Starting a new business is exciting and one question most entrepreneurs ask is which business entity type is right for his or her new venture. In this week’s post we will explore three popular choices and conclude with tips on picking the right one.
If you are operating by yourself and you don’t take any formation actions, you’ll be classified as a Sole Proprietor. In most respects this is the easiest option from an operations standpoint because you simply report your business income on Schedule C to your IRS tax return (Form 1040). You can still deduct business expenses and thus, you only pay income taxes on the net income from your business operations.
If you are using a different name to conduct your sole proprietorship than your own legal name, be sure to check your state’s fictitious name laws (sometimes called a DBA, or “Doing Business As”) because you may need to register your business name with your state. For example, Missouri allows you to file for a fictitious name online for only $7, while Kansas does not have any fictitious name requirements.
However, one very big disadvantage of operating as a sole proprietor is that you won’t have any shield from liability. Rather, since you are operating as an individual, you will be liable for all debts and liabilities of your company. This requires that you evaluate the risks associated with your business as opposed to the costs of forming one of the limited liability entities described below. By choosing one of the options below, and operating the company properly, you can protect your personal assets from liabilities generated by your business. If your business is relatively low risk (such as writing product instructional brochures) you may wish to operate as a sole proprietorship and invest your initial funds in appropriate insurance, such as “errors and omissions” coverage. If your business is hauling hazardous chemicals, you should probably form an LLC or corporation and get as much liability insurance as you can afford.
Limited Liability Company
Limited Liability Companies have become increasingly popular in recent years due to their flexibility. Individuals can create single-member LLCs and groups of individuals can create multi-member LLCs. Most states allow LLCs to be filed online and the filing fees are usually fairly low ($50 in Missouri and $160 in Kansas). Unlike Sole Proprietors, some LLCs must file annual reports with their Secretary of State to remain active (Kansas requires annual reports for LLCs, while Missouri does not).
If you are a single-member LLC and you don’t elect a different tax classification, you’ll be taxed as a sole proprietor as described above. If you are a multi-member LLC and you don’t elect a different tax classification, then you’ll be taxed as a partnership. Partnership taxation means that all income (as well as losses, deductions, etc.) is “passed through” to the member’s individual tax returns (much like a sole proprietor). However, your LLC can also elect to be taxed as a corporation, or as a s-corporation (we will cover s-corporations in a future post). In general, partnership tax rules are more complex than corporate or s-corporation taxation.
The governing document for an LLC is the operating agreement, which details the rights and responsibilities of the members with respect to one another and with respect to the company itself. It is also where you can lay out rules regarding the management of the company, which can be manager-managed or member-managed (another topic for a future post).
The most formal option is the corporation. Much like LLCs, you can form a corporation online in many states and the fees sometimes depend on the number and value of stock you issue.
The default tax classification for corporations is “C-Corporation” tax, which means there are two levels of taxation – first the corporation pays income tax and second the shareholders pay income taxes on distributions made by the company. However, some corporations can elect to be taxed under Subchapter S of the IRS Code (commonly called a “S-Election”) to cause all income (as well as losses, deductions, etc.) to be passed through to the shareholders much like partnership taxation as described above.
Corporations are governed by the terms in Bylaws and other corporate documents such as Shareholder Agreements and Buy/Sell Agreements.
Partnerships, Limited Partnerships, and Limited Liability Partnerships
Partnerships are one of the oldest forms of operating a business. All partners share expenses and profits according to their partnership interest, which is usually equal but may not be. Partners are personally liable for the debts of the partnership. A partnership should be documented by a Partnership Agreement, setting out how exactly how it is to be managed, how partners may be admitted, what happens when a partner leaves, and other topics. Otherwise, the partners will be subject to and governed by state statutes on Partnerships. State statutes and tax rules, and federal tax rules for partnerships are generally more complex than for other types of businesses. “Limited Partnerships” have a general partner and limited partners who do not take an active part in the business. A relatively new entity, not chosen very often, is a “registered limited liability partnership.” There is also a “limited liability limited partnership.” The differences and advantages of these less common entities are beyond the scope of the general review provided here.
Obtaining appropriate insurance is as important as selecting the correct business structure. In addition to providing coverage for claims, many liability, casualty or comprehensive policies will pay for an attorney to defend you. The cost of defense is sometimes more than the cost of a claim, and is a valuable benefit of insurance coverage.
How to Choose?
Obviously your decision will be heavily impacted by your unique situation and we advise you seek legal counsel when making this decision. Although, we will provide a few tips here.
First, if there is more than one “owner,” you will likely want to form some kind of an entity. Otherwise you will be classified as a partnership (which is another option in and of itself). Sometimes partnerships are appropriate, but other times your state’s default partnership rules will not be adequate for your situation.
Second, if you are seeking flexibility, go with an LLC. The LLC is probably the most flexible formation option because you can elect how to be taxed, how to manage your company, and more.
Third, if you wish to provide and deduct certain employee benefits, or you wish to make shareholder distributions of a portion of your profits to the owners, on which employment taxes are not paid, you should consider an s-corporation.
Lastly, if you are moving forward alone, the sole proprietor can be a great choice, provided you are not taking on too much liability in the process.
But keep in mind that there are many considerations to think about and the above outline is not a complete review of every consideration involved!
If you have more questions, feel free to contact any of our Kansas City Business Law Attorneys to help you make the right decision!
*This article is very general in nature and does not constitute legal advice. Readers with legal questions should consult with an attorney prior to making any legal decisions.