Taking the Leap: Starting Your Own Business!
What type of business entity would be most suitable for me?
Congratulations on taking that leap and starting a business! At some point you will need to determine which business entity is right for you. By not making a decision, your default is a Sole Proprietorship.
Let's consider the various entities and their benefits as well as detriments. The purpose is the article is to help you understand the differences in each entity. Note that each state has different laws regarding corporate entities. I am not an attorney. I recommend that you seek the advice of an attorney in your state. You should also consult with a tax preparer qualified to advise you on this matter.
Sole Proprietor or DBA?
Sole Proprietorship
Benefits: It is the easiest solution. You work under your own name. You may have business bank accounts and credit cards in your personal name, thereby saving business banking costs.
Detriment: No liability protection from lawsuit.
Sole proprietors have no separation between personal and business assets. You are personally liable for the debts and obligations of the business. Sole proprietorship can be a good choice for low-risk businesses or for owners who want to test a business idea before committing to a formal entity. On the downside, banks may be less likely to loan money to sole proprietorships.
Every state has different laws regarding business entities. Here in California where I live, you have two choices as a sole proprietor. You can work under your own name or have a "Doing Business As" (DBA) name. If your business name suggests other unknown owners, such as "Taylor & Associates," you must file a DBA through your county.
Partnership
Benefits: Two or more people form a business together as a partnership. Multiple people bring different skillsets to the organization and with multiple people you can get things done faster and more efficiently. A partner can help ease the financial burden of a start up.
Detriments: Partners don't always agree on expenditures, marketing, management, and work schedules. Dissolution can be ugly.
General partnerships - every partner is fully and completely personally responsible and liable for the activities and debts of the partnership no matter how small the partner's partnership share.
Limited partnerships - have one or more general partners with unlimited liability, and all other partners have limited liability. The partners with limited liability also tend to have limited control over the company, which should be documented in a partnership agreement prepared by an attorney. Profits are passed through to personal tax returns and are taxed at the individual's rate. The general partner(s) must also pay self- employment taxes.
Limited liability partnerships - are allowed in California for attorneys, accountants, and architects. LLPs generally offer limitations on liability to non-managing members, but are always subject to the practical points about liability noted below.
Practical points about liability - even if you establish your business in corporate or LLC form, banks and major suppliers are likely to require you to sign personal guarantees before making significant loans or advances to your business entity which will, of course, defeat the limitation on liability for that transaction that the entity otherwise provides. Even if you satisfy all the legal requirements for maintaining your chosen business entity as legally separate from yourself, if someone acting on behalf of the business entity acts wrongfully (negligently causing a vehicular accident, for example) both the business entity and the person so acting will be fully liable for any damage caused. In other words, the protection against liability afforded by the business entity only shields you from liability if you are not personally involved in the events giving rise to that liability. So, if you are the only person working at your business, having a "limited liability" business entity doesn't actually provide much protection against claims of negligent or otherwise wrongful conduct.
Seek the advice of an attorney for partnership agreements: The more detailed the partnership agreement is, the better. The agreement should include an exit strategy in case one partner wants to leave or retire.
Limited Liability Company
Benefits: protection from personal liability and lawsuits against your personal assets. Allows members to avoid double taxation.
Detriment: Generally, members are taxed as individuals rather than corporate rates.
An LLC lets you take advantage of the benefits of both the corporation and partnership business structures.
LLC members are protected from personal liability for business debts and claims in most instances. That means a creditor cannot sue to recover a member’s personal assets if the business can’t pay its debts. The members only lose their monetary investment. However, if one or more members commit an act that is legally actionable, both the LLC and the acting members can be held liable. See "Practical points about liability" above.
Unless the LLC elects to file a corporate return, it is treated like a partnership. Certain LLCs, however, are required under federal tax laws to file as a corporation. LLCs avoid double taxation - paying corporate taxes on earnings and paying personal income taxes on the same earnings.
Corporations
Benefits: This is the strongest form of protection from personal liability. Banks are generally more willing to issue loans to corporate entities. Depending on the circumstance, the tax structure may be more favorable to investors.
Detriments: It is expensive and complex to set up and maintain. There is a possibility of double taxation.
C Corp: A corporation, is a legal entity that is separate from its owners. Corporations can make a profit, be taxed, and can be held legally liable.
Corporations offer the strongest protection to its owners from personal liability, but the cost to form a corporation is higher than other structures. Corporations also require more extensive record-keeping, operational processes, and reporting.
Corporations pay income tax on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns.
Corporations have an advantage when it comes to raising capital because they can raise funds through the sale of stock, which can also be a benefit in attracting employees.
Corporations can be a good choice for medium- or higher-risk businesses, those that need to raise money, and businesses that plan to "go public" or eventually be sold.
S Corp:
An S corporation is a special type of corporation that's designed to avoid the double taxation drawback of regular C corps. S corps allow profits, and some losses, to be passed through directly to owners' personal income without ever being subject to corporate tax rates. S corps must elect to file as an S corp with the IRS after setting up their corporation.
S corps can be a good choice for a businesses that would otherwise be a C corp, but meet the criteria to file as an S corp. S corps must:
Be a domestic corporation
Have only allowable shareholders: may be individuals, certain trusts, and estates and may not be partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Piercing the corporate veil
While all of these entities are in place to protect shareholder's assets from creditors of the business, there are ways that individuals could still be liable in a lawsuit if the corporate veil of protection is pierced. One of the most common ways to pierce the corporate veil is to comingle business and personal funds. Others include diverting funds from business to personal use, treatment of corporate assets as if they were owned, failure to maintain company minutes, etc. As an accountant I want to focus on comingling funds.
It serves no purpose to create a corporation for liability protection and then use the company bank account to pay personal expenses, which pierces the corporate veil. The best practice for any business, corporate or otherwise, is to have a separate checking, savings, and credit card accounts for business and personal expenses.
