Learn about Business Formations in Under 5 Minutes
If you're starting a business of your own, choosing the right business formation (or legal entity) may be one of the most important decisions you'll make.
The business formation you choose will directly affect:
how you're taxed individually and at the entity level,
the speed in which you may be able to obtain outside financing,
your personal exposure to financial and legal liabilities,
the number of shareholders your business may have,
the type of federal, state and local tax forms you'll have to file,
your exit strategy (assuming you wanted to sell your business one day),
the number and types of licenses and the license fees you may pay,
All of these details are extremely important to know and deserve a much more extensive write up, but since I'm keeping to our under 5 minutes promise, I won't cover those details in this post.
What I will get share with you, and is just as important, are the types of business formations that are available for you.
You can think of each form of business as an mode of transportation. You can go from a motorcycle (sole proprietorship), which gives you the most flexibility and speed but also exposes you to a lot of personal risk, to a train (corporation), which is slow but once up and running, it's difficult to stop, and it gives you the ability to bring on a lot of people to help finance your overall trip to your destination.
So let's figure out which kind of ride you might be interested in taking for a spin.
The sole proprietorship is one of the most popular forms of organization for business owners, mainly because it's the easiest one to set up. Just pay your business licenses, obtain your permits and register a fictitious name (if your business name will not be your legal name) and you're basically good to go. With a sole proprietorship, you'll be the sole owner of all the assets, but at the same time, you'll also be on the hook for your company's liabilities, which means your personal assets can be used to satisfy debts your business owe.
A general partnership exists when two or more persons work together to carry on business activities for a profit.
In a general partnership, the partners share the good and bad that come with working together. Having taken partnership tax in law school and worked as a tax attorney, I can say with certainty that partnership tax is one of the most complex tax areas, so it may be helpful to round up a solid CPA, or attorney, to make sure you're complying with the partnership tax rules and regulations. As far as assets and liabilities go in partnerships, the partners share in these too. So if you decide to go the GP route, remember that you and your partners are jointly and severally liable for the GP's obligations. This means you can also be on the hook for a partner's handiwork, even if you didn't have a say in it. Like sole proprietorships, your personal assets can be up for grab to satisfy the debts of the partnership.
Warning: In some circumstances when a business owner works with another party, the IRS may consider the relationship to be a general partnership even though the owner and the other party don't consider themselves partners.
Limited partnerships are very similar to general partnerships, except that one or more of the partners can have a limited involvement in the partnership, which reduce their exposure to partnership liabilities.
Limited partnerships are common for hedge funds and venture funds, as the investors are limited partners and the general partners operate the fund. Generally, in this arrangement, the investors get a promised return on their investments and the general partners get a cut of any excess return.
Investors prefer limited status because their activity is passive in the partnership, which also limits their liability to the extent of their investments. So for limited partners, their personal assets will not be up for grab. While they could lose all their money from an investment, they do not have to be as concerned about personal assets as general partners. General partners, however, can still have their assets used to satisfy debts of the limited partnership.
Limited Liability Partnerships
A limited liability partnership (LLP) is a special type of general partnership. These were created to help prevent professionals from being held responsible for the malpractice of another professional. As a result, you'll see a lot of law firms and CPA firms organized as LLPs. Like LLCs, partners in an LLP can have their personal assets protected against liabilities arising from the LLP.
LLPs are governed by state law, so you'll need to check with your state to see exactly what the requirements are for filing and operating a LLP in your state.
Limited Liability Company
Ever since states adopted LLCs, more and more business owners have been using these legal entities to protect themselves and their businesses. These entities are quick to set up, and their filing fees are a lot less expensive when compared to corporations. The administrative work for maintaining an LLC is also a lot less cumbersome than a corporation.
LLCs are a combination between limited partnerships and S Corporations and can be used by one person. So if you're going to be a single business owner, you could set up a single-member LLC to afford you protection for your personal assets while also receiving some favorable tax treatments you would also receive as a sole proprietor. Conversely, your LLC can have multiple-members and can be managed by member or an outside manager. If you're interested in creating a multiple-member LLC, you would be doing yourself and your members a favor by having an operating agreement put in place to govern the relationship.
Different states have different rules for LLCs, so be sure to check with your respective state and a local tax advisor or attorney to find out if a LLC would be beneficial.
Like LLCs, corporations are created under state law, which means your state also regulates the types of powers your corporation can have. Corporations are almost the equivalent of a real person. They can apply for loans, sue other corporations, hire employees, purchase assets and more. Unlike the other entities, with a corporation, you may have several shareholders to answer to for corporation actions.
When it comes to taxes, corporations have what is called double-taxation. The corporation gets taxed on income, and if you're receiving a salary, you get taxed on your income. Compare this to your LLC or sole proprietorship where there is only one layer of tax. With corporations, Uncle Sam is definitely double dipping on hard earned money.
As you can see, I barely touched the surface of business formations, but there's enough information to get you started thinking on which one might work for you, your business and any potential business partners.
When you're ready to move forward on a legal entity and want more information with your decision and formation, reach out to us here for a FREE 30-minute consultation about your future small business.
Have you already chosen legal entity? Which one did you choose, and why did you choose it?
Please respond in the comments section below.
Chris McCauley, CPA, Esq. is the founder of McCauley Investment Risk & Legal Consulting PLLC, a Seattle-based law firm dedicated to helping professional athletes and small business owners guard their earnings and investments. Chris is an attorney licensed to practice in Alabama and Washington and a CPA licensed to practice in Washington and North Carolina.