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You should know . . . how to choose the right business entity

Chris Brown

Chris Brown

Entrepreneurs should consider their options carefully when starting a new business. Although there are dozens of options, the ones in this article are certainly the most common.

Sole Proprietorships

When an individual operates a business without filing anything with his or her state, he or she usually will be deemed a sole proprietor. This structure is simple in that you simply report all business profit and losses on your personal tax return, and you don’t file any formation documents with your secretary of state. The biggest downside to running a sole proprietorship, however, is that you’ll be personally liable for all of the businesses’ debts and liabilities. If you have anyone working for you (or contractual liability), you should seriously consider an LLC or corporation (see below).

Partnerships

Partnerships are a lot like sole proprietorships, except there is more than one person involved. Technically, you don’t have to file anything with your state to create a partnership, but if you are creating a partnership, it is a good idea to do so. There are many different kinds of partnerships, but it isn’t worth exploring them here. In a partnership, each partner will report his or her share of the partnership profit and losses on his or her personal tax returns. Unfortunately, each partner will be liable for all of the partnership’s debts and liabilities, which makes this a very risky structure for most businesses. (There are ways to limit that liability in a partnership, but in most cases an LLC or corporation is still a better choice.)

LLCs (Limited Liability Company)

LLCs are the most popular entity choices for entrepreneurs today. They are extremely flexible in almost all respects.

The only way to create an LLC is to file formation documents with your secretary of state. Once formed, the LLC can choose how it wants to be taxed. The default tax option for single-owner LLCs is sole-proprietorship tax, while the default for multi-owner LLCs is partnership tax. LLCs also can elect to be taxed as an S-Corp (which is common) or a C-Corp (which is not common).

One of the biggest benefits of forming an LLC is that the owners will not be liable for the businesses’ debts and liabilities unless the owner guarantees the debt or is personally liable for the liability due to personal actions. (They may also be liable if a judge “pierces the veil” due to fraud or some other extraneous circumstance.)

Corporation

A corporation is the most formal business-structure option. Much like LLCs, you can create a corporation only by filing formation documents with your secretary of state. (You also can convert an existing LLC into a corporation, if you’d like). And much like LLCs, the shareholders of a corporation will not be liable for the corporation’s debts and liabilities (subject to the same exceptions for LLCs, above). If you are going to raise professional investment money or if you want to take your business public, a corporation certainly makes sense.

Most new businesses do not choose this structure, however, because it creates a “double-taxation” situation. That means the corporation will pay taxes when it makes money, and then the shareholders will pay taxes when they receive distributions. (Note that you can get rid of the double tax by making an S-Corp election, as explained below.)

S-Corps

It is important to remember that an S-Corp is just a tax election — it isn’t actually a structure option. Rather, certain businesses can make an election with the IRS to be taxed under the S-Corp rules. The benefit is that in some situations, the businesses’ owners can reduce their tax liability. If you think this is a good option for you, you should speak to both a lawyer and an accountant to explore your options.

 

This article is general in nature and is not legal advice. You should speak to a licensed attorney about your unique circumstances before relying on this article.

Chris Brown represents startups, freelancers, and small businesses through his law firm, Pixel Law. He also co-founded Contract Canvas, a digital contract platform for creative professionals. You can find him on Twitter @thepixellawyer.

 

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