Registering a business entity can be a daunting task for the uninitiated, because there are several types of structures and they all come with their own unique benefits and drawbacks. You can simply do nothing and remain as a sole proprietorship, but you may be missing out on some key advantages and protections that would otherwise be granted to you.
Before you start to winnow down your selections, it’s important to have an understanding of the major factors that will impact your decision. Of course the number of owners of the business is one of the most fundamental, because some entities are only suitable for either one or multiple owners. Additionally, it will be important to consider whether you plan on attracting investment capital through the distribution of stock, because only certain types of businesses can issue shares of ownership.
And of course, taxes are a vital part of starting any business, and the type of entity you choose will have major implications when it comes time to pay the IRS and your state (or states). When you add in legal considerations such as assets, debt liability, and intellectual property (IP) protection it becomes clear that you have a lot to think about before making the choice that’s right for you.
The Most Common Business Entity Forms.
For the purposes of the IRS, any business is considered a sole proprietorship unless it is specifically registered as another type of entity. If you’ve ever done any contract work and didn’t bother to register your company, you still were acting as a company that was considered a sole proprietorship. In the case of a sole proprietorship personal and business assets are inseparable, meaning that your personal assets may be at risk in the event of a lawsuit, and all business income is taxed as personal income.
A C-corporation is perhaps the most well-known business entity. It provides a clear line of demarcation between personal assets and business dealings, and there are clear guidelines about what corporations can and can’t do thanks to many years of court decisions. Creating a C-corporation is a clear cut process (here’s a guide to how to form a corporation in California, for example), and the structure makes it easy to distribute shares of stock to investors now and in the future. For taxation purposes, the gains of the corporation are taxed before any net profit is distributed accordingly among the shareholders, which then must be taxed as personal income.
An S-corporation is similar to a C-corporation with a few key differences related to taxation. Rather than have the income of the corporation taxed before going to the shareholders as profit, the gains flow directly to the shareholders first and then must be reported as personal income. The S-corporation is a popular choice for solo business owners.
Limited Liability Company (LLC)
An LLC is a common choice of business entity for many startups because of the flexibility it provides in the company’s often fluid early lifespan. The operating agreement which defines the structure of the LLC is highly customizable, and member roles can be amended on-the-fly to suit the needs of the company. The LLC structure also protects personal assets from seizure in the event of a lawsuit in most cases. For an LLC, company gains are split between the members as defined by the agreement and considered as personal income. The major downside of the LLC is that distribution of stock is not permitted, although interests can be assigned (this can get complicated).
The single-member LLC was created to apply some of the same benefits of limiting liability to single-owner companies. Since LLCs were originally designed on the theory of partnerships, however, not every state is settled in law with regard to this entity for solo operators. The rules of this structure can vary depending on the state, so it’s best to evaluate your own state’s guidelines and regulations carefully for single-member LLCs if you are considering this type.
The best way to think about a general partnership is that it’s like a sole proprietorship that applies to multiple people. At least two partners agree that they are co-owners of a business, and any gains or losses are treated like personal income for tax purposes. Much like a sole proprietorship, the assets of the partners can be at risk in the event of a lawsuit or other legal issue, and one partner can be forced to cover the debts of the entire business if the others are insolvent.
Limited Liability Partnership (LLP)
You’ll often see “LLP” at the end of the names of partners in a law firm, because many states heavily regulate which kinds of entities can use the LLP designation. Essentially, creating an LLP is akin to adding asset protection to a general partnership, as well as bestowing some tax benefits on partners as well.
Making the Best Decision for Your Company.
Ultimately, you’ll have to weigh all of these factors accordingly and decide on the best route your company should take. Some choices will be disqualified for you by default, but beyond that there is no single right answer to the question of what kind of company you should create. It is probably never bad advice to consult legal and tax professionals when creating a new company, since the right choice in the beginning can pay down the road.
Studying your options and consulting your state’s business website will prepare you better to know the right answer, and to do what you think is best for you, your company, your partners and your employees.