This article describes the basic forms of legal entities in the United States. It covers the traditional forms on how an USA business can be set up including Sole Proprietorships, General and Limited Partnerships, Corporations and the more and more popular Limited Liability Company.
The major legal Business Entities in the United States
There are a variety of options on how to setup the legal fundament of your future USA business. Typically, American businesses choose between the following entities:
Limited Liability Company
What does "Legal Entity" or "Business Entity" refers to in the USA?
It is important to understand one basic aspect when looking at different forms of legal entities: Legal entities are abstracted from the actual persons which own the business. When Mr. John Doe owns an American LLC, the actions he is doing in the name of the LLC are legally not performed by himself, but by the LLC. In the United States a LLC as a legal entity can do almost the same as Mr. John Doe himself. A LLC can for example buy products, a LLC can sell products, and a LLC can make contracts with other legal entities or with individuals and so on.
There are of course much more details to consider and a variety of important exclusions which apply. For example, you should not assume that you now can break the law and simply let the LLC holding responsibility for it. In any case you would personally be hold responsible for criminal actions! But for the moment, just bear in mind: When you own and run a LLC in the USA, the LLC is "responsible" for the business and not you as a person as long as you do business in the name of the LLC
Now that we have that principle of abstraction on our mind, we can go into more details about business entities in the United States.
Selecting the legal entity for your American business
In order to select the ideal legal entity for your business, it is important to determine the criteria's which are important to oneself, to potential partners and to the actual nature and extend of the business. For example: If your objective is the maximization of protection against liability, a corporation would be a good choice. On the other hand, a corporation has numerous formal requirements especially in regards to reporting, internal organization and more.
The Sole Proprietorship is the most basic form of legal entity, since it is not distinguishing between the person who runs the business and the business itself. Most people doing businesses by themselves without setting up a specific entity are Sole Proprietors by default. A sole proprietorship has by nature almost zero regulation on how the USA business has to be organized. However, it has also only limited mechanisms to protect personal assets against claims resulting out of the business.
The main points of interest of Sole Proprietorships are:
Easy to setup and maintain: Beyond filing taxes, there are no specific formal requirements to setup and run a Sole Proprietorship.
Only one owner: By definition, a Sole Proprietorship can only have one owner.
No corporate taxation: Sole proprietorships are solely subject to personal taxation.
Unlimited personal liability: The major downfall of a sole proprietorship. As the owner is doing business in his own name, he or she is subject to be liable for all business debts in person.
Business is tied to the owner: With a sole proprietorship, the business is completely tied to the owner. If the owner for example dies, the business dies with him. Other forms of business organizations are abstract entities which can be transferred.
A General Partnership in the USA is understood as a relationship between multiple parties which form a business together and agree to share profits and losses. A partnership can also be understood as a collection of sole proprietors. All aspects of a partnership are almost the same as those of a sole proprietorship. The major difference is, that multiple persons are forming the business instead of just one person.
There is no limitation of liability for any partner of a General Partnership. The issue of liability is even more relevant than with the Sole Proprietor, since one partner is not only responsible for his own actions, but also for the actions of his partners. In relations to the outside world, anybody within that partnership can decide on behalf of the partnership and represent the business.
Due to the high interpersonal dependency of all partners in many aspects, it is highly suggested to have a written partnership agreement which typically regulates issues like:
Purpose of the business
Capital contributions of each partner
Distribution of profits and losses
Rights, responsibilities and duties of each partner
Transfer of partnership interests
Admission and withdrawals of partners
Rules for termination of the partnership
The Limited Liability Company (LLC)
The LLC have been a traditional form of business structure in Europe. In Germany for example, the LLC is the equivalent to a "GmbH". The LLCs made their way to the United States in the late 70s. As of today they are accepted as form of business in every state and are very popular especially for smaller American businesses. LLCs are very popular since they combine advantages of a partnership with those of a corporation. There is a high level of potential limitation of liability to protect personal assets (advantage of the corporation) as well as very low formal requirements (advantage of the partnership)
The main points of interest for LLCs are:
Limitation of Liability: When the LLC is in financial trouble, the owners are generally not liable for the business debts. The only exclusions are if the owners willingly agreed to personal liability for business debts or if criminal activities and/or gross negligence is involved.
