Business Entity
Why is it important for a new business owner to choose the type of entity carefully?
Choosing the right type of entity is essential as a new business owner. The main factors in deciding a business structure is a company’s governance and tax exposure. Other important issues are liability, continuity, transferability of ownership interests, and formality of operation. The most common entity classifications are sole proprietorships, partnerships, limited liability companies (LLCs), and corporations.
As a sole proprietor, the business owner will have unlimited liability and be exposed to any legal claims personally. The owners of this type of entity will report business income and expenses on their personal tax returns. This is the default entity type that does not require any filing, but they may file a DBA (doing business as) certificate. There is no formal organizational requirement, and business interests are transferred only by selling the assets themselves. Access to capital can be limited, and there is a potential for more tax liability with respect to other entity structures.
General Partnerships function similarly, with no formal organizational requirements or formal management or governance requirements. However, partnerships may have an agreement that spells out any procedures for dissolution or amendments. The exposures are generally the same as a sole prop, and any partner can bind the partnership. Therefore all partners are jointly and severally liable for all debts and obligations of the partnership (unless otherwise agreed by partners or as provided by law).
LLC’s are created by filing a certificate of formation with the SOS. This entity is a hybrid of a partnership and a corporation. The owners of the LLC are called members. A member can be an individual or any other legal entity. The company can be managed by managers or members as designated and stated in its certificate of formation. The main advantages of this type of entity are the corporate-like liability shield as the LLC is a legal “person” or entity. The members can enjoy pass-through taxation where all members can participate in the management of the company without losing its protected, limited liability status. A registered agent and principal office must also be designated in the certificate of formation. LLC’s are subject to self-employment tax unless you elect subchapter s designation.
Corporations are created by also filing a certificate of formation with the SoS. A corporation is a legal “person” separate from the people who own, control, and manage it. Owners are called shareholders. A board of directors manages the business. Shares of the corporation can be sold to anyone, person or entity. There is an issue with double taxation (unless S-Corp). There are rigorous management and governance structures. A registered office and agent for service of process must be designated. At least one director in charge of overseeing the business and at least one president and secretary as officers must be selected. One annual meeting of the directors and the shareholders of the corporation must be held, and directors and officers elected at the annual meeting.
As you can see, each structure has advantages and disadvantages depending on the goals of the company and its owners. It would be best if you had an attorney and CPA counsel you to select the right business entity.