A Quick Guide to the Different Legal Business Forms
When someone is starting a business, one of the first things to consider is what type of business entity to form. By using the term business entity, I basically mean the type of legal organization one chooses to have their business operate as.
Your decision about what entity best fits your business impacts things like:
- How much it costs to form,
- How you are taxed,
- How it is managed and operated, and
- Whether or not your personal assets are exposed to liability.
That is not a comprehensive list, but it hits on a few of the major factors you should be thinking about when deciding which entity works for you. Below is a quick guide to the four major players in the game.
1. Sole Proprietorships
The easiest business entity to own is a sole proprietorship. It basically requires nothing on your part because a sole proprietorship is a business that is the same as the owner in the eyes of the law. In other words, your business is you and you are your business. There are no formal steps one must take to become a sole proprietorship, however, in order to do things like open a bank account, you would typically have to submit a "Doing Business As" (DBA) form or "Assumed Name Certificate" as it is called in Texas.
The major pitfall for a sole proprietorship is the fact that all your personal assets are on the line with the business. In English, if you get sued for something in the business, the people after your money can go after your personal property in addition to all your business property.
The major benefit to a sole proprietorship is the simplicity of formation. Again you don't need anything to be a sole proprietor.
The next business entity is the Partnership. A partnership is very similar to a sole proprietorship because it is easy to form and provides no protection for your personal assets. In Texas, a partnership is formed when two or more people carry out business for a profit. The law in Texas doesn't even care if you intended to form a partnership or not.
As stated above with Sole Proprietorship, the simplicity of formation can be wonderful. However, this simplicity comes with the added risk of liability. See, if you enter into a partnership with someone (intentionally or unintentionally) and they do something that puts the businesses finances on the line, the creditor or the person suing the business can come after your personal belongings. That means that Bob's stupid mistake could cost Mike his car.
Partnerships are taxed the same way sole proprietors are taxed. A partnership does not pay separate taxes, however it must file documentation describing how much money the partnership earned or lost and the owners will be taxed based on this information.
Corporations are the big dogs in the business entity world, but all corporations aren't big. The things that make corporations special is that they make the business a separate being from the person who owns it. What that means in terms of practical impact is that owners of corporations get to enjoy limited liability.
If the corporation fails to pay back a debt, the corporation's assets are on the line, but the owners' assets--for the most part--are not. There are a few limited ways to lose the protection of limited liability as a corporation and they usually entail failure to treat the business as a separate entity with separate back accounts and functions and mistakes personally made by the owners.
Some of the major characteristics of a corporation is that:
- It is more complicated and expensive to form than a partnership or sole proprietorship,
- It requires more formal reporting on a regular basis,
- It is taxed as an entity and as a shareholder's dividends,
- It has default management guidelines, and
- It provides limited liability.
There are a few variations of this type of entity, but they will be addressed in a subsequent posting.
4. Limited Liability Company
This entity is the cool new kid on the block. It has the simplicity of a sole proprietorship, but the protection of a corporation all in one! To form an LLC one has to pay fees similar to those required for corporations, but the annual recording and reporting requirements aren't there.
On the flip side, despite not having to keep up with all the extra paperwork, a business owner still gets to enjoy limited liability--just as long as they keep their business funds and personal funds separate.
With regards to taxation, the IRS allows an LLC to choose whether it wants to be taxed as a sole proprietorship or a corporation. Due to all of this flexibility, LLC have become the entity of choice.
This is a really brief overview regarding a few of the business entities one could choose from, however, it is extremely important to sit with an attorney or tax specialist to determine what specifically fits your business's needs.