• Sole Proprietorship
  
  
• General Partnership (GP)
  
  
• Joint Venture (JV)
  
  
• Limited Partnership (LP)
  
  
• Limited Liability Company (LLC)
  
  
• Limited Liability Partnership (LLP)

The sole proprietorship is the simplest and most common form of business entity.  In effect, a sole proprietorship is a business that is conducted by a single individual owner (the “sole proprietor”).  The proprietor may hire any number of employees to assist in the business, but remains the sole owner.

Advantages of a Sole Proprietorship

• Sole proprietorships are simple to start, and avoid the operating expenses required for other legal entities such as corporations (additional expenses for other forms of business may include incorporation expenses, franchise taxes, and professional fees).  This is because the complex statutes governing corporations, partnerships, and other business entities usually do not apply to sole proprietorships.
  
  
• Sole proprietors make their own business decisions and thus avoid the conflicts that may occur among partners of a partnership or shareholders of a corporation.
  
  
• The owner of a sole proprietorship reports the profits of the business on his individual income tax returns and pay taxes on them.  For legal and tax purposes, there is no distinction between the individual sole proprietor and the business. The issue of “double taxation” that must be considered in a “C” corporation does not pertain to a sole proprietorship.

• Because there is no legal distinction between the individual sole proprietor and the business, the individual owner is personally liable for all of the debts and other obligations of the business.  If the business is unsuccessful, the owner is personally liable for payment of all business debts such as bank loans and unpaid bills to vendors and service providers (accountants, attorneys, etc.).  If the owner’s assets are insufficient to satisfy the outstanding debt, the owner may be forced to declare bankruptcy.
  
  
• It may be more difficult to obtain outside financing for a sole proprietorship, because a bank or other finance source usually looks at the net worth and individual credit history of the sole proprietor.
  
  
• Raising additional capital to start or expand the business is limited, as a practical matter, to “debt financing” (e.g., loans).  Because the sole proprietorship has only one owner, the proprietor therefore cannot sell “equity interests” (such as stock, or partnership interests) as may be done by corporations and other forms of business.
  
  
• A sole proprietorship is a greater financial risk for the business owner.  In addition to being personally liable for all obligations of the business, the sole proprietor has personal liability for the negligent or willful acts of employees or agents.  Thus, if an employee were to negligently injure a third person (like a customer or client) in the course of the employee’s duties, a sole proprietor may (along with the employee) be personally liable for the damages.  If a sole proprietor does not have insurance to cover the damages, the sole proprietor’s personal assets (car, home, stock portfolio) would be at risk to pay the damages.
  
  
• Legally, a sole proprietorship is totally identified with the owner.  Therefore, on the death of the owner, the business enterprise terminates, leaving only the assets of the business (such as equipment, accounts receivable, and real property).  The assets used in the business are not legally separate from the sole proprietor’s other assets.  Therefore it may be difficult to sell the business as a whole after the death of the sole proprietor – especially if there are disputes among the heirs.

A general partnership is a business enterprise entered into by two or more persons who do not form a corporation or any other type of business entity to operate a business.  If two or more individuals start a business together with the understanding that each will share in the profits of the enterprise, they are considered a general partnership even if they didn’t specifically intend to start a general partnership.  For example, if two sisters start a mail-order business over the kitchen table and agree to share the profits, they are usually be considered a general partnership if they don’t form some other kind of business entity such as a corporation.  Both very large and very small businesses can operate as general partnerships. It is not necessary to have a written partnership agreement to be considered a partnership (though it is often advisable in order to avoid unintended results that may occur from the application of a state’s default partnership provisions.)

For federal tax purposes, there are no restrictions on who can be a partner in a partnership.  Thus, individuals, estates, trusts, corporations, foreign persons, and tax-exempt entities can all be partners for federal tax purposes.  State law, however, may impose some limitations.  For example, state law may only recognize individuals who are licensed physicians as partners in a partnership providing medical services.

Like a sole proprietorship, general partnerships usually are not required to file any certificates or other organizational documents with municipal authorities, but they usually must file a “fictitious business name” or similar statement in the municipality where they are located.  Statutes in the state where the partnership is formed (for example, the California Uniform Partnership Act) typically govern the rights and duties of the partners.  These rights and duties may also be governed by a partnership agreement if the partners choose to have one prepared.

Advantages of a General Partnership

• The arrangement of duties is flexible.  Each state has a general partnership act, but partners may generally establish arrangements according to their own agreement, which will override most of a state’s default partnership provisions.  A partnership may also have several different classes of partners, each having different economic rights in the partnership.

