The first step in setting up a successful corporate or small business is choosing the proper legal form that your new business will take. For businesses composed of licensed professionals — such as doctors, lawyers, accountants, engineers — the choice of business form can be complicated by state laws, income tax, personal tax and business incomes that may impose various restrictions on these professional entities.
The Importance of Choosing the Proper Entity
While there are many factors that should be weighed when considering the proper form for a business, three of the most important are:
- Ownership: For most businesses, the chief factor is the number of people who can own or invest in a company. For a professional business, however, state laws may restrict place restrictions on the type of owners; for instance, some states require that all owners of a professional corporation be licensed within the same profession.
- Liability: For many, this is the single most important factor to consider when forming a business. Certain entities — such as corporations or LLCs — are legal individuals separate from the persons who own the business. With only a few exceptions, these entities are held responsible for business debts and actions, and thus if something goes wrong the assets of the entity are at stake, rather than those of the owners.
- Taxation: One downside to certain business forms is the prospect of "double taxation" — once on tax earned by the business and again when profits are distributed to the business owners. Certain business forms have been developed that retain the liability shield offered by C-corporations, for example, but allow business profits to "pass-through" to the owners without first imposing corporate taxes.
Sole Proprietorship and Partnership
Not all businesses choose the business structure under which they will operate. In fact, many owners simply set up shop and begin operating their business without taking any formal legal steps at all. When this happens, state laws generally regard those businesses as one of two entities: sole proprietorship or a general partnership. The sole proprietorship is the default business form for a single professional — or other business owners — who opens a practice or business without choosing an entity. The partnership is the default form for a group of business owners who do so.
A sole proprietor is one person who is legally inseparable from their business: If the sole proprietor dies or ends his or her practice, the business dissolves. The sole proprietorship also offers no liability protection, as the business owner is personally liable for all of the business's debts. On the other hand, the business profits or losses are reflected in the sole proprietor's personal tax returns, and no corporate taxes are imposed, though they may have self-employment taxes.
Similar to a sole proprietorship, a partnership exists until a partner dies or leaves the partnership. Partnerships offer no liability shield: Partners share all profits, losses and legal liabilities equally. In fact, this is the reason why some professionals have grown uncomfortable in partnerships. If one partner commits malpractice, the other partners may be liable for any damages not covered by the offending partner's malpractice insurance. Again, however, as with sole proprietorships, profits and losses are reflected in the partners' individual tax returns, and the business itself is not separately taxed.
Because the lack of any liability shield in sole proprietorships or partnerships was simply untenable to many professionals, when state laws began to relax and allow professionals to choose some of the forms common to other businesses, the response was immediate. While many states still impose restrictions on professionals in business formation, the following entities are common to most states.
Professional Corporation
A corporation is a legal entity separate from its owners and shareholders — it survives the death or departure of owners and, generally, shields owners from liability for the acts of the company, board of directors, or shareholders. On the other hand, corporations are taxed as independent business entities, subjecting shareholders to double taxation.
While similar to a general business corporation, a professional corporation or small business corporation (also called an "s corporation") must generally be formed purely to provide professional services. All shareholders, in most states, must be licensed within the same profession (although a few states allow similar professions, such as psychiatrists and psychologists, to share a corporation). Professional corporations do not always offer the same liability shield as other corporations, as many states do not provide a shield for any malpractice by licensed professionals.
Professional Limited Liability Partnership
A professional limited liability partnership is a hybrid partnership comprised of licensed professionals. Generally, the "limited partners" contribute assets to the business and are entitled to a share of the profits, but cannot make management decisions. Limited partners enjoy the limitation of their personal liability to the extent of their contribution. They are not, however, insulated from liability for the partnership's general debts. General partners make management decisions and are not shielded from personal liability. States often impose mandatory insurance requirements on the owners of a professional LLP.
Professional Limited Liability Company
Almost all states now allow professionals to form a limited liability company or LLC. As with the Professional Corporation, anyone doing business as a professional LLC must generally be licensed within the same profession. You can also choose to have a single-member LLC.
Unlike a professional corporation, however, the profits in an LLC are subject only to "pass-through" taxation, avoiding the double taxation problem of many corporations. The liability shield offered owners of an LLC may vary, as some states only shield against the actions or liabilities of co-owners; one's own actions may still expose an owner's personal assets to liability. Further, many states require a professional limited liability company to append the designation "PLLC" on the company's name.
Article provided by Hammerle & Finley Law Firm.