Depending on your individual circumstances, you will need to choose from among four basic types of business entities:
SOLE PROPRIETOR A sole proprietor is an unincorporated business with a single "owner" responsible for all liabilities and debts of the entity. Essentially, the sole proprietor-type company is an extension of the individual owner. The entity is seldom used in the construction industry because the proprietor's personal assets are not protected from creditors or potential law suits. So, for example, if you as a sole proprietor build or design a structure that collapses, you will be personally liable for any damages and your personal assets will be at risk.
PARTNERSHIPS A general partnership is a partnership which consists of two or more partners, all of whom are "general" partners. General partners have full rights of managerial control over the partnership affairs but also have unlimited personal liability for partnership debts. Limited Partnerships consist of one or more general partners and one or more "limited" partners. Limited partners are primarily investors and have little or no managerial control. They also have limited liability for partnership debts. A limited partner who has invested $100,000.00 in a business cannot lose any more than what he has invested. A general partner does not have this protection, but does have decision-making authority.
CORPORATIONS A corporation is the most popular multi-person business entity in the United States and is generally the entity of choice for the construction industry. The most common form is known as "closely held" because the stock is not publicly traded and is owned by only a few persons. A corporation is recognized as a "legal person" for purposes of taxation, contracts, and the right to sue and be sued. Thus, the personal assets of the principles involved in this corporation (i.e. shareholders, officers and directors) are generally protected from liability by a Corporate "veil" created by state law. If the business is sued, the individuals' personal assets will not be subject to execution by creditors. Larger corporations whose stock is publicly traded and held by many shareholders sometimes evolve when the original owners sell their interests in the company or a thriving business needs to raise capital by selling shares to public investors.
Engineers, architects and other licensed professionals often incorporate as a professional corporation, (abbreviated "P.C."). The only significant disadvantage to a professional corporation is that all of the shareholders must be members of the profession. Therefore, all shareholders of an architectural P.C. must be licensed architects. This can be inconvenient if one purpose of the corporation is to pass the business assets to a spouse or family member upon the death of the principal or if a key individual in the business is not licensed but would like to be a shareholder. Unless that person is a member of the profession, the transfer of the assets will result in the loss of liability protection. The P.C. does not protect a licensed professional from liability for professional malpractice or that of employees working under his or her direct supervision.
LIMITED LIABILITY ENTITIES In February of 1995, the Limited Liability Act took effect in Pennsylvania. This Act provides the liability protection of corporations to certain entities (such as corporations and partnerships) while affording them the favorable federal tax treatment given to partnerships. Unfortunately, only a very small class of businesses will benefit from forming such a company. The availability of substantial insurance coverage and state law taxation are two factors that may affect whether an "L.L.C." or "L.L.P." is appropriate for your business.
While deciding which entity is right for your business needs, an experienced business lawyer will help you consider the following factors:
TAXES In Pennsylvania, corporations are taxed twice. First, the corporation pays Corporate Net Income Taxes (CNIT). The income is then taxed again as ordinary income to the shareholder when dividends are paid. Contrary to a common myth, incorporating in another state, such as Delaware, does not avoid the double tax - it just results in payment of various business privilege taxes that apply to "foreign" corporations. Many Corporations act to avoid this double tax by making a sub chapter "S" election which allows you to avoid the CNIT while still being afforded liability protection. However, an "S Corp" that holds real estate for development may not qualify to be an S Corp if the business generates high levels of passive income, such as rent. If you form initially as an S Corp and later become unqualified for the S election, you could incur liability for back taxes.
Partners in a general partnership are taxed as individuals. The income "passes through" the partnership and is taxed only once at the partner's individual rate.
LIABILITY As a business owner, you may be personally liable for debts and liabilities of your business. This is especially important to many small business owners who do not want to put their personal non-business assets at risk. Typically, these risks include uninsured tort liability (job site injuries, defective construction materials, etc.) extended contractual liability, and substantial business losses (inability to pay subcontractors or material suppliers). Corporations, professional corporations and limited liability corporations provide the greatest degree of protection and for that reason they are generally the entity of choice in the construction industry. By contrast, sole proprietors, general partners and joint venturers are all personally liable, without limitations, for all business debts and liabilities.
MANAGEMENT AND CONTROL FACTOR If you have taken the step of going into business for yourself, you probably want to have a voice in the management and control of the business, and protection against being frozen out of control of the business in the future. There are a variety of ways to structure corporations to meet these organizational and management goals, but less flexibility is afforded to other entities. In a limited partnership, for example, the limited partners are completely excluded from any decision-making authority. The key to management and control is the shareholder or partnership agreement that you develop when you first set up your business.
TRANSFER OF ASSETS The ability to transfer the assets of the business, particularly upon the death of the owner, can also be a factor in the choice of entity. The question of disposition of the assets or of an individual's interest in a business is especially critical when your attorney is preparing the "buy-out" provisions of your partnership or shareholders agreement. Generally, the legal fees associated with the formation of an entity are far less than those incurred when a dispute arises when a business is dissolving or being sold and the principals did not thoroughly plan in advance for such an event. When the company is being transferred because of the death of a key owner, the process is even more complex and often results in litigation. Careful planning and periodic review of your business structure can prevent the bitter litigation that may result if your effort to "just keep it simple" at the beginning leaves a gap in the documentation.
Upon the death or resignation of a partner, provisions of the partnership agreement will govern whether that partner's share automatically transfers to the remaining partners or whether the remaining partners need to buy the share. Likewise, in a closely held corporation, there are restrictions on ownership of the stock that may preclude the ability of a shareholder to sell to anyone other than another shareholder. Upon the death of a shareholder, the company may find it necessary to buy the stock from the estate. Consequently, many corporations carry life insurance policies on the lives of key shareholders in order to fund this buy-back of the stock.
Another factor to be considered in choosing a business entity is the cost of starting up. While many small business owners fear the start-up costs and the detailed record-keeping requirements of incorporating, the long term protections often quickly pay back the initial investment. Likewise, a carefully planned, comprehensive shareholder agreement or partnership agreement is essential to avoid future problems.
Planning for and setting up your business structure is not a "do it yourself" project. Small mistakes or oversights can leave you vulnerable to personal liability or significant tax exposure and can be disastrous for your heirs. It is important to have competent legal and financial advisors who keep up to date on current developments in tax and business law. In essence, setting up a new business entity calls for the legal equivalent of "measure twice, cut once."