So, you are ready to start a business. Before you meet your first client or take your first order, you have some important choices to make about how to structure your company.
If you just hang up a sign and start doing business on your own, you have a sole proprietorship – or, if you go into business with others, a general partnership. These entities have no existence separate from the owner or owners. Most businesses today use a separate legal entity. The most common types are corporations, limited partnerships (LPs) or limited liability companies (LLCs). To determine what form of business entity is best for you, consider formation and operating formalities, limiting your personal liability and the differences in tax consequences.
Starting Up and Operating
Forming a proprietorship or general partnership entails only the minor cost of business name registration. Forming a corporation, LLC or LP requires organizational documents and making filings with the Secretary of State. The filing for an LLC or LP is a simple certificate entailing a small fee. A corporation requires filing articles of incorporation containing some basic information about the business and its capitalization. These entities also require documents that govern their operation and the rights and responsibilities of the owners to each other: an operating agreement or partnership agreement for an LLC or LP, and bylaws for a corporation. Moreover, state law imposes some formal requirements upon operation of LPs, LLCs and, especially, corporations.
On the other hand, customers, lenders and additional investors in your business may be more comfortable doing business with an entity than with a proprietorship. As the business grows, the need for a formal entity becomes greater. At the extreme, it is difficult for a business other than a corporation to go public. The size, complexity among owners, and whether the company may ever go public affect your choice of entity.
Limited Liability
Proprietorships and general partnerships expose the personal assets of the owners (home, car, savings, etc.) to claims of creditors and others. One of the most important reasons to do business as an entity is that the liability of owners of a corporation or LLC is limited to their capital contributions to the business. This protects personal assets from risk of loss if the business is sued and a judgment is rendered against it in, for example, contract disputes and cases of ordinary negligence.
Limited liability protection only goes so far, though. Owners can be liable in some cases for failure to pay taxes, claims by the government for violation of environmental laws or certain employment violations. Moreover, the owners of a small or new business may need to personally guarantee loans or leases to the business. And LPs must have at least one partner – the general partner – who retains unlimited liability; limited partners have no personal liability so long as they do not manage the company.
Tax Consequences
Depending on the entity used, your business will either be subject to federal income tax at the entity level, or the income and losses will pass through to the owners (who will be taxed on it), or both. For proprietorships, general partnerships and limited partnerships, income and loss from the business pass though to the owners, who are taxed on the income as individuals.
Generally, income to corporations is taxed at the corporate level. Cash paid to the owners as salary is deductible to the corporation but taxed to the individual, and other cash distributed to the owners is taxed at the corporate level and again at the individual level. This is referred to as “double taxation.”
Corporations can elect to have corporate income pass through to the owners – a so-called “Subchapter S” election – but S corporations remain subject to certain restrictions. Limited liability companies are more flexible, since the owners can elect to be taxed either as a corporation or as a partnership. State tax treatment may vary. Also, depending on the state, the business may also need to pay a business entity tax.
Also, corporations generally must withhold income taxes and pay a portion of FICA and Medicare taxes for owners that work for the company, while owners that work for an LLC or LP pay self-employment taxes, generally are not subject to withholding and instead make quarterly estimated payments to the IRS.
Other Observations
The choice of a business entity is important, but turns on many factors. To properly analyze the various issues, it is always best to consult your attorney or tax advisor. Doing it right up front is well worth the cost.
Steven R. Jenkins is an attorney in the Hartford-based business law firm of Pepe & Hazard LLP. This column is offered for informational purposes only, and is not legal advice. E-mail editor@hbjournal.com to suggest a question.