Selecting the correct entity form for a company is essential in developing a profitable enterprise. Many partners and investors in firms will utilize different formations in order to receive the optimum benefit. The formation type called the Limited Liability Company is a fairly new idea that attempts to merge the benefits of a corporation with the benefits of a limited partnership.
The combination of these two entities creates a very attractive model that many companies will consider when choosing the best option for their investments. Another item that is important when deciding which type of corporate structure to pursue is identifying how the protections of the entity type can be overcome.
This is important because if a business chooses a limited liability company because of the limited liability aspect of the practice, but a partner in the firm binds the company to increased risk, then the limited liability protection can go away for that partner and the other partners. For example:Like a sole practitioner or general partner, each member of an LLC is liable for his or her own acts of negligence and/or civil and criminal violations.
This aspect of the LLC example demonstrates how a corporate structure may be the best for a given company, but it may still bind members unfavorably. This type of limited protection is called a “partial shield,” and should be considered whenever a company selects an organization model. (Miller & Tucker, 2005, p. 71) The partial shield is just one of the events that a company should be aware of despite what benefits an LLC may provide.
In spite of a partial shielding, the limited liability company offers many advantages over other types of organizational structures. A look into the advantages and disadvantages of other entities as compared to the LLC will be beneficial in assisting managers in their organization decision-making.Advantage/Disadvantage OverviewMany options exist for a group of investors to choose the organizational structure of a company. Four of the most utilized forms for a business are the general partnership, the limited liability company, the limited partnership, and the corporation.
The general partnership can be started with a handshake, the limited liability company requires some type of filings (professionals use a form of LLC called a limited liability partnership), the limited partnership is similar to the general partnership in scope but requires a filing, and the final of the big four is the corporation which requires the most filings of any form. (Williams, 1998, p. 77) These four are the largest forms, but they are not the only options available to a business. Sole proprietorship and the s-corporation are two more forms that many businesses utilize in their formations.
A general investigation into each of these forms will serve as a beneficial introduction into the choices a management team will need to make when deciding the most favorable entity relationship.The first form of organization is the sole-proprietorship. The sole-proprietorship is the easiest version of business structure to form.
In this business, the owner is entitled to all the profits and all of the decision-making. (Parrish, 1998, p. 34) Basically, the owner will have total control over the organization and essentially does not have to answer to any person when deciding the best course of action. The advantage of this type of structure is that the owner makes all the decisions and is entitled to 100% of the profits from the enterprise.
This is beneficial because an owner may believe that the company is their own creation and will not want outsiders infiltrating the business. This is also beneficial because the owner can enact an event, and the enacting of that event will take place right when they say it will without the need for discussions or compromises with other investors or partners. A glaring disadvantage accompanies this type of formation, and this disadvantage cannot be ignored.
In a sole-proprietorship, the owner carries unlimited liability for any debts or tort actions that may arise from the running of the business, and the government deems a sole-proprietorship and the individual that creates the sole-proprietorship as one in the same. (Parrish, 1998, p. 34) This disadvantage is great because the sole-proprietorship essentially becomes an extension of the owner. If a worker negligently commits a tort, and the sole-proprietorship cannot maintain the entire judgment, then the court will look to the individual for further compensation.
This aspect of the sole-proprietorship of course puts the business at risk, but it also puts the owner at risk. The owner’s personal assets could be used to fully satisfy a judgment due to the negligence of one of the sole-proprietorship’s workers. The disadvantage of this form has caused many financial professionals to urge their clients to seriously consider their level of liability when considering a sole-proprietorship organization.
The general partnership is another form of business organization that differs from sole-proprietorship in one aspect only. A general partnership needs at least two members to be commenced, while a sole-proprietorship requires only one member. (Moll, 2004, p. 293) A general partnership is a form of partnership where the two members invest and manage the company and agree to split the profits and liabilities that may result. (Parrish, 1998, p. 34) Two major advantages of a general partnership exist, which makes the form somewhat appealable. First, a general partnership does not contain many government restrictions, and one can be established by buying a partnership certificate at a local store.
This is beneficial because it diminishes the costs of formation for the partners as well as the time and effort needed in order to creation the general partnership. Another advantage of a general partnership is that it allows profits and losses to pass through into the general partners’ personal income so in essence profits are only taxed one time. (Parrish, 1998, p. 34) This is helpful because it creates a more profitable environment for the partners.
