A sole proprietorship is an unincorporated business owned by one individual. It is a non-entity. A sole proprietorship is the default for single-owner businesses who do not select an entity structure. Sole proprietors typically manage the business and often do the labor work as well.
Example: Sonja’s 30-year career was in marketing. During the COVID-19 pandemic, she lost her job and has been unable to find a new job. However, she has built up a lot of contacts through networking over the years and has decided to do some consulting. Sonja does not need to select an entity. She is by default a sole proprietor.
Sole proprietors typically have no organizational filing that needs to be done. Although, note as we discussed in Unit 6, filing for the “fictitious name” that a sole proprietor is using – maybe as a DBA (doing business as) – could be required under Consumer Protector Laws.
A sole proprietorship is considered at one with the owner; it is not separate from its owner. In other words, the business is the owner, it does not stand on its own. As such, the business does not file its own tax returns. The income, expenses, and debts of the business are the owner’s. Many sole proprietors do not set up a separate bank account for the business, however, I recommend that they have one.
Whether or not this entity structure is right for an entrepreneur depends on what the business is engaged in, and the many considerations outlined below.
As shown above, a sole proprietorship is a default non-entity for a business with one-person ownership where the business was not organized as another entity. A partnership is a default entity for a business with two or more owners where the business has not organized as another entity. Often people don’t even realize they have established a partnership. Why? The definition of a partnership is “an association of two or more persons to carry on as co-owners a business for profit.” 💡Think about what steps two people can take in order to be unintentionally considered a partnership.
Partnerships typically have no formal filing requirements and are generally governed by a Partnership Agreement. (It’s common to refer to partnerships as “contractual entities.”) The Partnership Agreement can be written or oral but as lawyers, we prefer written. If partners defaulted into a partnership, they likely have nothing more than a handshake or oral deal on what they are going to partake in. They may say “we are 50-50 partners” and that could be the extent of their arrangement. There are state laws in place to guide partnerships that have been created with an incomplete agreement or even no agreement. For instance, the general rule is that all partners have equal rights to manage, share in profits equally, and share in losses in the same proportion as profits. Partners can alter these defaults by way of a Partnership Agreement if they’d like.
💡 How are partners advantaged and disadvantaged by being automatically placed into a default partnership?
The Partnership Agreement is a contract between the partners and is subject to contract law. Most statutes defer to the Partnership Agreement out of respect for the partners’ relationship as set forth in it. However, many state statutes provide for hard and fast laws that cannot be waived, not even in the Partnership Agreement, e.g., some fiduciary duties are unwaivable; the right to inspect books is unwaivable, etc.
The Partnership Agreement sets forth the details of the relationship between the partners. It typically will cover such topics as:
- Purpose and objectives of the partnership
- Term or length of the partnership
- Governance: voting, management, etc.
- Ownership Interest
- Sharing of Profits and Losses
- Buy-sell arrangements
- Admission of new partners
- Winding up procedures
- Waivers of fiduciary duties (where permissible)
We will discuss formation in Unit 10.
A Partnership is considered a distinct legal entity. It can sue and be sued. It can own property in its own name. However, unless the Partnership Agreement or governing state statute states otherwise, a partnership dissolves upon the death of a partner. Some states allow for the remaining partners to vote to continue the partnership but not all do. As such, it is best to include such an preference in the Partnership Agreement.
There are three types of partnerships: general partnership, limited partnership, and limited liability partnership. A general partnership is formed either by default or intentionally. The partnership outlined above where partners have equal rights to manage, vote and to profits, etc. is a general partnership. A limited partnership (LP) is different. A LP has one or more general partners but there are also limited partners. Limited partners have very little to do with management; typically they are passive investors in the company. A limited liability partnership (LLP) is designed to protect partners from one another’s misconduct or negligence. You see these most often with professional firms such as law, doctors, engineering, and accounting firms. If your client is organized as a limited partnership or limited liability partnership, it must have the designation “LP” or “LLP,” respectively, at the end of its name.
