Partnerships and corporations are two common forms a startup business can take. Forming a corporation requires the business to register its articles or certificate of organization with the governing state agency. Partnerships aren’t usually required to register – though it’s recommended they do – and can exist by default.
A partnership consists of two or more owners operating a business. It can be a general or a limited partnership. Most state laws consider two or more people who own a business partners by default, but many new owners don’t realize the implications of this. Because each partner is jointly and severally, or individually, liable for the partnership’s obligations, the action of any partner binds the partnership, even if agreements are made without the other partners’ knowledge or consent. One partner may invest more money in the business assuming that gives her more decision-making authority, but this is not the case unless spelled out beforehand.
Ignorance of the rules can devastate a new business. To avoid common pitfalls, the partners should draft (or have their attorney draft) a comprehensive partnership agreement that addresses, at a minimum, contribution amounts, allocation of expenses, distributions, management authority and limitations, dissociation, buyout rights, dispute resolution, admission of new partners and dissolution procedures. Without this written document, the default partnership rules of the partnership’s jurisdiction prevail, with results often not what the partners intended. For tax purposes, a partnership is a flow-through entity, and all gains and losses pass through to the individual partners. In a limited partnership, the general partner runs the business and the limited partner receives returns on investment but makes no decisions. A limited partner cannot bind the partnership.
With a corporate structure, equity consists of shares of stock and owners are shareholders or stockholders. Shareholders don’t have personal liability for the corporation’s obligations and don’t run the corporation’s everyday affairs; these duties fall on the officers or board of directors. Board members are elected by shareholders, and some states allow as few as one; the board, in turn, appoints officers.
Corporations are governed by bylaws that outline administrative details such as shareholder meetings, number of directors and officers and their responsibilities, indemnification and accounting procedures. Shareholders may receive benefits, including dividends, and other preferential rights outlined in the corporate certificate or charter.
Many new businesses choose not to incorporate because corporations typically are more expensive to form than partnerships and require ongoing state filings. Corporations also are subject to “double taxation,” because the corporation’s shareholders are taxed on any dividends they receive and the corporation is also taxed on its profits. If a corporation chooses “S” status, it’s considered a pass-through entity for tax purposes, and shareholders report all profits and losses. Not all corporations are allowed “S” status, and timing requirements are stringent. Business owners should discuss the mechanics of an “S” election with an attorney and accountant.