Instead of having their profits taxed as an entity and as personal income, the government deems the profits taxed as personal income only. A disadvantage accompanies this form of business structure, and that disadvantage is the amount of liability both partners are prone to. A general partnership carries unlimited liability, which means both partners are 100% liable for all the partnership’s debts and actions. (Parrish, 1998, p. 34)
For instance, if an employee is reckless and causes an injury to another, the general partners are liable for the action as well as the partnership. This causes great risk to the general partners’ personal assets, and is one of the reasons that a general partnership is unfavorable in certain circumstances.A limited partnership is a further form of partnership that involves more member names than a general partnership.
This partnership is usually sought when a partner needs increased investment in order to further expand the company, but the partner does not want to lose control or share control of the business. (Parrish, 1998, p. 34) The limited partnership involves a general partner that manages the business and has total control over the business and also a limited partner that merely provides investment and will partake in a certain amount of the profits. (Parrish, 1998, p. 34)
The advantages of the limited partnership are two-fold. First, there is an advantage for the general partner, and second there is a separate and unique advantage for the limited partner. As Parrish, 1998, suggests, “this business entity is best suited for a general partner looking for a silent partner(s) not involved in the day-to-day operation of the business (for example, an investor). The limited partner is not liable for debts and claims.” (p. 34)
The limited partner benefits by having an investment option where he/she only risks their capital investment, and the general partner can benefit by maintaining management/control over the business and also have some further investment from the limited partner. The disadvantage of the limited partnership is the same as the general partnership except the limited partner is not affected. The general partner is personally liable for all the debts and actions of the partnership, but the limited partner is only liable up to their capital investment. (Parrish, 1998, p. 34)
In conclusion, a limited partnership is beneficial to the general partner and limited partner in some respect, but is detrimental to the general partner only when discussing personal liability.The next business form is the C Corporation, or better known as the corporation. This type of entity is common among big firms that have a vast marketplace and infrastructure.
A company that is experiencing growth and looking to branch out into different areas should consider a regular corporation structure. (Parrish, 1998, p. 34) The corporation has benefits and drawbacks just like any other business entity, which means a company contemplating the corporation structure, should weigh what they are willing to give up and what they are anticipating from the business. The main advantage of the corporation is that it protects “shareholders from any liabilities and allow[s] large earnings to be retained and reinvested in the growth of the business. ” (Parrish, 1998, p. 34)
A corporation is mainly concerned about shareholders and shareholder value. This aspect of the corporation draws its appeal from the need of investors to enhance their investment in long-term growth and further their capital returns. (Kobayashi & Ribstein, 1996, p. 464) Three disadvantages exist for a corporation. First, to create a corporation there must be filing fees, articles of incorporation, and other formality fees in order to comply with federal guidelines. (Parrish, 1998, p. 34) These fees may be great at the inception of the corporation, and can cause a decrease in profitability and an increase in initial investment may be needed.
The creation of the corporation involves careful planning and usually needs financial advisors, which will cost money. (Bacon, 2001, p. 1087) This will hurt the corporation in the beginning, which may in turn affect shareholder value. Another disadvantage of the corporation is the approval of shareholders.
A corporation may want to enact some type of activity, but the corporate executives will need shareholder approval before major changes to the corporate structure and environment are made. (Hansmann & Kraakman, 2000, p. 381) This can cause delays in corporate activities as well as an abrupt stop in the decision-making process. A final disadvantage of the corporation involves the taxing of the entity.
The government deems the corporation as a separate entity from the investors, and as such will impose taxation on the corporation itself as well as proceeds from the investment on the individual investors. (Parrish, 1998, p. 34) The taxing is essentially composed of two steps by the government. This taxing of the individuals as well as the corporation is called “double-taxation” and can cause a dramatic decrease in final profits that are afforded to shareholders and investors. (Wortham, 1998, p. 21)
The corporation does shield investors and can create exponential growth by reinvesting profits, but it also is accompanied by three major drawbacks that can harm shareholder value.A final examination of business structure involves two different types of structures that are similar in many respects but also offer some very distinct differences. The sub-chapter S corporation (S-Corporation) and the limited liability company (LLC) both present similar advantages, however, the s-corporation contains some disadvantages that the LLP does not have.
It should be noted that both structures protect the principals and investors from financial and tort liabilities afforded to the companies. (Parrish, 1998, p. 34) Both entities also allow for pass-through taxation, so the problem associated with the corporation double-taxation is non-existent. (Parrish, 1998, p. 34)
The LLC offers more advantages that the S-corporation does not. For instance, the S-corporation is limited to 75 member shareholders, while the LLC needs only one or more shareholders (depending on the state) but does not include a maximum number of shareholders. (Parrish, 1998, p. 34) This is a great benefit over the S-corporation because the LLC can increase investment capital by including more investors.
