Business Launch 101: What You Need to Know Before Choosing a Business Entity
When an individual or group establishes a business, one of the key first steps is deciding on the most appropriate business entity. To make an informed decision, you first need to understand the four major business entity types to consider. These options include a sole proprietorship, a partnership, a corporation, and a limited liability company.
A Sole Proprietorship
A Sole Proprietorship is a business owned by one person individually. A sole proprietor operates the business under his/her name. Alternatively, they can file a ‘doing business as’ (DBA) certificate with their local town and select a different name. An owner of a sole proprietorship has complete control of the business and is personally responsible for the liabilities of the business.
A Partnership is a business entity that is owned by more than one person, all of whom are partners. Partnerships can either be general partnerships or limited partnerships.
In a general partnership, the partners participate in the management and control of the business and can be held jointly and severally liable for the obligations of the general partnership. Such a partnership can be agreed orally or formalized by a written agreement. Joint and several liability mean that each partner is responsible for all of the liabilities of the partnership. For example, if the partnership is sued, each and every partner has exposure.
In a limited partnership, there are two types of partners: general partners and limited partners. The general partners manage the partnership but they also have personal liability for the partnership. The limited partners cannot participate in the management and control of the partnership’s business, and therefore generally, do not incur personal liability. Both forms of a partnership file a tax return, but the profits/losses of the partnership generally “pass through” to the partners, who are each taxed on their proportionate share of the partnership profits/losses.
A Corporation is an organization authorized by a state to act as a single business entity with liability limited to its assets. A corporation is owned by shareholders, who adopt By-Laws that govern the operation of the corporation and elect a Board of Directors to oversee the corporation’s activities. Typically the Directors then appoint officers such as President, Treasurer and Secretary. The shareholders’ personal assets are protected from claims against the corporation. There are different types of corporations with different attributes and purposes, such as for-profit corporations, not-for-profit corporations, and public corporations.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a legal business entity that has the characteristics of both a corporation and a partnership. Owners of LLCs are called members. The LLC can be managed by either members or designated managers. The members are not held personally responsible for the debts and liabilities of the company. A single-member LLC generally does not pay taxes as an entity, and profits/losses are reported on the member’s personal tax return. A multiple-member LLC is generally taxed as a partnership with profits/losses flowing down to the individual members. LLCs have flexibility in determining their governance structure.
After understanding the types of business entities, the next step is to review various factors regarding how your business will operate. Before choosing the best legal entity for your business, here are the top factors of your business to consider:
- Limited Liability: Business owners should consider limiting liability to the business entity’s assets. You must carefully balance the protection afforded to your personal assets from the liability to the administrative and financial burdens of some business entities.
- Funding: Whether you have investors providing equity into the business or if you are borrowing funds from a lender, both investors and lenders will have requirements that might impact which entity you select. Any person who directly or indirectly owns 20% or more of an entity (this concept is commonly known as “Know Your Borrower”) will likely need to disclose and provide financial information and potentially guarantee any loans to the new entity.
- Decision making: If there is more than one business owner, you need to determine how decisions will be made. For example, some owners will have authority over the day-to-day operation of the business, whereas major decisions may need to be made by a majority of the owners or require unanimous consent. It is important to decide if it is preferable to choose an entity that does or does not require that the owners are of public record.
- Taxes: It is prudent to consult an accountant and tax advisor to discuss the accounting and tax ramifications that will affect the operation of your business. There are also filing requirements that vary for the different entities on the Secretary of State level, as well as with the IRS and the state Department of Revenue.
While there are many caveats and nuances to each type of business entity, each has its strengths. Regardless of the type of business entity you choose, it is critical to thoroughly evaluate the advantages and disadvantages of each. It is also important to understand the ongoing legal requirements to maintain such an entity, in addition to the formation and annual costs involved.
Contact the Ligris team today for assistance with choosing the best business entity for you and your business.
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