The Basics of Business Entities
You must make a choice about your Business Entity
Of all of the choices you make when starting a business, one of the most important decisions is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, the personal liability faced by the owners, and your ability to raise money.
Consider the following situation I recently encountered: I had to change a LLC to a Corporation because the founders wanted to bring on investors that wanted shares in the company. A LLC does not have shares, so the change from registering as a LLC to becoming a Corporation was time consuming and expensive. An entrepreneur needs to know their options up front, so they do not make a costly and time consuming mistake.
Every situation is different, so you should consult a lawyer and an accountant before selection a structure. It is better to spend a little money up front rather than have a horror story in a year or two when you discover that you made a decision with adverse tax or legal consequences.
Types of Business Entities
The type of business entity you choose will depend on three primary factors: liability, taxation, and record-keeping. The following is an overview of the differences between the most common forms of business entities.
This is the most common form of business organization. It is easy to form and offers complete managerial control to the sole owner. However, the owner is also liable for all the financial obligations of the business.
A Sole Proprietorship may have to file for a DBA/Fictitious Business Name or a business license depending on the name of your company and the type of business. A Sole Proprietor should consult an attorney to make sure the sole proprietor has filed all proper documents, for appropriate licenses, and tax documents.
A Partnership involves two or more people who agree to share in the profits or losses of a business. A primary advantage is that the Partnership does not bear the tax burden on all profits, because losses or losses-profits are offset against the profits. These benefits are passed through to partners to report on their individual income tax returns. The primary disadvantage is that in a partnership, each partner is personally liable for the financial obligations of the business.
Unlike a Sole Proprietorship, a Partnership should consult an attorney (or even attorneys for each member of the Partnership), to draw a Partnership Agreement that lays out the all the details of the Partnership relationship.
A Partnership may have to file for a DBA/Fictitious Business Name or a business license depending on the name of your company and the type of business. A Partnership should consult an attorney to make sure the Partnership has filed all proper documents, for appropriate licenses, and tax documents.
Limited Liability Company (LLC)
A Limited Liability Company ("LLC") is a hybrid form of a Partnership and a Corporation. It is popular because it allows owners to take advantage of the benefits of both the Corporate and Partnership forms of business. The advantages of this business format in crude the ability to pass profits and losses through to owners without taxation of the business it's and owners are shielded from personal liability for obligations of the business.
In most states, filing for a LLC is easy. It involves filling out a form and sending it into the state where you are forming the LLC. However, there is another step that a LLC for which a LLC will want to bring in an attorney. A LLC, like a partnership, needs to have an agreement between all of the members of the LLC. For a LLC the document is called an Operating Agreement; these agreements are usually long and complicated, particularly when there are multiple members partnering in the LLC.
A Corporation is a legal entity that is created to conduct business. The Corporation becomes an entity that is separated from those that founded the organization. The responsibility of the Corporation is passed on to a Board of Directors as soon as the Corporation is formed, and the Board of Directors make decisions about how to issue stock to investors. Like an individual, a corporation can be taxed and can be held legally liable for its actions. The Corporation can also make a profit. The two key benefits of a Corporation are (1) the avoidance of personal liability for investors in shares of the Corporation, and (2) a Corporation is the best vehicle to allow for investment by non-founder individuals and companies in exchange for stock.
A disadvantage of a Corporation is double taxation. The Corporation is taxed at the corporate level, and then founders who also work in the company will be taxed on their salary and dividends. The founders have none of the "pass through" advantages found in a LLC, Partnership, or Sole Proprietorship. Another disadvantage of a Corporation is paperwork; a Corporation must hold yearly meetings and create meeting minutes and a Corporation will often need to make resolutions when they desire to make decisions regarding the Company.
Filing for a corporation is a little more complicated than filing for other types of business entities. First, the Articles of Incorporation must be filed with the state where the founders intend to incorporation. Some states have forms that serve as the Articles of Incorporation, however, most founders will want to use an attorney to create their Articles of Incorporation so they are tailored to the needs of the founders and the Corporation. Second, founders will want an attorney to draw up the corporate bylaws in a way that allows the founders to make decisions for the company. Finally, founders will need an attorney to create the first minutes for the Corporation, which will appoint the founders to the Board of the Directors and as Officers of the Corporation.
An S-Corporation ("S-Corp") is a hybrid of a LLC and Corporation, and takes many of the advantages of both and discards many of the disadvantages as well. The S-Corp provides business owners with the liability protection of a Corporation and allows the profits and losses to be passed through to shareholders and included in their individual taxes. The "pass-through" in an S-Corp, like and LLC, prevents the problem of double taxation that exists in Corporations.
However, S-Corps aren't for every company. An S-Corp may not have more than 100 members or shareholders, all shareholders must be individuals (with a few exceptions), it may not have a nonresident alien as a shareholder, and may not have more than one class of stock. Additionally, in some states (particularly CA and NY) there may be special tax laws that impact all S-Corps, LLCs, and Corporations. Additionally, an S-Corp has all of the reporting and record-keeping responsibilities of a standard Corporation.
To receive the benefits of an S-Corp, an entity does not have to be a Corporation. LLCs can also elect on their tax forms to be taxed under the rules of a S-Corp rather than the rules of a LLC.
As you can probably see from these descriptions, choice of entity can be difficult and often should be made while being advised by both an attorney and an accountant
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Author: Aimee Haynes
I motivate, I blog, I listen, I give advice, I help, I create, I work with others, I stand my ground when needed, and I am always open to new ideas. In addition to the qualities that define me most, I'm also a Corporate Law attorney working with entrepreneurs, creatives, and small businesses to help them achieve success.