Most, if not all, of the entrepreneurs I speak to are understandably anxious to start doing their “Great Business Idea.” In fact, their passion is why I love doing what I do (and why I became an entrepreneur myself). But that excitement also makes many entrepreneurs dive right in without doing some of the less glamorous, behind the scenes work. And a great example of this is not forming a business entity before launching the business.
Properly forming a business entity can reduce your personal exposure to liabilities of the business, minimize taxes, ensure that business is being conducted efficiently, help you obtain financing for your business, and prevent misunderstandings among the various stakeholders (your business partners, investors, managers, etc.).
So when should you form your business entity? Since the right entity can limit your personal liability, the obvious answer is before you taken on any significant business obligations. Before 1) signing any contracts or leases, 2) entering into any type of agreement with a third party, or 3) raising funds from others, even family and friends, you should have your legal business entity in place. While these types of relationships always start out very friendly, it’s these same relationships that will be the greatest potential source of conflict down the road.
You can protect yourself and your personal assets by understanding the difference between having your business enter into these legal relationships versus you personally entering into these relationships. And the key to doing so is forming a business entity. So what type of entity is right for you—sole proprietorship, partnership, limited liability company, S Corporation, or C Corporation?
A sole proprietorship is a business owned by one person. It is the default option when you start a business without any business partners and without filing anything with the Secretary of State. But as a sole proprietor, you are personally responsible for everything, including all of the debts and obligations of the business. A sole proprietorship is not a separate legal entity, and for that reason alone, it really isn’t an entity anyone should choose. You’ve started a business, but you haven’t limited your personal exposure should anything go wrong.
Like a sole proprietorship, a general partnership is the default entity for two or more people who go into business together for a profit. Each partner is still liable for everything that goes on in the business, including anything the other partners do or fail to do. For example, you and a friend go into business together. Your friend has the great idea, but you have the means to fund the business. Your friend tries to grow the business too fast and signs a contract the business really can’t afford yet. Guess who is liable for the entire debt? You are! The business’s creditors can come after your personal assets for the entire obligation and likely will if they get the sense that you are the money behind the operation.
Of course, every business partnership should have a partnership agreement, and it should address who the partners want to handle worst-case scenario situations such as this. But like the sole proprietorship, this default choice of entity is really no choice at all.
Limited Partnership and Limited Liability Partnership
In a limited partnership, there is at least one general partner (who remains liable for everything that happens in the business), and one or more limited partners. In exchange for limited liability, the limited partners cannot participate in the management of the business. They are essentially silent investors, but they cannot lose any more than their investment in the business. This can be a great option for silent partners (who are truly willing to remain silent), but because there is still a general partner with personal liability exposure, there are still better options.
Another time of partnership is the limited liability partnership, but this type of entity is typically only used by professionals, i.e., law firms, whose business operations, for various reasons, don’t fit in well with the other entity types.
Limited Liability Company (LLC)
Forming a limited liability company or LLC is probably the most common choice of business entity for entrepreneurs and small business owners. The reason is because every member (the legal term for owners of an LLC) enjoys limited liability for the debts and obligations of the business, while still being able to participate in the management of the business (at least to the extent allowed by the LLC’s operating agreement). Going back to our earlier example, if an LLC incurs a debt, then the LLC—and not the members who own the LLC—is the only legal “person” responsible for paying back that debt.
This is true even where the LLC only has one member. The LLC, as a separate legal entity, should have its own bank account and tax ID number entirely separate from the entrepreneur’s personal bank accounts. Contracts and leases are signed by the LLC instead of the entrepreneur personally. Agreements are entered into with the LLC. Similarly, funds are raised by the LLC—your friends and family members invest in or loan money to the business, not to you personally.
Unlike defaulting to a sole proprietorship or general partnership, forming an LLC requires filing Articles of Organization with the Secretary of State and paying a filing fee. But this is a small price to pay for limiting your personal liability. The LLC should also have an operating agreement in place—a legal agreement among the owners of the business and the business itself—that governs how the business is to be run and everyone’s rights and obligations.
Another advantage to forming an LLC is that it can be taxed as if it were a partnership, meaning that each member of the LLC pays income tax on his or her share of the profits earned by the LLC (or deducts as a loss his or her share of the losses). But an LLC can also elect to be taxed as a corporation. Typically, the owners of the business would choose corporate taxation when they have a long-term plan to reinvest the business’s earnings back into the business. In this scenario, the owners of the business have not received their share of the business’s earnings; therefore, they don’t want to pay taxes on income they haven’t actually received. Of course, anytime you start planning tax strategies, you should plan to sit down with both your accountant and your business attorney.
Corporations – S Corp and C Corp
Last, but not least, is the corporation. It is the traditional form of business entity, and like the LLC, is a legal entity or “person” separate from its individual owners (called shareholders). Corporations raise money by selling stock in the corporation, even small closely held corporations. Shareholders have the same limited liability as members of an LLC. If a corporation is sued or owes a debt, the shareholders generally can’t lose any more than their investment in the corporation. (In a future post, we’ll discuss the major exception to this rule, called piercing the corporate veil, and how to protect yourself from that possibility.)
The difference between an S Corp and a regular C Corporation is the way they are treated by the IRS. An S Corp, like most LLC’s, is a pass-through entity for tax purposes. Whatever the S Corporation earns shows up on the individual shareholder’s income tax returns much like a partnership’s income would. The IRS does, however, place limits on S Corporations. They can have no more than 100 shareholders, and generally, all of the shareholders have to be individuals. Again, like most areas of the law, there are some exceptions, but the point is another business entity cannot own shares of an S Corporation. So you couldn’t have, for example, Parent Company, Inc. that owns Subsidiary Company, an S Corp. S Corporations can only have one class of stock, although the class can be divided into voting and non-voting shares. Typically, this comes into play when the founders of the corporation want to issue preferred stock to the initial investors in the corporation.
So Which Entity is Right for Your Business?
While the details of your situation may vary, here are some general guidelines:
As always, if you have questions about your specific circumstances, contact me today for a free consultation.