Choosing the Right Legal Entity for Your Business
Americans are hungry to start businesses, and they have more tools at their disposal than ever to tap into the United States’ free enterprise system. But starting a small business requires more than dreaming big.
To achieve the American dream of being your own boss and running your own company, you must be pragmatic as well as idealistic, and one of the first practical concerns you face as the founder of a business is how to legally structure your business.
Among the factors to consider when choosing an entity structure are the complexity of the business, the potential risks it faces, protecting your personal assets from claims against the business, and the amount you pay in taxes.
How to Choose a Business Structure
One of the first and most important steps in starting a new business is choosing a structure for it. A business’s structure, which you should select before registering your business, affects issues such as taxation, fundraising ability, filing requirements, and personal liability, so it is important to choose wisely.
Each of the following business structures provides a different mix of benefits, drawbacks, and legal protections to business owners:
Sole Proprietorships
A sole proprietorship is a business founded and owned by a single individual. This is the least complicated type of business to set up. In fact, it is the default structure for a business owned by one person that is not registered as another entity type.
Sole proprietors should register an assumed business name (i.e., a “Doing Business as” or DBA name), typically in the county where they are located. The Internal Revenue Service (IRS) does not require a sole proprietor to obtain a separate employer identification number (EIN) or taxpayer identification number (TIN); the business’s profits and losses are reported on the owner’s personal income tax returns.
Sole proprietors have complete control over how the company is run and are responsible for its day-to-day management. They own all assets and keep all profits of the business, but there is no limitation on their personal liability because of the lack of a legal distinction between them and the business. That means their car and house could be vulnerable to lawsuits against the business or claims made by the business’s creditors.
Partnerships
Like sole proprietorships, partnerships are simple and inexpensive to organize and can be established without a formal state filing or entity registration, provided the business is a general partnership and not a limited partnership (LP) or limited liability partnership (LLP).
General partnerships typically must register their DBA in the county in which the business is located. Also, like sole proprietorships, income from a partnership is reported on each partner’s personal income tax returns; however, partnerships must also file an information return to report the partnership’s income, gains, losses, deductions, and credits from its operations.
Because partnerships involve two or more people, there are some complexities not encountered with sole proprietorships. The partners should enter into a partnership agreement that states how the business will be operated and any future disputes handled.
Corporations
Sole proprietorships and partnerships may be used by entrepreneurs who want to test their business idea before creating a more formal business entity, such as a corporation.
Filing articles of incorporation with the appropriate state agency creates a legal entity that is separate from the corporation’s owners, i.e., the corporation’s shareholders. Legally, corporations have many of the same rights and responsibilities as individuals. They can earn a profit, pay taxes, buy and sell assets, and sue and be sued. An important benefit of forming a corporation is that a corporation’s shareholders typically cannot be held personally liable for the corporation’s debts and obligations.
Compared to other forms of businesses, corporations involve more complexities and costs, including higher formation costs, more extensive record-keeping and reporting requirements, and double taxation. A corporation that meets certain requirements may elect to be taxed as an S corporation to allow profits and losses to pass through to the shareholders, avoiding the double taxation of C corporations, which are taxed on profits and then again when shareholders receive dividend payments.
Limited Liability Companies
Limited liability companies (LLCs) are a hybrid business structure that combines the limited liability protection of corporations but allows profits and losses to be passed through to the owners’ (members’) personal income, similar to sole proprietorships and partnerships. Typically, an LLC’s members are not personally liable for the LLC’s debts and obligations.
Flexibility is one of the primary benefits of the LLC structure. LLCs must be registered with the state and file annual reports, but owners may create an LLC operating agreement that governs the rights and duties of each member.
IRS tax treatment of an LLC varies depending on whether the members have decided to be taxed as a partnership in the case of a multimember LLC or as a disregarded entity in the case of a single member LLC—the default classifications in the absence of another election—or have elected to be taxed as a C or S corporation. Unless a corporate tax structure is elected, LLC owners are considered self-employed individuals and must pay self-employment tax (Social Security and Medicare taxes) on compensation they receive from the LLC.
We Can Provide Legal Advice for Your New Business
When you start a new business, you must position it for success from the start using a sound business strategy. For advice about choosing an entity structure and the other legal considerations involved in starting a business, please contact us to schedule an appointment.