Sole Proprietorships
In general terms, a sole proprietorship requires no fees, legal documentation, or filings other than state and local business permits. However, there are disadvantages to functioning as a sole proprietorship: (1) it only has one owner and if additional capital is required from another investor, the form is not available and a partnership or other entity form is required and (2) a sole proprietorship provides no protection for the founder against creditors of the business. By contrast to corporations and LLCs where, the creditors of the business cannot successfully sue the founders and other investors.
General Partnerships
If there is more than one founder, a general partnership is sometimes chosen as the legal form of business entity. If possible, the founders will agree on a partnership agreement to “set the rules” among the founders; however, if the founders do not agree on a partnership agreement, most state laws will supply the rules in the absence of an agreement. The income of a partnership is taxed directly to the partners on a pro rata basis. Finally, each partner is generally liable for the debts of the business and therefore exposes the personal assets of each partner to the business’ creditors.
C corporations
These are formed under state law (typically in the state where the business will be first operated or in a state that is known for its well developed corporate law). Most venture capital backed companies are C corporations.
S corporations
These are formed under state law but have favorable tax treatment for closely held (not more than 100 shareholders) corporations under federal and state tax laws.
LLCs
These are formed under state law and are a combination of corporation and limited partnership and have certain tax advantages over C corporations.
Limited Partnerships
These are formed under state law and are usually formed to hold investment real estate and also are often the “investment vehicle of choice” for private equity firms and hedge funds.
Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax, and accounting issues. However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital in contrast to sole proprietorships and partnerships.
Sole proprietorships and partnerships can later convert to a C or S corporation, LLC, or other legal entity.
