Among the more important issues to consider when starting a new business, or deciding to formalize the arrangements for an existing business, is what form of legal entity should be used to govern that business. The most popular alternatives for small businesses include a corporation, a general or a limited partnership or a limited liability company.

Factors normally influencing the decision of which form of entity to use are (1) the level of personal liability to be assumed by the principals to third parties, (2) the level of control over business operations desired by the principals, (3) treatment under relevant income tax laws, (4) liquidity, as reflected by transferability, of ownership interests in the business, and (5) the formalities required to create the entity.

General Partnership

The easiest entity to form is a general partnership, which only requires two persons engaging in a business for profit. Although no written agreement is required by law, it would be foolhardy not to document at least the most basic understandings of the parties to such an arrangement, and it is preferable that more considered thought be given to problems or situations that might arise as the business becomes successful or other changes occur and to document the parties' agreements respecting those matters. Each partner in a general partnership has the right to control its business, and all partners are fully liable for all debts and obligations of the partnership. Interests in a general partnership normally are not easily transferred due to personal reliance by each partner on the other(s), and that likely would be even truer with a properly drafted general partnership agreement.

Limited Partnership

A limited partnership avoids personal liability for the limited partners, but every limited partnership must have at least one general partner, who has the same personal liability as a partner in a general partnership. However, in order to achieve limited liability, the limited partners also must surrender much of the right to control the business of the partnership. Limited partnership interests are only slightly more liquid than general partnership interests in concept, but in a typical limited partnership agreement, partners are restricted from transferring their interests except under specified conditions, which may include preferential rights for the other partners to acquire the interest of a partner desiring to transfer its interest. Formation of a limited partnership usually requires more comprehensive documentation than most general partnerships, and a Certificate of Limited Partnership must be filed to protect the limited liability of the limited partners.

Corporation

Although the corporate form shields all principals from personal liability for business debts and obligations, its primary disadvantage is the taxability of corporate income. Except for a Chapter S corporation, which requires compliance with specified criteria, income of a corporation is "double taxed", once by taxing the corporation on its earnings, and then again by taxing the dividends paid to shareholders. Also, the shareholders of a corporation conceptually do not control its business, whose affairs are managed by a board of directors. In a small business, this may be a distinction without meaning, since the shareholders also may be the directors, but at the very least, the principals must observe the formalities of directors' meetings and the recording of minutes. Forming a corporation for a small business in most cases requires the completion and filing of relatively simple forms with the state. Although corporate shares theoretically are freely transferable, in a closely held corporation shares usually are not more transferable than general partnership interests, and it is common for the shareholders to enter into an agreement restricting the transfer of shares, as in a limited partnership.

Limited Liability Company

Limited liability companies are a relatively recent phenomenon in forming businesses, becoming recognized by statute and attaining popularity within the past 10 years. They have the advantage of limited liability for all members to third parties, as with the corporate form, while allowing the members to operate the business directly as if it were a partnership. In addition, a limited liability company is taxed the same as a partnership, requiring the company to file only an information return, while the tax is imposed upon income paid or imputed to the members. Forming a limited liability company requires the filing of registration forms with the state, as with a corporation, and also requires the preparation of an agreement among the members, as with a partnership, which usually includes restrictions on transfer of ownership interests. Even though formation may require more thorough legal documentation, other features of a limited liability company make it a preferred form for many types of businesses, particularly in real estate development and other investment ventures and multi-principal businesses limited to specific transactions, objectives or goals.