Entity Formation 101: Choosing the Type of Entity
This month StartUp Grind is partnering with Baltimore Innovation Week to present a star-studded panel of accomplished athletes who have founded or co-founded a business after their initial career ran its course. In making the transition from playing field to office space, these entrepreneurs faced the same choices we all face in starting a new business. In this blog, I take on an age-old startup question: what type of entity is best suited for my new business? To answer that question, let’s look at three considerations: liability, convenience and tax implications.
Limited liability means that a creditor of your new business can look only to the entity (and not to you as owner or shareholder) for satisfaction of the debts and other monetary obligations of the entity. That creditor could be the bank that made a loan to the entity, a litigant who claims to be harmed in some way by the entity’s operations, or another shareholder who believes the entity owes him or her money. Put another way, limited liability means your liability in connection with the business is limited to the amount you invest into the entity. Your own assets remain your own, and not subject to claims arising out of the entity’s operations.
A sole proprietorship has no limited liability—the assets and liabilities of the business and the owner are one in the same. In a general partnership, the partners are collectively responsible for the debts of the partnership, which, depending on your partner(s), could be riskier than a sole proprietorship. In a limited partnership, there is one or more general partners and one or more limited partners, who enjoy limited liability. A corporation provides limited liability to its shareholder/owners; and a limited liability company provides the same to its members/owners.
One way to look at sole proprietorship is to ask yourself: what additional liabilities am I exposed to by virtue of owning and operating my new business? If you are making handicrafts at home and selling them online, you might well conclude that your business does not add any significant risk to your life, or if it does, that those risks can be contained by well-written contracts and procuring the right insurance. Remember, forming a legal entity for your business does not eliminate the risk that you will ever be sued or that liability will ever attach to you: limited liability only protects you (personally) against claims which relate to the entity or arise in the course of the entity’s operations.
The ease with which you can start doing business as a sole proprietor should not be underestimated. You may wish to file a tradename certificate, but otherwise, the legal paperwork required to create and maintain a corporation or LLC is simply not needed. Similarly, a partnership is created by agreement of the partners, or simply by the fact of two or more people operating a business together. Starting a corporation or LLC requires filing articles of organization with a state (and a substantial filing fee) and annual franchise filings and taxes thereafter. Corporations generally require more extensive internal paperwork (e.g., annual meeting minutes) than LLCs, but the value of either form of entity as a liability shield depends on the owner’s regular observance of formalities that delineate the entity’s existence independent from the owner.
With a sole proprietorship, the income from your business flows directly onto your tax return as personal income. Similarly, the income from your partnership flows onto your return in proportion to your percentage ownership of the partnership. With a corporation, the income generated in the business is taxed at the corporate rate on the entity’s corporate tax return. Any income that is transferred from the business to you as owner/shareholder (e.g., a dividend) is taxed again, as personal income on your tax return. Any income the corporation pays you as an employee is subject to income and withholding taxes. With an LLC, you can choose whether you would prefer for the entity to be taxed as a sole proprietorship (the default tax treatment the IRS imposes on single-member LLCs), as a partnership or as a corporation.
Choosing an entity requires a clear understanding of how you intend to run your new business. Once you know your liability, convenience and tax preferences, you will be in a great position to make that choice.