Tax situation: Profits and losses can be "passed through" to the personal income tax. A corporation for example is subject to double-taxation and needs to pay both: corporate income taxes and the owners again have to pay personal income taxes on the dividends.
Less paperwork: There is of course some paperwork involved in setting up and maintaining a LLC, but it is - especially in comparison to a corporation - very limited.
Flexible in size: Most states allow one-person LLCs which offer a lot of flexibility. However, most states define a maximum numbers of owners.
USA S-Corporations and C-Corporations
In general, an American Corporation is the more professional form of a business entity. Most large companies in the USA are choosing this form. The roots of USA Corporations are going way back in history and have been transferred to America due to British influence. Corporations are created under state law. The basic idea is to divide a company's total capital into shares of stocks whereas each stock represents a unit of the ownership. Stocks can be sold to or bought from stockholders. As with the LLC, the corporation is a separate entity from the individual stockholder. Any liability is limited to the capital invested in the corporation.
There are two types of corporations in the United States, S-Corporation and C-Corporation. Subchapter C corporations are mostly large, publicly-held businesses. They can be owned by foreigners and are subject to double taxation. The C-Corporation needs to file corporate income tax before paying dividends. In addition, the person who receives dividends needs to pay personal income tax on his dividends.
Subchapter S corporations are simply a dedicated form of C-Corporations. The major difference is the special status with the Internal Revenue Service: they are not subject to double taxation. Similar to a LLC, revenues are now passed through to the personal income tax. However, this status comes with some limitations like:
Must be domestic (S-Corporations can be owned by foreigners)
Not more than 75 shareholders (before 1997: 35)
Shareholders must be individuals and not other legal entities
Not more than one type of stocks
The following points of interest are important when dealing with corporations:
Taxation: S-Corporations are subject to double taxations. Forming a C-Corporation can overcome that but is subject to other restrictions.
Formal requirements: Corporations require the highest degree of formal requirements in comparison to all other forms of legal entities. Such requirements includes for example filing of Articles of Incorporations, holding regular official meetings, preparing corporate minutes and having shareholder voting on major decisions.
Going public: Corporations are the most ideal form of bringing companies to the stock market.
Limitation of Liability: As with the LLC, the corporation limits the personal liability only to the assets invested in the corporation.
USA Limited Liability Companies (L.L.P.) and Limited Partnership (L.P.)
The most exciting point about business entities is that the different forms can be mixed up in almost all kinds of imaginary combination. It is important to understand that a business organization like a LLC is an abstract legal entity. A legal entity can perform almost always the same legal transactions a real person is able to perform. That includes that a LLC can for example be a partner of a General Partnership. This situation gives everybody the chance to mix and combine legal entities to increase the total advantages and decrease the total disadvantages of each entity.
A form of such a mixed entity is a L.P. (Limited Partnership) or a L.L.P. (Limited Liability Partnership). The LP is basically a partnership but has two different kinds of partners: At least one "general partner" who is liable with his personal assets and one or multiple "limited partners" which are only liable with their capital invested in the partnership. In LP's, the general partner is typically another legal entity like a LLC. That means that the only entity in the Partnership which is supposed to hold Unlimited Liability for the Partnership's business, is now limited in liability by its own form of legal entity. A LLC as a General Partner is still fully liable for all Partnership's debt, but once the L.P. becomes bankrupt, there is nothing more what the Partnership could get from the LLC. That is why a Partnership with a LLC as a General Partner is titled as "Limited Partnership"
USA Business Entities - Wrapping it Up
This short article did of course only cover a tiny fraction of the way business can be set up or managed. When setting up your business, you may want to consider to get professional help from a lawyer. Still, even when working with professionals, it is always good to know and to understand the procedures and legal issues involved.