Personal liability exposure, taxation, compensating/making distributions to the partners, and exit strategies will be covered later in this Unit.
Corporations are separate, distinct legal entities. In other words, they are considered as beings all on their own, and in some cases treated the same way as individuals. They have unlimited life and an owner (shareholder) can freely transfer ownership (sell their stock) in the corporation. Corporations can transact business and lease/own property. They can sue and be sued. Generally, if a shareholder dies, their stock transfers via last will and testament to their heirs. There are exceptions to this in smaller (or close) corporations where shareholders may execute a buy-sell agreement which will govern the transferability rules for the corporation.
Corporations must file Articles of Incorporation in order to be organized. Corporations are creatures of statutory law. They are not governed by a contract like partnerships. In Pennsylvania, the Pennsylvania Business Corporation Law governs the operation of a corporation. The BCL contains many requirements such as the requirement to hold annual shareholders’ meetings, have a board of directors, which transactions require shareholder approval and which just board approval, and many more. Corporations are permitted to have a set of rules, called bylaws, that sets forth the policies and responsibilities of the shareholders, directors and officers. We will discuss bylaws and formation more in Unit 10.
Shareholders have voting rights on certain matters and they vote based on the number of shares (or stock) they own. Typically, shareholders do not manage the corporation. The shareholders vote in the corporation’s Board of Directors who oversee the corporation. The Board hires executives to run the day-to-day operations. Some executives are: Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Information Officer (CIO), Chief Diversity Officer (CDO), Chief Operating Officer (COO), etc.
Corporations can be owned by a single shareholder.
As far as the Internal Revenue Service is concerned, there are two kinds of corporations: C-Corporations and S-Corporations. The C or S prefix references the Subchapter of the Internal Revenue Code that the corporation is subject to, e.g., Subchapter C and Subchapter S. In order to qualify as an S-Corporation, a corporation must, throughout its life, meet the requirements in Subchapter S or 26 U.S. Code § 1361.
A S-Corporation must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
If the S-Corp fails to meet one of the requirements, technically it will terminate and automatically default to a C-Corporation which can be devastating. However, if the S-Corp is able to demonstrate that the failure to meet one of the requirements was inadvertent, the IRS may provide a waiver to restore the company back to S-Corp status.
💡 Can you imagine a scenario in which an S-Corporation may inadvertently no longer meet its requirements?
So why is there a distinction? What is the bonus for meeting all of the requirements to be an S-Corporation? It all comes down to taxation. Stay tuned, or satisfy your curiosity by jumping to Tax Considerations.
Remember, corporations are corporations regardless of their Internal Revenue Code designation when you are treating them in some manner other than for tax purposes.
Personal liability exposure, taxation, compensating the shareholders, and exit strategies will be covered later in this Unit.
Limited Liability Companies
A limited liability company, mostly known by its acronym “LLC,” is a popular entity structure for start-ups. LLCs share attributes with both partnerships and corporations. It’s important to remember that LLCs are not partnerships and they are not corporations. They are a distinct entity that is a hybrid between partnerships and corporations. Therefore, please do not intentionally or accidentally refer to LLCs as “limited liability corporations” because there is no such thing. (Despite the fact that sometimes judges and even legislators err in using proper terminology.)
Like partnerships, LLCs are contractual entities. Owners (members) of an LLC create an Operating Agreement that is much like a Partnership Agreement in content. Unlike partnerships however, there can be a single-owner LLC, known as a Single Member LLC (SMLLC). Anyone and anything can be an LLC member: a corporation, a partnership, an individual, etc. There is no maximum as to how many members can own the LLC.
LLCs need to organize by filing Articles of Organization. LLCs are entities and therefore they can transact business, lease/rent property, and sue and be sued.
Personal liability exposure, taxation, compensating and making distributions to the members, and exit strategies will be covered later in this Unit.
💡 Start thinking about the questions you need to ask your client in order to gain the information you need to help them select the appropriate entity.