Business Entities: Your Business' Legal Identity

After making the decision to establish a business the first thing entrepreneurs want to do is make it official by creating their legal business identity (a.k.a. business entity). There are a lot of options and many people don't know why they should choose one or another. Here is a brief overview of the most popular business entities.
Sole Proprietorship- The owner of a sole proprietorship keeps all the profits and maintains complete and total control of the company. However, the owner is also personally liable for anything that goes wrong (example: you're a hairstylist and get sued for dying your client's hair purple, if the client wins she can put a lien on your house). Establishing a sole proprietorship does not require filing documents and registering your business. Instead it arises just from your acting like a business (i.e., getting paid for providing a service or product to customers). If you have employees or are in a situation where you could be liable for someone else’s actions then its best to create a formal business identity.
General Partnership– This entity consists of two or more people in business together for profit. Like a sole proprietorship, a general partnership can arise without formalities. It is possible to be in a general partnership without knowing it. In the general partnership, each individual partner is liable for all of the debts of the partnership whether they agreed to or knew about that debt or even if one of the partners disagreed with incurring the debt. If you are in a general partnership you should have an ironclad partnership agreement that states the rights and responsibilities of each partner.
Limited Liability Company– The Limited Liability Company  is a hybrid of a partnership and corporation. LLCs do not have as many formalities as corporations which makes it easier to manage because there are no officers, meetings, etc. LLCs also get the benefit of pass through taxation which means that all income from LLCs are treated as income of the individual owners. However, due to fewer formalities, there is less protection for your personal assets. LLC owners must show that business property and funds are separate and not commingled. Note:  Single owner LLCs are treated like Sole Proprietorships so you don’t get the liability protection unless there is more than one owner.
Corporation– Also known as a C-Corp, a corporation is a legal entity with its own identity separate from its owners and its own “social security number” called an Employment Identification Number (EIN). Corporations own their own property, maintain their own bank accounts and sign their own contracts. The big benefit of having a corporation is that the personal assets of the owners are protected from business creditors and obligations as long as the corporate form is maintained. This means that if the company fails, the corporation’s creditors cannot come after your personal bank accounts or property (which encourages entrepreneurs to take a chance creating a business that may or may not succeed). However, in order to maintain that protection, the corporation must have meetings with minutes kept, a board of directors, officers, separate accounts and appropriate records. The formalities are not as big a deal as many new business owners think. One of the drawbacks of corporations is that they are taxed on company profits and then again on dividends paid out to shareholders. There are accounting tricks to avoid being double taxed but you’ll need an accountant for that.
S-Corporation– S-Corps are similar to C-Corps in that the same formalities are required. However, a big advantage is that the S-Corp acts as a pass through for tax purposes; all the profits and losses are passed to the shareholder-owners who claim it on their personal taxes (which means no double taxation). An S-Corp shareholder does have to pay himself a salary that is deemed appropriate and reasonable for the position by the IRS. So if you’re an architect, you can’t pay yourself $8/hour. There are certain requirements that must be met: there can only be 75 shareholders or less and they must all be American citizens, there can only be one class of stock and the S-Corp must operate on a calendar year rather than a different fiscal year (for example, July-June).
These are the basics of business entities. If you have a question about which entity is right for you leave a message in the comments or send me an email.
While I am a lawyer, there is no attorney-client relationship between me and you (the reader) and this blog should not take the place of obtaining an attorney for advice on your specific situation. If you want to hire an attorney to determine which business entity is right for your company, call my office to schedule a free consultation via telephone or Skype.