Start-Up Companies: Choosing a Business Entity
So you’ve decided to start a business, but you have no idea what kind of entity you should form. You’ve heard about the different kinds... I mean you could be a sole proprietor, or you could have a partnership, or a limited liability company, or a corporation, etc. You clearly have options. But … what exactly does it mean to be a sole proprietor? What is a partnership? An LLC? A corporation? Which would be better for my needs? For my company’s needs? These are all questions that every single person starting a business has. This post is designed to help steer you in the right direction in choosing a business entity.
Well, first, in order to actually make a decision on what entity will work best for your needs, there are several questions you should ask yourself in your initial planning stage. Some questions you should ask yourself are:
Are you going into business with yourself? Or will you have partners?
What type of business are you starting?
How much money do you have to invest in your business?
How risky is the business you’re going into? Is there a high likelihood that you may be sued, or does the nature of your business have the possibility to create conflict?
How much control do you want to have over the company?
By evaluating such questions, you know exactly what issues are most important to you as a business owner. This list is not exhaustive, but it is a good starting point when considering what type of business entity to use.
Once you’ve answered all of these questions and are confident that you have a solid understanding as to the specifics of your future company and what aspects are most important to you, then your next task is to learn and understand (on a basic level at first) the differences between the main types of business entities. A summary of, the four most common business entities is below:
(1) The Sole Proprietor
The sole proprietorship is the simplest type of business entity, mainly because it is not an actual legal entity and the requirements to form one are painless. Basically, a sole proprietor is another name to call a person who owns their own business. To become a sole proprietor, there is not really much for one to do. Most states only require that you file a Business Certificate with the Secretary of State and pay a minimal fee. You must renew your Business Certificate every certain amount of year, according to your state’s rules. At the outset, setting up a sole proprietorship seems like the best thing to do because of how easy it is. However, things can get difficult down the line if issues pertaining to debt or liabilities come up because the sole proprietor is solely and personally responsible for the debts and liabilities of not only themselves, but also of the company.
(2) The Partnership
The formal definition of a “partnership” that is often given is that it is an association of two or more people who are carrying on as co-owners of a business for profit. In layman's terms, this just means when a group of people start a business together with the intention that everyone will get paid. There are no formal steps to creating a partnership. You do not have to file any documents with the Secretary of State, nor do you have to pay any fees in order to begin operating as a partnership. Also, partnerships may receive some tax benefits that are not available to other business forms. (SIDE NOTE: If you would really like to understand the difference in tax treatment according to each business form, please consult a tax attorney).
This sounds excellent, right?! Well, it's great if you really, really, really, really trust your partners. In a partnership, each partner is personally liable for not only their own debts, torts, and authorized acts, but they are also personally liable for the partnership’s debts, torts and authorized acts as well as the other partner’s debts, torts etc. So basically, if someone sues the partnership, you, personally, will be held liable for whatever the outcome of that suit is. If someone sues one of your partners for actions that s/he undertook in their role as a partner with the partnership, you will also be held liable for whatever the outcome of that suit is. This is definitely something to take into consideration when deciding on entering into a partnership. Of course, there are other sub-groups of partnerships that may help limit an individual’s liability, such as the “limited partnership,” but generally speaking, the liability level in a partnership is very high.
(3) The Limited Liability Company (“LLC”)
The LLC is a mix between a corporation and a partnership. Its for the business owner who wishes to have the best of both worlds, i.e. limited liability and preferential tax treatment. To create an LLC, the persons organizing it generally must file their Articles of Organization with the Secretary of State. Some states such as Massachusetts, require that the organizers additionally publish a summary of their Articles of Organization once a week for 6 weeks in a row and must also adopt an Operating Agreement.
There are several benefits to an LLC. Two I have already mentioned: (1) as shareholders in an LLC, generally speaking, you have limited liability and are therefore not liable for the LLCs liabilities, nor for the other members; and (2) tax consequences can be more preferable than other forms. An additional pro to forming an LLC is that, as an owner, you have the ability to have as much or as little control over the company as you wish. You can do it all or you can hire others to do it. It is up to you.
Cons of LLC are that it has limited life, meaning at some point in time the LLC will dissolve, whether it is by a statutory specific time, or a time specified in the Operating Agreement and there are statutory and contractual limitations on membership transferability.
Like the other forms, there too, can be subcategories to the LLC, such as the Registered Limited Liability Company. Registered Limited Liability Company are for individuals engaged in professional services (e.g. lawyers, doctors, etc.).
(4) The Corporation
A corporation is its own legal entity and is treated as such by the law. This means that the corporation, and the corporation only, is liable for its debts and torts. No single member can be held accountable for the actions of the corporation, generally speaking. And I underline and bold that because when you get into the more legal issues related to corporations you encounter things like “piercing the corporate veil” and the “duty of loyalty”, which is a discussion for another article.
To form a corporation, there are some necessary steps that must be taken. There must be one or more incorporators who file the Articles of Organization with the State. The Articles of Organization is required to include some basic information such as corporation name, name and address of all incorporators, information about stock, etc.
The benefits of limited liability seem to be the most appealing about the corporation. However, when considering forming a corporation, one must really take into consideration the tax implications because, again, the corporation its own legal person, and, as such, pays income tax, as its own legal person, and at a much higher rate.
There are many kinds of corporations, all each serving an individual purpose, such as the Professional Corporation or the S-Corp. If you do decide on forming a corporation, then you can delve deeper into the various kinds of corporations, their individual tax implications and which would suit you best.
I hope all of the above information has been helpful in some way. Starting a business can be stressful at time when facing decisions such as choosing a business entity, but it can also be very exciting and rewarding. If you are interested in learning about how you can protect the business that you create and its name and brand, check out my article, “Why Trademarking is So Important for the Start Up Company”.