Starting A Business Series (Part 2 – Choosing the Right Business Entity)
You’ve made the decision that you are serious about starting a business. The first step to getting your legal ducks in a row is to determine the type of entity that you would like to have. While there are numerous entity types, the most common entities (and the ones that this post will cover) are sole proprietorships, partnerships, corporations, and limited liability companies.
If you have not filed with the Secretary of State to form an entity, you are a sole proprietor. Sole proprietor is another way of saying “unincorporated individual.” The good thing about being a sole proprietor is that you are taxed on business profits at your personal tax rate. Also, you don’t have to file a separate tax return for an entity, which may save you some money.
The scary thing about sole proprietorships is that you have no liability protection. That means you could have a business dispute with a client that could lead to a personal judgment against you. (Of course, this can be somewhat – though not completely – addressed with insurance.)
When to use it: I advise using the sole proprietor entity type when you are exploring whether you really want to form a serious business. As soon as you are making any material amount of money from a business venture, the sole proprietor entity type is risky and not advisable.
A partnership is an association of two or more individuals engaged in activity to generate profit. A general partnership is what exists “in the wild” when there is an agreement between two people to have a profitable enterprise. Think of it as like a sole proprietorship, but for multiple people.
In a general partnership, each partner is liable for the debts and liabilities related to the business of the other partners. This can be problematic very quickly. The partnership can still have internal agreements about how to handle various issues. Nevertheless, the liability to the public from the acts of fellow partners does not go away in a general partnership.
When to use it: In my humble opinion, the only time to use a partnership method of doing business is in the very early stages of a business when you are trying to establish proof of concept and determine whether the business is viable. The moment the business appears to be viable, a limited liability company or corporation should be created.
Corporations and LLCs – Liability Shields
Corporations and limited liability companies (LLCs) share a common very important characteristic: individual liability protection. The maximum liability of the LLC owners is the assets of the LLC. Such liability protection is the primary reason why corporations and LLCs are the entity of choice for the vast number of American businesses.
To illustrate how the liability protection works, imagine this scenario: Sam, a sole proprietor, owns a widget making business that suffers a $100,000 judgment against it. Lucy, the 100% owner of a limited liability company, also owns a widget making business and suffers a $100,000 judgment against the business. For Sam, he is the business, which means that Sam must pay the $100,000 or face a court ordered liquidation of assets and bankruptcy. For Lucy, the only way she has to pay the $100,000 judgment is if the business bank account has the money in it. She may also have to liquidate her business assets to pay the judgment. But, Lucy will never lose her house over liability from a business issue.
Corporation or LLC?
The differences between corporations and LLCs may seem subtle, but they are there. Those differences include:
· Nomenclature: LLCs file articles of organization to be formed. Corporations file articles of organization to be formed. The controlling document for LLCs is called an operating agreement. For corporations, it is called bylaws.
· Management: Corporations require an initial board of directors who control the direction of the company, including electing the officers. LLCs can elect to be either member-managed (more like a board of directors) or manager managed (authority for most decisions is delegated to a manager).
· Taxation: Corporations are taxed twice, once at the entity level and again when the shareholders are paid dividends. (Electing s-corp status is an option for many small businesses that takes away the double taxation problem.). LLCs are not taxed at the entity level, but the owners have to pay self-employment taxes if the owners work in the business.
· Specific Requirements for Corporation: See Ohio Rev. Code § 1701.591 for list of requirements for annual shareholder and director meetings and for having a board of directors. These rules are very specific and rigid. LLCs on the other hand have less pitfalls that can accidentally cause the company to lose its entity status.
In general, I tend to recommend that most small business start-ups go with a limited liability company status, and, if they intend to work in the business and draw a salary, an s-corp election. More on s-corp elections next time!