Many family businesses begin as hobbies or side jobs before they turn into a real money-making operation. While operating as a sole proprietorship or partnership can make sense until your business reaches that point, it’s important to turn your family side project into a formal legal entity as soon as possible.
Without the liability protection of a limited liability company or corporation, the entire family can end up in hot water if there’s a lawsuit or you are unable to pay business debts. What happens if everyone signs for a loan or chips in cash for the business, only for it to go under? Taking the next step to form an LLC or incorporate can shield all business owners from being responsible for business debts and liabilities and make the family business more legitimate.
Here are the most common business entities for family businesses in the United States.
Sole Proprietorship and General Partnership
The sole proprietorship is the most basic type of business and it is not a formal legal entity. This means the business has no legal separation from the owner. In this case, the owner’s personal assets are at risk for business obligations and debts.
The general partnership is similar. This basic type of partnership is made when two or more people engage in business together. It requires no formal paperwork, and it’s how many family businesses begin. Unfortunately, a general partnership offers no liability protection. This means all partners are equally liable for the debts and obligations of the business, and the personal assets of all partners can be part of seizure for business debts.
Limited Partnership (LP)
A limited partnership is similar to a general partnership, except a limited partnership has general partners and limited partners. Unlike a general partnership, an LP gives owners limited personal liability protection. The general partner or partners are those who make business decisions and they will be personally liable for business debts. The limited partners are the ones who invest money in the business and may have a little control over operations. But they are not personally liable for the debts of the business.
A limited partnership can allow some family members to help fund a business. For example, parents investing in the business of their children without taking an active role in business management.
Limited Liability Partnership (LLP)
A limited liability partnership is another type of partnership. LLPs are often used by professionals like accountants and lawyers who do not want to be personally liable for the actions of another partner, such as malpractice claims. With an LLP, each partner is protected from any debts against the partnership. These debts can arise from professional malpractice claims against another partner.
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Limited Liability Company (LLC)
An LLC is a great choice for the majority of small family businesses because it gives personal liability protection like a corporation without strict formalities. Forming an LLC helps separate many family members from the business. It is so because individual owners will be protected from personal liability if the business is sued or can’t pay debts. LLCs are pass-through entities, which means business profits and losses flow through directly to the owner. Setting up this formal legal entity can also make it easier to transition the business to new owners.
Incorporation
Finally, family businesses can incorporate as a C-Corp or S-Corp. The corporation is a separate formal legal entity that shields owners from personal liabilities and makes it possible to issue stock. Incorporating usually isn’t a good option for small family businesses because corporations are more expensive to form. Additionally, they require meeting very strict ongoing requirements like keeping corporate minutes.
