If you’re starting a business, one of the things you’ll need to decide is what kind of legal entity to use for your business. Choose the right answer and you’ll pay less tax, shield your personal assets, and perhaps save money on accounting costs. Make the wrong choice and you’ll pay extra tax and put your home and personal assets at risk. So, which legal entity is right for you?
The first choice is a sole proprietorship, which is an enterprise owned and operated by a single person. Under this legal structure, both the owner and the company are treated as being one and the same for tax and legal purposes.
Sole proprietorships are the default form. Every business with a single owner is automatically a sole proprietorship unless they take steps to select a different legal entity. This is true even if the business never obtained licenses and permits or registered with the appropriate authorities.
Consider an example. Say you have a day job but have a knack for snapping photos. A friend asks you to capture their wedding for a small fee, which you do without creating a name, forming a company, or getting a business license. Congratulations: You’re a sole proprietor.
The downside to being a sole proprietor is liability. If the business cannot pay its debts, the owner is on the hook for them. If the business is sued, the owner is ultimately responsible. In short, the owner is personally liable for all of the business’ debts—he or she has unlimited liability. And, so, if a business is sued for enough money, the owner could lose virtually all of their personal possessions—their car, their savings, and perhaps even their home.
Alarming? Maybe. But before you get too worried, ask yourself what would happen if everything went wrong with a client. Do they go to the hospital? Do they lose millions of dollars? Or do they just lose the money that they paid for your service? If a really bad day at the office includes clients getting sick, hurt, or losing heaps of cash, then unlimited liability can be a nightmare. But if you’re the previously mentioned photographer who would merely need to refund some money, then the risk of unlimited liability shouldn’t keep you up at night.
That brings us to legal entity No. 2: a partnership. At its simplest, it looks almost the same as a sole proprietorship, except that instead of one owner there are two or more owners. In other words, like a sole proprietorship, if a business has two or more owners but has yet to register and get licenses and permits, then the business is a partnership. Also, like a sole proprietorship, the business and each owner are treated as one and the same for tax and legal-liability purposes. Thus, a big enough lawsuit would risk almost all of the owners’ collective personal assets.
Fortunately, if you want to start a business but don’t want to risk all of your assets, you have three other legal entities to choose from: S corporations, C corporations, and limited liability companies. In each case, if something goes wrong, the owner will only lose what they invested, nothing more.
Of the three, S corporations are probably the least well known to the general public. But this form is popular for privately owned companies. And a key reason is tax savings. Unlike sole proprietors and partners who must pay FICA tax on all business profits, an S corporation only needs to pay FICA tax on the owner’s salary. The difference can be tens of thousands of dollars more in the owner’s pocket each year.
But S corporations are not for everyone. For example, corporate and foreign investors cannot own an S corporation. And there are strict rules about how profits are distributed and losses deducted. Plus, you’ll need to run payroll even if there are no non-owner employees.
The next option is a C corporation, which is well suited for companies that raise significant funds from outside investors. For instance, all publicly traded companies are C corporations. And the same for most high-growth startups that fund themselves through investment rather than business revenue.
But only about 5% of companies nationwide are C corporations. That’s because it has a couple significant drawbacks for the typical small- to medium-sized business. First, a corporation is taxed twice—once on the income that the company generates and then again on the dividends that it transfers to the company’s shareholders. Second, corporations tend to be more complicated to set up and maintain. You will need to create corporate documents, appoint a board of directors, and follow various corporate formalities such as holding annual meetings and executing corporate resolutions.
That brings us to the last and most popular legal form: LLCs. This form is so widespread because it allows you to mix and match the best of the other legal entities. It shields an owner’s personal assets from liability. It’s easier to administer than S or C corporations. And you get to pick if it will be taxed like a sole proprietorship, a partnership, an S corporation or a C corporation. Plus, you can change your pick later. For example, people often elect for their LLC to be taxed as a partnership early on and then switch to S corporation status after the LLC starts making enough money to justify the extra accounting headaches.
This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.