Monday, November 7, 2011

Your Legal Entity Is the Life Jacket of Your Business

Living in the Seattle area, it’s probably not too surprising to discover that I have a boat. I love owning a boat, but one thing about living on the Sound that I’ve learned is that there’s a lot of prep that has to be done before the boat gets launched. The same thing is true about launching a business.

There’s more to consider when launching a new business than what the name should be, and a lot of the decisions you make about the business should be made before you start. One of the most critical decisions you’ll make about your business is what kind of legal entity to create. It can be very confusing. Many calls I receive for help are from people who are half-way through trying to set up their business using an online service like LegalZoom and they suddenly realize just how complicated the matter can be.

Everything from how you handle banking to how you are taxed will be affected by the type of entity you create, so choosing the right type for you and your business is crucial. In the coming months, we’ll explore the advantages and disadvantages of different types of legal business entities in more detail.

Business Types

There are several different options you have when forming your business. Which you choose depends entirely on the needs of you as a person, the needs of the business, and the number of people involved in the ownership of the company. There is inherent risk in operating a business, but choosing the right entity formation can help minimize your risk.

Sole Proprietorship. A sole proprietorship is the simplest and the least costly to create. However, it does not offer any protection for personal assets against risk. Basically, the individual is simply operating under his or her own name or using a business name for doing business by filing a DBA form with their county clerk. The individual owns and operates the firm, assumes all the debt and liability of the firm, and files taxes using his or her own social security number at the end of the year.

Partnerships. A partnership is similar to a sole proprietorship. It is easy to form, with minimal start up costs. The only difference is that two or more people come together to form the business and agree to work together as co-owners of the business, usually under a partnership agreement or contract.

Limited Liability Corporations. Limited liability corporations (LLC) have become the most popular form of business entity, combining the strength of a partnership with the protection of a corporation without assuming the corporate tax structure. The terms of an LLC as an entity are governed by state statute, so laws will vary from state to state.

C Corporation. A C corporation is so named because it is governed by subchapter C in the IRS code governing corporations. A C Corporation files taxes as an entity and must have shareholders who elect a board of directors to make business decisions. The risks associated with a C Corporation are minimal compared to the other forms of business, but the costs associated with start up can be quite high.

S Corporation. To overcome the singular disadvantage of a C Corporation, in which both the corporate entity and the individuals who share in its profits are taxed on the same income, an S Corporation can be organized. The organizational structure of an S corporation is similar to that of a C Corporation, but in an S Corporation, the members can elect to be taxed individually for the profits generated by the business rather than be required to pay corporate taxes. The S Corp—as well as the Limited Liability Entity—has the added benefit of providing the owners savings on Self Employment Tax.

The forgoing information should be considered informational only and not construed as legal advice. Before selecting a business entity, a person should consult an attorney in his or her jurisdiction.

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