Types of Business Entities and Legal Issues: An Executive Briefing

Introduction

The president of my company is considering setting up a spin-off business.
He is new to that kind of undertaking, having inherited his current business from his
mother. In this report, I brief him on the U.S. contract law and other legal issues as
they relate to different types of business entities, the main types of business entities
in the U.S. being sole proprietorship, partnership (including limited liability
partnerships and joint ventures), Limited Liability Company (LLC) and corporation
(Global Alliance of SMEs, n.d.).

Types of Business Entities and the U.S. Contract Law
Because sole proprietorships and general partnerships are not legal entities
separate from their owners, their contracts are created, negotiated, approved and
executed in the names of the proprietors or partners themselves (Rice University,
2019). However, for limited liability partnerships (LLPs), joint ventures (JVs), LLCs
and corporations, because they are legal entities that can sue and be sued,
contracts are created, negotiated, approved and executed in the name of the LLP,
JV, LLC or corporation itself.
In all these cases, the person executing or signing the contract must have the
authority to do so. Otherwise, the contract will be voidable at the discretion of the
other party (Rice University, 2019). In the case of a sole proprietorship, the proprietor
herself is the authority. In the case of a general partnership, the authority comprises
all the partners who are signatories to the partnership deed. For an LLP or JV, the
authority can be traced from the LLP or JV agreement. For an LLC or a corporation,
the authority can be tracked down from the articles of association.

TYPES OF BUSINESS ENTITIES AND LEGAL ISSUES 3

Types of Business Entities and Contract Liability

Contract liability refers to a party’s obligation to make good any damages or
losses suffered by the other party as a result of the first party’s failure to discharge its
commitments under a contract. In this context, a major advantage of business
entities that exist as separate legal entities (LLPs, JVs, LLCs and corporations) over
those that do not (sole proprietorships and general partnerships) is that in the former,
an executed contract legally binds only the business entity. Conversely, for the latter
group of business entities, an executed contract binds both the business entity and
its owners. In other words, both a sole proprietor and her business are liable for any
legal claims that may arise.

Types of Business Entities and Taxation

A sole proprietorship or general partnership itself does not pay taxes (Global
Alliance of SMEs, n.d.). Rather, it is a proprietor’s or a partner’s personal income that
is taxed. LLPs, JVs and LLCs are taxed like general partnerships, but only if they
have no more than two of the four qualities that characterize a corporation: the
capability to transfer ownership interests, centralized management, continuity of life
and limited liability. If it meets more than two of these qualities, an LLP, a JV or an
LLC is taxed as a corporation. For tax purposes, a corporation can choose to be
treated like a partnership (an S corporation), and thus not be taxed itself, or it can be
regarded as a taxable entity.
A major disadvantage of taxable business entities is that they could amount to
double taxation whereby both the entity and its owners are each taxed separately on
their incomes. Thus, it would appear that, for most business owners and
shareholders, the preference is for their businesses to be taxed like partnerships.

TYPES OF BUSINESS ENTITIES AND LEGAL ISSUES 4

Selling Different Types of Business Entities

Selling a sole proprietorship or partnership involves transferring the entity’s
assets for an agreed-upon price (Inc., 2021). These assets could include inventory,
business equipment, “good will”, trade names, and trademarks and patents. The
seller then uses the proceeds from the sale to pay off any debts, keeping the
balance as their profit. Generally, buyers prefer to acquire businesses this way
(through asset transactions) because of the advantages it offers them. For example,
an asset transaction may allow a buyer to claim greater depreciation deductions on
their taxes.
On the other hand, an LLC or a corporation is more likely to be sold through
stock sale where the seller receives an agreed-upon price in exchange for their
shares in the company (Inc., 2021). Often, such a transaction means that the buyer
acquires company liabilities as well, not just its assets. Sellers find this arrangement
attractive because of its tax advantages. For example, the sale of stock passes as a
capital gain, and makes it possible for the seller to avoid double taxation, as the
proceeds from the sale go directly to the seller without going through the company.

Conclusion

It is believed that this analysis will help the president of the company in
deciding on the most appropriate type of business entity as he contemplates setting
up a spin-off business. Particularly, the analysis should inform his contracting,
taxation and exit plan considerations for the new venture.

TYPES OF BUSINESS ENTITIES AND LEGAL ISSUES 5

References

Global Alliance of SMEs. (n.d.). Types of Business Entities & Corporation in the
USA. Retrieved from Global Alliance of SMEs:
http://www.globalsmes.org/news/index.php?func=detail&detailid=417&catalog
=22&lan=en&search_keywords=
Inc. (2021, January 5). Selling a Business. Retrieved from Inc.:
https://www.inc.com/encyclopedia/selling-a-business.html
Rice University. (2019). Business Law I Essentials. Houston: OpenStax.