The question of what entity type to choose when starting a new business can be overwhelming and it is important to choose the one that best fits your business needs. While there is no one-size-fits-all approach, here are some things you should consider before making your decision.
Common Business Entity Types
The most common types of legal entities used for business are corporations, limited liability companies (LLCs), partnerships and sole proprietorships. At the highest level, the type of entity you organize depends on the type of business you are forming, the growth path of your business (self-funded, traditional lenders, or venture capital), your personal preference (do you hate annual meeting minutes, for instance), and your tolerance to taxes and liability risks.
Sole proprietorships are among the easiest business to start and, with the exception of local business license rules, can generally be started without filing any paperwork (unless you want to use a unique name, then you likely need to file a fictitious business name statement). Similarly, partnerships do not require paperwork and only require the agreement of two or more people to engage in business together.
Corporations and LLCs both require the filing of a Certificate of Incorporation (sometimes Articles of Incorporation) or a Certificate of Organization (sometimes Articles of Organization), respectively, with the applicable Secretary of State before they may conduct business. Your state may have additional requirements for adopting written rules to address the governance of the business, typically Bylaws or an Operating (LLC) Agreement.
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A significant factor in selecting an entity are the tax implications, both at the outset of the business and taking into consideration what the business will be doing when it is in full operation.
Partnerships (the default tax scheme for multi-owner LLCs, too), sole proprietorships, and corporations that have elected to be taxed under Subchapter S of the Internal Revenue Code (so-called “S-corps”), are subject to pass-through taxation in which the owners pay taxes on business income at their individual income tax rates; there is no tax imposed at the entity level. This can result in higher effective tax rates for businesses that operate as S-corps, partnerships, or sole proprietorships where the top personal income tax bracket is 37% (2022), though the Tax Cut and Jobs Act of 2017 (“TCJA”) does offer a 20% deduction for certain businesses and taxpayers.
In contrast, corporations (“C-corps”) are generally required to pay corporate income taxes at a flat rate, currently 21% (down from 35%) due to the TCJA. That said, when owners of a corporation want to take money out of the business (typically, in the form of a dividend or wages paid to the owner as an officer of the corporation) it will be taxed again, at the personal income tax rates of the owner receiving the distribution.
Often a primary concern of new business owners, alongside tax implications, is whether their personal assets would be at risk if something goes wrong with the business, whether that be injured customers, broken contracts, loan defaults, or disputes among owners.
While partnerships and sole proprietorships are straight forward to operate, they do not insulate an owner from the liabilities that arise out of the operation of the business. So, if someone is severely injured at or by your business (assuming your insurance is insufficient to cover) then you face the prospect of losing your non-business assets to pay the injured party.
Conversely, corporations and LLCs will ensure that only your investment in the business is at risk of being lost in these scenarios. While this may mean that the business itself could fail or go bankrupt, the owners’ personal assets are generally not subject to claims by injured parties.
Management & Operations
With partnerships and sole proprietorships, absent agreement to the contrary, each owner has full authority to run and manage the business, without needing to seek approval from higher governing body. For the variety of LLC known as “member-managed” this similarly holds true, and the owner-members each can run the business. While simple on the surface, without the proper contractual limitations on authority between the owners, the business can splinter off in the direction of the whims of any one owner.
With the “manager-managed” variety of an LLC, the power to run the day-to-day matters of the LLC are given to the manager or managers and major decisions are often reserved for votes by the owners.
Corporations offer the most formal structure, with three levels of decision-makers. At the top, shareholders (owners) get to vote on a variety of major company transactions and are responsible for appointing members of the Board of Directors (“Board”). The Board is often best seen as being in charge of the vision or strategy for the business, approving transactions, budgets, and larger events for the business, they hand down directives and oversee the officers of the business. Officers then, such as the CEO, CFO, and Secretary, are responsible of the day-to-day operation of the business, following the directives of the Board. It is not uncommon that the shareholder, directors, and officers of a corporation are the same person or people, though the management structure must still be followed and decisions at each level documented to ensure continued liability protection, discussed above.
While selecting the right business entity can be daunting, it is important to get your business of on the right foundation to reduce administrative headaches, taxes, and liability. A good team of professional advisors such as lawyers, accountants, insurance brokers, and bankers can help you select the right entity to avoid overpayment of taxes or unwanted liability exposure, or to ensure you can meet capital requirements to grow the business.
The attorneys at Gesmer Updegrove LLP have decades of experience advising businesses across all industries and revenue levels, and would be happy to assist you in selecting the correct entity.
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