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Many people new to business wonder if they should create a business entity such as a corporation or a Limited Liability Company (LLC), or simply remain as a sole proprietor. It’s an important question—business advisers generally agree that the choice of business entity can be one of the biggest decisions that entrepreneurs need to make.
There are sound reasons for securing your business as a structured entity. Considering your tax obligations and limiting your liability are motivators to help you learn how to ensure that your personal assets are kept separate from business assets in the event of a lawsuit. Other factors that figure highly in the need to structure protections into the business include receiving investments, managing partners with different stakes, sharing profits, and hiring employees. Protecting intellectual property (IP) is also a key element of working with partners, contractors, and employees. When neglected, it becomes a frequent cause of regret for entrepreneurs as their company becomes more successful.
Many of the requirements placed on different business entities are a function of state law. Your state’s Secretary of State website will contain a wealth of business-specific information, usually easy to read and scan through to find the forms and procedures to register your business as a corporation, LLC, partnership or other entity.
Knowing which entity to choose may ultimately depend on the specific advice you get from your tax and legal professionals. It’s a good rule of business that money spent on such a business advisors role is a lot cheaper than getting by without it. Even so, a little background research will save you time and money, and the right questions to ask your accountant or lawyer will be at your fingertips.
LLC, Corporation, or Nothing? Common Business Entity Choices
Sole Proprietor. Many small businesses never form a business entity. This is especially true of self-employed contractors. The IRS regards such people as sole proprietors by default, and assumes personal and business funds are commingled, and that all revenues are personal income subject to tax. Most states require a sole proprietorship to register its business name if one is used other than the name of the owner. Search on “DBA” (Doing Business As) for more information about this.
Single-member LLC. This is a recent variant of the LLC, and may be treated differently by each state. The LLC entity was essentially founded on the principle of partnerships, and the single-member hybrid has required clarification by courts and state legislatures as to the liability and tax protections it gives. Check carefully for your own state.
S Corporation. This is a corporate structure often chosen by individual business owners or investors. It’s a slightly restricted corporation, and the “S” part of it is simply a declaration to taxing authorities that revenues are flowing through directly to the shareholders as personal income. This avoids taxation falling on the corporation itself, the notorious “double taxation” of standard corporations.
Corporation. This is the oldest form of business structure in the world, and has the most settled law behind it. It’s a very cut-and-dried form of business structure, making it simple to offer shares, receive investment in return for shares, and allocate profits according to shareholding. It provides clear separations between the personal assets and other business dealings of shareholders, and limits liability accordingly. In payment for this rock-solid separation, the corporation itself is taxed, before any remaining profits are disbursed to shareholders as their personal income.
Limited Liability Company. The LLC is a very flexible way for partners and investors to join in a business endeavor. The paperwork and report-filing requirements are less stringent. The “engine” of this entity is the Operating Agreement, which is extremely customizable, and acts like a contract between all the members according to the status of each. Start-ups love to form LLCs because it’s easy to use, it accommodates working members and silent investors, and it flows distributed revenues directly to any member as personal income or loss.
General Partnership. The standard partnership is like the sole proprietorship in that it doesn’t offer any protections or tax sheltering. It’s simply an agreement between partners to join in a common enterprise as co-owners, and with revenues disbursed according to the agreement as personal income to each partner. In the event of lawsuits, each partner can be liable for the full debts of the business, and would then have to sue the other partners to share this burden.
Limited Partnership & Limited Liability Partnership. The LP and the LLP add liability protection to the basic partnership, keeping the partners separate from any debts or liabilities incurred by the business, and offering some tax relief for silent partners. The LLP is especially suited for professionals such as the members of a law firm, and many states restrict the use of the LLP to such professionals.
Think Local: Know How Your City, County, and State Treat Your Choice
The business entities described above are created under state law and through the state government. It’s important to know how your state treats your choice of entity. Should you incorporate in Delaware? If you have to ask, the answer is probably NO. If you can truly gain benefit from being registered in a state other than your home state, you’re big enough to have professional advice already from your accountant or lawyer, spelling out these benefits. Otherwise, it typically makes most sense to register in your own state, file your annual investment reports and spend a little time learning the local laws.
Remember also that counties and cities can have a say in how you run your business, in terms of licenses, taxes, registrations and report filings. It’s quite straightforward to handle all of these obligations, and filing services such as my own can take the startup and annual filing workload away from you, for affordable fees.
Nothing here can be construed as legal or accounting advice, so please be sure to check in with your accountant or lawyer if you have the slightest uncertainty about which business entity will serve you best over the years as your company grows and prospers.
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