If there was one business mistake that I saw far too often back when I practiced law, it was the entrepreneur who failed to choose the right legal entity for his or her business.
It seems like no big deal, right? I mean after all, does it really make that much of a difference if you choose, say, a partnership over a Limited Liability Company (LLC)? You bet it does. It’s a huge deal in fact. It could, for instance, mean the difference between keeping your house and losing it.
When many entrepreneurs start out, they begin their venture as sole proprietors and the reason for this is simple: this form of business is easy and cheap to create. All you need to do is obtain a business license and a bank account, and away you go. No expensive lawyer to retain, no complicated forms to fill out. And no legal protection (but I will get to that in a moment).
- Sole proprietorship
There are pros and cons to each, so let’s take a look.
Sole proprietorship: This is the proverbial ‘hanging out a shingle’ approach. It takes but a few forms to create a business this way and that is because it is not really a separate business. It is considered “doing business as” or a dba. Sheila Bookman is doing business as Sheila Bookman Enterprises.
The problem for Sheila is that, because she and the business are one and the same, if anything goes wrong with the business, Sheila is personally on the hook. If the business gets sued, Sheila is the one being sued. If the business goes under, it is Sheila’s personal debt.
Partnership: If you have a partner, then your business can be a partnership (or a corporation or LLC as explained below). But, as with a sole proprietorship, a partnership does not afford the partners any legal protection. The good news though is that you will have a partner, and not unlike a marriage, your partner is equally responsible for the business’ debts and obligation so in that regard it spreads the risk around.
Another option is something called a limited partnership. This means there is one “general partner” (you, for instance) and several limited partners. The general partner runs the day-to-day operations of the business, while limited partners are essentially passive investors with limited liability.
Corporations: S and C corporations (S and C are subchapters of the tax code) are another option that solves the problem of liability. Once incorporated, the business becomes a separate legal entity and is liable for the business’ debts and activities. If something goes wrong, it is the corporation, and not you individually, that is liable.
Becoming incorporated offers other benefits as well, including:
- The ability to issue stock, and thereby attract investors
- The chance to offer employees shares of the business
- An opportunity to enhance credibility since people tend to take a business more seriously if there is an ‘inc.’ after the name
To get these benefits requires the owner(s) to follow the rules and procedures for starting and maintaining a corporation. This may require the assistance of an attorney, an accountant, or both. You will need to file the right documents with your state, keep records, hold directors meetings, and, do all of those things that a proper business is expected to do.
Additionally, there are tax consequences to choosing the corporate structure, and these must be reviewed with your team so that you can make the right decision for your business.
LLCs: Limited Liability Companies are like a cross between a corporation and a partnership. Like a partnership, they are less formal, but they still provide the limited liability that makes the corporate structure so attractive. That said, there are also a few downsides to the LLC structure:
- Taxes: Single-member LLC owners are treated as sole proprietorships for tax purposes and must pay self-employment tax on income generated by the LLC (unless it chooses to be taxed as a corporation). With multi-member LLCs, the profits and losses are generally treated as individual income for each LLC member.
- Investment issues: Because corporations have been around longer (LLCs are a fairly recent phenomenon) and investors are used to them, an entrepreneur may find the corporate structure more conducive to outside investment.
- Lack of structure: The very nature of an LLC, with its looser structure, may be problematic unless clear lines are laid out from the start.
However, these drawbacks do not usually prove to be too significant, and unsurprisingly, LLCs are the structure of choice for many entrepreneurs.
Choosing the right form for your business does not need to be overly difficult or time-consuming, but it is something that requires some thought and effort. You should definitely speak with your lawyer before making this decision. It is Business 101 to choose the right form, and is business malpractice if you don’t take this choice seriously.
So, let’s pass the first test and make the right, smart decision.
Disclaimer: The opinions expressed are solely those of the author and interviewees. You should consult a qualified professional to assist you in determining the most effective business structure and/or tax structure for your business.
About Steve Strauss
Steven D. Strauss is one of the world's leading experts on small business and is a lawyer, writer, and speaker. The senior small business columnist for USA Today, his Ask an Expert column is one of the most highly-syndicated business columns in the country. He is the best-selling author of 17 books, including his latest,The Small Business Bible, now out in a completely updated third edition. You can listen to his weekly podcast, Small Business Success, visit his new website TheSelfEmployed, and follow him on Twitter. © Steven D. Strauss.