Choosing the Business Entity
Once you’ve decided to start a business, you’ll need to decide whether to form your business as a separate legal entity, and if so, what that entity will be, and what are some of the other steps you’ll need to take to get up and running. This article is meant to be general business advice, though, so you should still obtain specific legal advice for your particular situation.
Sole Proprietorship. Single owner businesses sometimes choose to operate as a sole proprietorship. In this situation, the business essentially operates as an extension of the owner. The profits and losses of the businesses will be accounted for on the individual tax return of the owner. This form of business has the obvious advantage of simplicity in that there are no separate corporate or partnership formalities to be followed.
However, all liabilities of the business will also flow directly through to the business owner. This means, for example, that if a customer is injured on the business premises, or the business incurs debts beyond its ability to pay, then the personal assets of the business owner are legally available to satisfy those claims.
General Partnership. Two or more individuals who own a business may elect to form a General Partnership. In a general partnership, the general partners determine how they will share profits and losses of the business, and enter into a written partnership agreement documenting these shares. The profits and losses of the general partnership then flow to the tax returns of the individual partners in accordance with the ownership percentages that are set forth in the partnership agreement. The partnership itself is not subject to any separate income tax.
However, despite the agreement between the partners in how to share profits and losses, each and every partner is exposed to the full amount of all liabilities of the business. This means that a creditor or plaintiff can collect the full amount of any claim or judgment from any of the general partners.
Limited Partnership. The Limited Partnership form of business is similar to the General Partnership in that profits and losses are distributed to the partners and flow through to the tax returns of all partners in accordance with the percentages the partners determine in the partnership agreement.
However, some of the partners can be “limited” partners, meaning that they would not be subject to any personal liability for any of the debts or judgments against the partnership. There must be at least one general partner in the Limited Partnership, and this general partner will have unlimited personal liability. The general partner(s), but not the limited partner(s), will be responsible for management of the business.
Limited Liability Company. A Limited Liability Company (or “LLC”) is comprised of one or more “members.” The ownership percentages, profit and loss distributions, and voting powers of each LLC member are determined by an agreement between the parties, which is generally reduced to writing. When the LLC is formed, it elects whether to be taxed like a partnership with profits and losses flowing through to the owners’ tax returns (as discussed above), or taxed like a corporation (as discussed below). The members of the LLC are protected from the liabilities of the LLC.
Corporation. A corporation (perhaps the most well-known form of legal business organization) is owned by one or more “stockholders” and managed by a Board of Directors elected by the stockholders. The Board appoints officers who run the actual day-to-day business of the corporation. The stockholders, directors and officers of the company are generally protected from the liabilities of the company.
For tax purposes, there are two types of corporations: “C” Corporations and “S” Corporations. In a “C” corporation, the corporation is a separate tax entity, so the profits and losses of the corporation are taxed directly at the corporate level, and do not flow through to the tax returns of the stockholders. The “C” corporation may also be subject to a separate level of “franchise” tax at the state level. If the stockholders elect to be treated as an “S” corporation for tax purposes, then the corporation will be taxed as a partnership. This means that the profits and losses of the corporation will flow directly to the stockholders in accordance with their stock ownership.
There are also other differences between “C” corporations and “S” corporations, including the permissible number of stockholders for each.
How to Form.
In many situations, it will make the most sense to form your entity (if you decide to form a separate legal entity and not operate as a sole proprietorship) in the state in which you will primarily operate. Since partnerships, LLCs and corporations are separate legal entities, they can generally be formed in any state, regardless of where the business actually operates. However, organizing under the laws of the state in which you primarily operate will save you the cost and administrative burden of maintaining a “registered agent” in the state of formation.
The websites of many Secretaries of State contain a great deal of additional information on how to form in their state. In some cases, downloadable forms are available to assist, and sometimes entities can be formed directly through an online interface.
Depending on the type of business you’ll be operating, your state may require that you obtain and maintain certain additional licenses. Examples of these types of businesses can include daycare facilities, healthcare-related business, restaurants and catering businesses.
As your business grows, and you expand your operations into other states (including having employees in other states), you may need to “qualify” your business on those other states. This process is generally easier (and less costly) than forming the company, but you need to take care to do so correctly.
The Bottom Line.
As you start your business, make sure to take the time to consider how your choice in business form will affect your personal tax situation. Consider seeking professional legal and tax guidance so that you are comfortable making the correct decision based on your needs and concerns.