Choosing a Business Entity
You’ve made the decision to finally be your own boss. Congratulations! After you’ve made the decision, it’s not time to make the leap from dream to reality, so what’s the next step? You now have to decide if you want to run your business as a sole
proprietor, a partnership, a limited liability company, or a corporation. Each business form is different and has its own unique advantages and disadvantages. Keep in mind when reading this post that this is a very broad and basic overview of these entities. I will dive deeper into each business type in more detail in later posts.
This is the simplest and the more common type of business entity to form. The way to start a sole proprietorship can be as easy as waking up one morning and deciding you’re going to start a new business. For tax purposes, your business income is look at as personal income. The biggest disadvantage of a sole proprietorship is unlimited liability. This means that if your business gets sued or takes on any debt, you are personally liable for that suit or that debt. For example: let’s say your new business (set up as a sole proprietorship) gets sued by a customer, your personal savings account and even your home could be used to satisfy that judgment against that suit.
Another disadvantage to starting a sole proprietorship is the fact that there are no real opportunities for equity, issuing stock, or getting investors. If you think your new business idea is so great that you’re going to try to take it to Shark Tank to have Mark Cuban make that half a million dollar investment, then a sole proprietorship is not the best option for you.
Last, another big disadvantage to a sole proprietorship is when the owner dies, so does the business. Starting a sole proprietorship doesn’t give the owner an option for the business to continue on after their life; the life of the business dies with the owner.
While start-up and tax implications of this type of business entity are fairly easy, the disadvantages may outweigh the advantages depending on the type of business you’re wanting to create.
There are two main different types of partnerships; a general partnership and a limited partnership. A general partnership is similar to the sole proprietorship discussed above, except now your including another person as an owner. If you and a friend decide you want to start a business together and agree that you will share in all the profits and losses of that business, this would be a form of a general partnership. Like the sole proprietorship, it is fairly easy to start-up and isn’t expensive. For this entity, since there are two owners, you might want to have a name for your business which can be created by filing a trade name with the secretary of state. This is also referred to as a “DBA” (doing business as).
Since there are two individual ownership in this form of business, you would want to create a solid partnership agreement between the two partners. This document puts the agreement between you and your partner in writing, establishing the terms of the agreement, and acts as a binding contract between the two individuals.
Some disadvantages to a general partnership are the lack of liability protection and no real opportunities for investments. The general partner’s personal assets are vulnerable to the liabilities and the debts of the business. With the vulnerabilities of a general partnership, most investors are not going to want to open themselves up personally to any liabilities or debts of the partnership.
Finally, with a general partnership, the partners have a fiduciary duty of loyalty, fair dealing, and good faith. Fiduciary duties is another animal all in itself, but essentially it means that the partners have a duty to the partnership first and foremost. This means, for example, that a partner cant sabotage the business and can’t steal potential business opportunities for the business.
Another form of partnership is a limited partnership. In this business form, there is one person who is a general partner and another who is a limited partner. The big advantage to a limited partnership is the limited partner has limited liability for the business liabilities and debts. The limited partner’s personal assets are protected from the liabilities of the business based on their investment into the partnership. If the business gets sued or were to fail, the limited partner would generally only be liable for the amount of money they invested into the business.
In a limited partnership, this opens the doors to the ability of getting investors into the business as limited partners. Investors would have protection from the business debts and liabilities, but have no control over the day-to-day operations of the business. The general partner in the limited partnership would be have unlimited liability for the business debts and liabilities.
Limited partnerships are a little harder to set up and have some paperwork that you would need to file with the secretary of state, but would still need a solid partnership agreement in place.
A corporation is a living breathing entity that is looked at as a whole new person. Setting up a corporation can get costly and entails a great deal of paperwork when forming. In a corporation, the business owners personal assets are protected from all liability if the corporation is handled and managed correctly.
With this type of entity, there are plenty of opportunities for venture capitalists and investors through issuing stock. The biggest disadvantage to setting up a corporation is taxes. The corporation is “double taxed.” This means that the corporation is taxed on all income at a corporate tax rate, then the income is dispersed to the owners where that income is taxed again at a personal income tax rate.
With a corporate business entity, there are also a lot of formalities that every corporation must do in order to keep its owner’s personal assets protected.
Limited Liability Company
A limited liability company, or LLC, is a mixture of a corporation and a partnership. The owners of an LLC are called members, and get the protection of their personal assets so long as the entity is run correctly. Setting up an LLC is fairly easy and inexpensive, but does require certain paperwork filed with the secretary of state.
A big advantage to an LLC is that this entity has pass through taxation, meaning that there is no double taxation. Income is flowed directly to the members (owners), but there are some tricky tax rules for LLC’s so make sure you have a good accountant to help you out of come tax time.
With an LLC, you’re going to want to have articles of organization as well as an operating agreement; which is similar to a partnership agreement.
This is just a very broad overview of these types of entities. Each type has its own sets of advantages and disadvantages depending on the type of business you want to create and the type of business you’re going to be doing. Contact Howard Law to discuss what option would be best for you and your business at (312) 469-0758.
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