• The arrangement of benefits is flexible.  In a corporation, allocation of profit and loss is proportional to the percentage of stock held by each shareholder. That is, a shareholder who owns 10% of the outstanding shares in a corporation would be entitled to receive 10% of any dividends paid by the corporation. In a partnership, distributions of profits, losses and capital gains need not be directly proportional to the percentage interests held by the partners.  This flexibility permits an individual partner to receive a disproportionately higher percentage of profits as a reward for taking special economic risks or for services provided to the partnership. It also permits a higher income partner to receive a disproportionately higher share of any loss incurred by the partnership (to offset income from other sources, thereby reducing overall personal tax liabilities).

  • Even though partnerships do not require the legal formality of a written agreement, one should be created to protect the partners’ interest.  Without such an agreement, the default provisions of state partnership law may cause unfavorable or unintended results, such as equal shares of profits and losses regardless of original capital contributions.
    
    
  • Some limitations control how a partnership can allocate profits and losses.  The federal tax code, for example, limits the ability of partners to deduct passive losses against most income.  A partner may not deduct tax losses that exceed his initial investment in the partnership plus his share of its liabilities.
    
    
• A partnership interest may be transferable because, unlike a sole proprietorship, a partner’s interest in the partnership is a discrete asset. A partner may transfer his partnership interest to his heir or estate, or to another person.  Customarily, however, transfers of a partnership interest are restricted under the terms of a partnership agreement.
  
  
  • Transfer restrictions usually give the partnership and/or the existing partners a “right of first refusal” when a partner wants to transfer his interest in the partnership, even if the transfer is to a member of his immediate family.
    
    
  • One important purpose of these provisions is to prevent existing partners from allowing other individuals to become partners without their consent.
    
    
  • Transfers are also restricted to prevent unfavorable tax consequences that may occur if more than a certain percentage of partnership interests is sold within a certain period of time.
    
    
• A partnership pays no income tax as a separate entity; profits and losses are passed through to the partners, and are reported on each partner’s individual tax return.
  
  
• General partnerships are more attractive to lenders because the lender will look to the aggregate net worth of all the partners in making a decision to extend credit.
  

• Each partner in a partnership has personal liability for the obligations of the partnership.  Each partner is liable, at a minimum, for at least his proportionate share.  Under most circumstances, however, each partner may be liable for the entire amount of all partnership debts and other obligations.  This is known as “joint and several” liability. It means that each partner has 100% liability to satisfy partnership obligations to a third party, but has a corresponding right to seek reimbursement from other partners for their proportionate share of the payment made by such partner. Therefore, if the partnership becomes bankrupt or insolvent, one partner with greater assets may be required to satisfy the liabilities of the other partners even if they exceed what would ordinarily be considered that partner’s proportionate share of those liabilities.  Great care should therefore be taken in selecting partners.
  
  
• Under the partnership statutes of most states, partnerships usually terminate upon the death or withdrawal of any partner unless the partners agree to continue the partnership.  The partners may include a continuation provision in the partnership agreement, or, in the event of a death or withdrawal, the remaining partners may simply agree to continue the partnership.  Usually, the agreement to continue must be made within a specified period of time.  If there is only one partner left, however, the partnership will be dissolved unless an additional partner (or partners) is admitted to the partnership within a specified period.
  
  
• Unlike a sole proprietor, general partners may not act unilaterally in making partnership decisions.  However, partnership agreements often give designated partners the authority to make specific kinds of decisions.
  
  
• General partnerships are limited in their ability to obtain financing other than debt financing.  Unlike sole proprietorships, partnerships may raise capital by selling equity interests in the partnership, but the sale of such interests on a large scale is very difficult because of the prospect of potential personal liability and the usually limited market for resale of the interest.  Also, publicly traded partnerships are taxed as corporations.

A joint venture is essentially identical to a general partnership, except that it is usually formed either for a specific, limited purpose or for a limited period of time.  For example, technology companies often form joint ventures to fund research and development of a particular item useful for their respective businesses (such as a specialized computer chip) when development might be too expensive for either company to fund alone.  In real estate, a builder may form a joint venture with a landowner to develop property and split profits. A joint venture is often is not intended to have the indefinite continuity of other forms of a partnership.

A limited partnership (LP) is a partnership in which the duties and obligations of the partners are divided between one or more “general partners” and one or more “limited partners.”

A general partner is a partner with the same liability and power as in a general partnership, who is responsible for managing the partnership and its operations. Like the partners in a general partnership, general partners in an LP are personally liable for all of the partnership’s debts and other obligations

A limited partner, in contrast, does not participate in the partnership’s management and day-to-day operations.  In fact, the limited liability of the limited partner usually depends on adhering to specific prohibitions against being actively involved in the management or operation of the partnership business. Unlike the general partner, the limited partner is usually not personally liable for the partnership’s debts and other obligations, except to the extent of the capital he has contributed to the partnership (or is obligated to contribute in the future under the partnership agreement).

