There are six basic ways to organize a business. First, there are the business organizations that are relatively simple to start but also come with unlimited personal liability such as the sole proprietorship or the general partnership. Other business entities take more effort and money to get started but can limit the investor’s liability to just the money he or she has invested in the business. These entities are limited liability entities: limited partnerships, corporations, limited liability partnerships and limited liability companies. Corporation may also be S corporations or C corporations. Both are corporations but they differ in how they pay their taxes. This article lays out the pros and cons of business entities that are the most common possible candidates for market growers. The article also provides a guide to when it might be time to form a limited liability entity. Individuals tend to become interested in forming limited liability entities when they become worried that a loss or claim resulting from their business could cause them to lose their personal as well as their business assets.

Sole proprietorships are the default selection of business entities. If you’re not anything else and you’re conducting business by yourself, then you are a sole proprietorship. This is the one-man band business, where the business and its owner are essentially one and the same entity. For example, Jane Grower raises vegetables and sells them as Jane Grower, Market Gardener. All the taxes, profits and potential liabilities or claims against the business are claims against Jane and all of her personal assets.

There are advantages and disadvantages to doing business as a sole proprietorship. It’s fast and it’s easy to get going as a business. While forming limited liability entities requires paperwork and registration with the state, getting into business as a sole proprietorship requires a bare minimum of paper work. Depending on state and local regulations, you may have to file a notice that you are doing business and get a permit. If you are not conducting business under your own name, you’ll have to show you have filed a “doing business as” notice so people know who is conducting the business. While you have to pay taxes on your earnings, you are only taxed at one level and you will report your business earnings on schedule C on your personal tax return.
However, several distinct disadvantages exist as well. If you get sued and lose, then the judgment will be entered against you personally. This means that your business and non-business assets are all at risk because they are all in the same pot. In addition, if you die or become disabled, it will be difficult if not impossible for the business to keep operating without you. There are also some practical limits on how much money you can raise from outside investors. Corporations can sell stock or shares to raise money, but a sole proprietor has no easy option to divide up his or her ownership in the business. When a business is a corporation, then the bank might lend money to the corporation based on the corporation’s assets as collateral. However, in a sole proprietorship, the loans are to the owner personally, so by default he or she is personally responsible for them.

The next form of business organization is the general partnership. General partnerships are loosely defined as two or more individuals working together to generate a profit. Partnerships are basically sole proprietorships with more than one person.

Partnerships have many of the same advantages of sole proprietorships. Next to sole proprietorships, they are the quickest and easiest business entities to get started. They usually do not require written agreements, although it’s folly to start a partnership without one. If the partners decide they don’t want to do the business any longer or don’t wish to do it with each other, a written partnership agreement can be enormously helpful in winding up the business. If the partners go to court to resolve their differences and there is no written agreement, the court may decide what happens under the provisions of the state law governing partnerships. This could have some unpleasant surprises for the parties.

If the partnership conducts business under a name other than the partners’ they must file a “doing business as” or “dba” announcement to show for the public record who the participants are. Partnership income must be reported to the state and federal tax authorities but it flows through to the partners’ personal returns and is only taxed at one level. Partnerships have one huge advantage over sole proprietorships, in that more participants means more chances for the business to acquire capital for investment. The partnership agreement can be structured to reward the partners who invest more with a greater share of the profits.

Partnerships share many of the disadvantages of sole proprietorships as well. First, there’s no automatic continuity of operations. For example, unless the partners have an agreement which provides otherwise, the death of a partner terminates a general partnership. Second, there is no liability limit for the partners for the debts of the partnership, so all of the general partners’ personal assets are still at risk in a general partnership. In addition, partners may be held liable for the actions of the other partners.

Limited partnerships are the first of the limited liability business entities. A limited partnership differs from a general partnership in that at least one of the partners is a limited partner. This means that the limited partner does not actively run the business. The general partner, or partners, actively conducts the business, while the limited partner is passive or silent.

A person who invests in a limited partnership as a limited partner can limit the amount he or she has at risk in the business to his or her actual investment in the partnership. This means that the partnership can have access to more capital, and the limited investor can invest knowing that his or her liability is limited to just what he or she has put at risk. Another advantage to this business form is that the income and losses of the business still flow through to the partners’ taxes at the individual tax level of the partner.