Another advantage over the S-corporation is that the LLC does not need as many formalities. As Parrish, 1998, suggests, the S-corporation is essentially a corporation that does not have double taxation, however, since the S-corporation is in the same realm as the corporation the same formalities and regulations govern the entity. (p. 34) The LLC does not have so many formalities and regulations, which creates another advantage of the business structure.
State taxation includes another form of tax for the S-Corporation that will invade the bottom-line of the company. Basically, the S-Corporation contains all of the disadvantages of a regular corporation except for double-taxation; however, the inclusion of state income taxation will affect shareholders in the company and harm shareholder value. The LLC appears to be a better option for shareholders who want all of the advantages of the corporation and none of the disadvantages.Advantages/Disadvantages of Of S-Corporations and LLC’s (Further Review)The S-Corporation and LLC offer the same protections against liability.
The LLC affords limited liability to a shareholder just as in an S-Corporation and a regular corporation. So, it seems there really is no advantage of an S-Corporation over a LLC. To fully understand the LLC, an investigation into the basics of its formation is needed. The LLC is seen by the government as a corporation for liability issues and as a partnership for tax issues. (Cleveland, Wells & Yoshimoto, 1996, p. 26)
At first glance this may appear to be further requirements of the LLC entity, but these are needed in order for the government to discern between a LLC and a corporation/S-Corporation that is attempting to pose as a LLC.The LLC and S-Corporation are two of the most popular forms of business formation that attempt to rely on the benefits of the corporation and attempt to disregard the disadvantages of the corporation. However, the LLC is the only business structure that truly achieves this purpose due to the S-Corporation containing some regulations that demonstrate a close similarity to the corporation in some aspects.First, the requirements of a LLC are a lot less as compared to the S-Corporation.
These requirements mainly are concerned with what the shareholders can do while being a member of the S-Corporation. The first difference between the two was discussed earlier, and that was the limits on members, which is set at 75 and has been reduced during some years to 35. (Price, 1992, p. 48) This means that the S-Corporation may not be able to fund the enterprise to the extent that a LLC can.
This will cause the S-Corporation to carefully plan their activities in order to limit losses and still maintain an amount of funding to continue business efforts. Another difference between the S-corporation and the LLC is found in ownership and stock attributes. The S-Corporation shareholders cannot own 80% or more of another corporation’s stock, can only have certain types of shareholders, can only have one class of stock, and cannot have any nonresident alien stockholders. (Price, 1992, p. 48)
This greatly diminishes the power of the shareholders in the S-Corporation and can limit the amount of shareholders that are willing to invest in the company. For instance, suppose a prospective shareholder is will to invest a large amount into the company, and this prospective shareholder owns over 80% of another corporation’s stock The shareholder must either sell the corporate stock to get in under 80% or choose not to invest in the S-Corporation.
The LLC does not contain any of these requirements and restrictions, which makes the LLC more attractive for business owners and investors.Another difference between the two structures that demonstrates how an LLC is better for an investor is the increasing of investment that correlates to the amount of debt incurred.
References
- Bacon, L. A. (2001). “Freedom Of” or “Freedom from”? the Enforceability of Contracts and the Integrity of the LLC. Duke Law Journal, 50(4), 1087.
- Cleveland, G., Wells, W. R. , ; Yoshimoto, G. A. (1996). Is There a Limited Liability Company in Your Future?. Review of Business, 17(3),
- Hansmann, H., ; Kraakman, R. (2000). The Essential Role of Organizational Law. Yale Law Journal, 110(3), 381.
- Kobayashi, B. H., ; Ribstein, L. E. (1996). Evolution and Spontaneous Uniformity: Evidence from the Evolution of the Limited Liability Company. Economic Inquiry, 34(3), 464-483.
- Miller, N. J., Mcleod, H., ; Oh, K. Y. (2001). Managing Family Businesses in Small Communities [*]. Journal of Small Business Management, 39(1), 73.
- Miller, S. K., ; Tucker, J. J. (2005). Limit Practice Liability: Select Your Form of Business and Your Associates with Care. Journal of Accountancy, 200(3), 71+.
- Moll, D. K. (2004). Shareholder Oppression and “Fair Value”: Of Discounts, Dates, and Dastardly Deeds in the Close Corporation. Duke Law Journal, 54(2), 293+.
- Parrish, D. (1998, September). Management Advice: Choosing the Best Corporate Structure. Black Enterprise, 29, 34.