A limited partner who violates the restriction on participating in management of the LP risks losing his limited liability for partnership debts and obligations.  Limited partners are, nonetheless, typically given certain voting rights with respect to major partnership decisions such as:

• The sale of all (or substantially all) of the partnership’s assets,
  
  
• The admission, removal, or retention of a partner.

A limited liability partnership (LLP) is a partnership in which the liability of all of the partners is limited.  Generally, the partners in an LLP are liable only to the extent of their original investments; they are not responsible for the errors, negligence, malpractice, wrongful acts, or misconduct of their partners or employees unless they themselves are directly supervising, controlling, or involved in the action.

This business structure is used most commonly by professionals such as public accountants and attorneys.  In California, in fact, only licensed accountants, architects, or attorneys may form an LLP.  This imposes a limitation on the members of an LLP to only licensed practitioners of the business in which the LLP is engaged. Like professional corporations, the specific professions which may or must form an LLP instead of an LLC are regulated by the individual states and therefore vary from state to state.

LLPs as a business entity are of very recent origin in California. The catalyst for their development is a prohibition contained in the California Corporations Code precluding persons whose occupations are dependent upon licenses, certificates or registrations issued by the state from conducting business in the form of a limited liability company. A limited liability company has the combined advantages of limited liability of its members (identical to the limited liability of shareholders in a corporation) with the “pass through” tax treatment of partnerships ensuring that profits are only taxed once.

LLPs are governed like general partnerships and have a similar degree of management flexibility.  However, because the liability of each partner is limited, LLPs are generally required to maintain certain levels of insurance.

LLPs are regulated by state statute and are usually formed by filing required paperwork with the Secretary of State, or appropriate state agency, either creating an LLP or converting an existing general partnership into an LLP.

A limited liability company (LLC) is an unincorporated association of two or more members to conduct a business for profit.  The members are co-owners of the LLC and may be individuals, partnerships, trusts, estates, associations, corporations, or other LLCs.  Members may be from foreign countries.  An LLC may have an unlimited number of members; the only restriction is that some states require an LLC to have at least two members.

An LLC is a relatively new business entity in the United States (though it has a long-standing history in Europe), combining aspects of both a corporation and a partnership.

Like a corporation, the formation of an LLC shields its members from personal liability for the debts and obligations of the company.

Like a partnership, an LLC allows members considerable flexibility in determining the management structure, rights of members, allocation and distribution of profits and losses, and transferability of memberships.  These provisions are contained in the LLC’s Operating Agreement (a required document similar to a partnership agreement).  The increased flexibility in management is one advantage of an LLC over a corporation.  For example, an LLC may be managed in the following ways:

• Solely by its members (similar to a partnership)
  
  
• By its members and a management committee (serving in a function similar to the board of directors of a corporation)
  
  
• By its members, a management committee, and officers (appointed by the members, by the management committee, or both)
  
  
• Solely by one or more managers

• The limited liability of a corporation is combined with the flexible management and allocation options of a partnership.
  
  
• Using the LLC form of conducting business will not be an impediment to raising capital in offerings of the company’s securities because of the protection against liability afforded to equity holders and the ability to provide for free transferability of equity interests.
  
  
• Many states now permit professionals to operate their practices through LLCs, but in such instances a professional may have personal liability not only for their own negligence or misconduct, but also for the negligence or misconduct of other professionals under their direct supervision.  California, however, does not allow persons whose occupation requires a professional license or certificate to operate as an LLC.
  
  
• Like a partnership, an LLC pays no income tax as a separate entity; profits and losses are passed through to the members.

• A state may require an LLC to have a limited life or specific termination date.
  
   
• An LLC does not have stock – and thus does not get the benefit of stock ownership and sales.  “Interest certificates” or “membership certificates” represent members’ interests in the LLC.
  
  
• As in a partnership, it is advisable to have a written Operating Agreement prepared (similar to a partnership agreement) to avoid automatic application of a state’s default provisions and possible unintended results. The legal cost of preparing a tailored Operating Agreement may greatly exceed the cost of forming a corporation, particularly an “S” corporation that enjoys many of the same characteristics and advantages of an LLC.
  
  

• Major California disadvantage: LLCs in California are subject to the payment of a gross receipts fee on their gross revenues from all sources (not taxable income, which may be a substantially lower amount after deducting expenses). The first $250,000 of gross revenue is exempt from the gross receipts fee. Thereafter, each increasing income range pays a higher fixed fee. This fee is in addition to the payment of the minimum franchise tax of $800 that must be paid annually by LLC's in California. Also, the $800 franchise tax is not credited against the gross receipts fee. To see the table of current gross receipts fees in California, click here.