in California is subject to California securities laws. Most other offerings are also subject to either California and/or Federal securities laws.

Compliance with securities laws can be very simple or very complicated, depending on the circumstances.

Based on all of the above, you can see how many important considerations one must make before deciding on the best business entity for their needs. For the needs of the majority of small, closely-held business, the LLC or corporation is likely the best option, because they provide the best balance of limited liability, ease of transferability and control, and ability to raise capital. However, your attorney is best suited to guide you through the non-tax considerations of business entity selection.