One of the fundamental questions for a entrepreneur starting up a new business is how to legally structure the new entity. Each has its advantages or disadvantages, and no one structure will work for every kind of business or individual owner.
If you are thinking of starting a new business, it is best to thoroughly research the pro’s and con’s of the respective entities and think through your goals in starting the business. Do you want a side business that generates a little extra income to supplement a primary job? Do you want to grow the business to be the next Apple or HP? Is this a simple business with minimal risk or do you anticipate your new business’s activities could expose you and your personal assets to a lot of risk? How you come down on these issues will help you determine what entity is right for you.
The most common ways of organizing a new business are as a sole proprietor, a partnership, an LLC, or a corporation.
A sole proprietorship is the easiest and least expensive form of ownership. Sole proprietors are in complete control, and may make decisions as they believe would be best for the business. Profits from the business flow through directly to the owner, and the owner claims the profits on their personal tax return. The business is also easy to wrap up.
There are also disadvantages to a sole proprietorship, including the fact that sole proprietors have unlimited liability and are legally responsible for all debts against the business. The owner’s business and personal assets are at risk – which may not be an issue now if you don’t have many assets, but it could be an issue later. Also, it may be more difficult to raise funds for the business or the owner may be limited to using funds from personal savings or consumer loans. Finally, it may be harder to attract high-caliber employees, or those that are motivated by the opportunity to own a portion of the business.
A partnership is similar to a sole proprietorship in that the law does not distinguish between the business and its owners. Generally, partners have a legal agreement laying out how management decisions will be made, how to share or divvy up profits, how to resolve disputes, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed.
Like a sole proprietorship, a partnership is generally pretty easy and cheap to establish. However, partners are jointly and individually liable and profits must be shared with others.
Limited Liability Company (LLC)
An LLC is generally easier to set up, cheaper, and more flexible with fewer formal requirements than a corporation. It is a very popular format for small business owners because of its flexibility. LLCs were essentially designed by state Legislatures to create a more flexible and easier way for small business owners to start new businesses. Like a Corporation, an LLC is a separate legal body. The owners have separate legal protection so they’re not liable for the business debts and judgments (unless the owners agreed to be personally liable for the LLC’s debts, contracts or judgments). Owners can pay business taxes on their individual income tax returns.
A corporation is controlled by state law and considered a unique entity, separate from its owners. A corporation can be taxed, sue and be sued, and can enter contractual agreements. (However, another company may require start-up owners to agree to be personally liable for debts, loans or contracts before that company will be willing to go into business with a new start-up). The owners of a corporation are the shareholders. The shareholders elect a board of directors to oversee the corporation and guide its major decisions. The advantages of a corporation include that shareholders have limited liability for the corporation’s debts or actions. However, officers in the corporation can be held personally liable for their actions.
The disadvantages of a corporation include: corporations take more time and money than other organizations to set up, corporations require more formalities, and corporations may result in higher overall taxes.
As mentioned above, there is no “one size fits all solution” for a new business owner. The best way to discover what type of business will work is to do thorough research and/or to consult a professional who can help you to weigh the advantages and disadvantages of the various options.
John Corcoran is an Associate with Plastiras & Terrizzi law firm in San Rafael, California (Marin County). He advises clients on various small business matters. He may be reached at email@example.com or (415) 472-8100 x211.