However, a limited partnership also has some disadvantages. These types of entities require written agreements, and registration with the state. Limited partners may not actively manage the business or they will lose their limited status and become general partners. If that happens, then the limited partner will be subject to the same risks that the general partner bears.

Corporations are the next business entity. Corporations are the oldest limited liability entities in existence. A corporation is an artificial person, and it is first organized by individuals and then given life by the actions of the state government when the individuals file the articles of incorporation with the state government.

Corporations have several advantages. They offer clear and established limits to business liability. In addition, they offer the clearest and easiest ways to transfer division of ownership in a business because people can buy stock or shares of ownership in the business.

Corporations also have their share of disadvantages. While you may be planning on running a fairly simple business of growing and selling vegetables, you now have the same business structure as General Motors or Coca Cola. Incorporating a business requires action by the state government. Corporate documents must be filed correctly and on time, and the corporation must submit annual reports and pay fees. If these corporate protocols are not done or done incorrectly, the corporation’s investors may lose the very limited liability protection they went to all this trouble to acquire. Another disadvantage is what is known as double taxation. This means that corporate income is first taxed at the corporate level and then again when the individual investors receive it. As a practical matter, small corporation often pay out the majority of their earnings in salaries to the owner operators. By paying out the income as an expense this greatly reduces the tax burden of the corporation and helps eliminate the double taxation.

S corporations are an attractive option for many small businesses. This entity allows the investors to have the same limited liability protection that a corporation offers but allows them to be taxed like a partnership. This means that the income and losses of the business flow through to the tax return of the individual. This advantage eliminates the double taxation problem of a C or traditional corporation. There is no magic or hidden meaning to the term C Corporation or S corporation – the letters refer to the part of the tax law where the provisions regarding the corporations are found. S corporations may have a simpler tax structure than C corporations, but S corporations must still observe all the technicalities of a class C Corporation. This means that like C corporations, S corporation investors should have meetings, keep a corporate minute book, file annual reports and observe the required corporate formalities.

The last form of business entity is the Limited Liability Company or LLC. The LLC is a relatively new creature in the Unites States. It offers some of the advantages of a partnership or sole proprietorship with the limited liability protection of a corporation.

The LLC offers the advantage of flexibility and relative ease of operation. An operating agreement between members of the LLC governs the entity. If you live in a state which allows single member LLCs then you can make the agreement whatever you wish. If you form your LLC and pay your fees and abide by the laws of the state in which it is formed, then you should have the same limited liability of a corporation. That means that your risk is limited to what you have invested in the LLC. And the huge advantage is you get this without the requirement of filing annual reports and observing all the organizational technicalities that come with a corporation. In addition, your earnings should be taxed at the partnership level.

Limited Liability Companies also have disadvantages. They are relatively expensive to set up and operate. Corporations have been doing business for hundreds of years so the law governing them is settled and predictable. LLCs, in contrast, have only been recognized in the U.S. for less than 25 years, so they are a new creature. This means that the law governing them is not as developed and this makes it harder to predict how courts will decide cases involving Limited Liability Companies. Also, if the members do not make provisions for how they want specific matters to be settled in their operating agreement, and if the matter goes to trial, then the courts will apply the limited liability company act of the state to resolve the problem. This may result in unpleasant surprises for the members.

Forming a limited liability business entity should involve careful analysis and business planning. Limited liability business entities offer some significant advantages such as limits on liability for the investors, continuity of operations and the ability to raise capital. So, the first question for the business owner to think about is just how worried about liability are they. If you’re worried about limiting your liability to lawsuits then a limited liability entity can offer some peace of mind and protection by limiting the risk to the amount invested in the business. However, the owners of the LLC will still have to meet the requirements imposed by the state the LLC was formed in to successfully limit their liability. The LLC may, also, offer some advantages in protection from creditors as well.

Every business decision involves weighing the risks and rewards of contemplated actions. Choosing the right business entity to form could be as important as picking the right crop to grow. If your business involves an activity which could expose you to lawsuits or other actions by creditors, the right business entity could protect your personal assets. In addition, the right business entity can allow you to recruit investors, and it can make passing on the family business to your children infinitely easier.

Rich Schell is an attorney with a particular interest in market farming. He can be reached at schellville@excite.com or 847-635-0551.

This article is not legal advice, and it does not form any attorney client relationship. Copyright©2002 by Rich Schell. All rights reserved.