It’s important for entrepreneurs to select the right kind of business entity. Whether they need to protect their personal assets or raise money, selecting the right type in the beginning will help them prepare for the future. Of course, there are pros and cons for each type.
1. Sole proprietor
A sole proprietorship is when a single person and the business are one in the same. There are no partners, and the life of the business ends with the sole proprietor or when they decide to shut it down. For example, if little Donny wants to start an ice cream stand, he can do so as a sole proprietor.
- Easy to start: Once Donny decides to open up his ice cream stand, he can just go out and buy the materials he needs and start selling. He would probably need to get some city permits and maybe file a fictitious business name statement with the county, depending on what name he wants to use, but Donny doesn’t need to open a separate bank account or file any paperwork with the state as a sole proprietor.
- No personal liability protection: Sole proprietors put their personal assets at risk. If Donny bought some supplies on credit and defaulted or if someone slipped and fell in his shop, then Donny’s personal assets are at risk to pay off those claims.
- Turning away business: Some companies may not want to do business with sole proprietors. This helps them clearly mark the line between the independent contractor and employee and helps them avoid this and other liability issues.
A corporation is a separate and distinct entity from its owners. It could go on and operate well past life of the founding owners. So, if Donny wants to incorporate, he files the appropriate paperwork with the state, obtains separate bank accounts and completes the other required paperwork involved.
- Liability protection: Shareholders enjoy protection of their personal assets. However, they must observe the corporate formalities and keep their business and personal lives separate.
- Increased appeal: Some vendors and clients like to do business with incorporated businesses or LLCs.
- Tax benefits: Income shifting, fringe benefits and self-employment tax are some of the benefits available.
- Easier to raise money: If you’re looking for venture capital, C-corporations are of choice venture capitalists when funding businesses.
- Annual maintenance: A corporation must conduct annual shareholder and directors meetings.
- Annual fees: For example, California has an $800 annual franchise tax, whether you make money or not.
- Double taxation, unless S-Corp: Small business owners will get taxed on the income at the corporate level and again at the salary level.
The benefit of liability protection only works if the owners of the company operate it separate and distinct from their personal affairs. Otherwise, it will allow others to “pierce the corporate veil” and their claims will reach the owners personally. The corporation can also elect to be taxed as an S-Corp, which allows profits and losses to be passed through to the shareholders.
3. Limited Liability Company (LLC)
The LLC is a relative new type of business entity. Many business owners like this structure because it allows for the protection of personal liability without the formalities of maintaining the books like a corporation. If Donny plans to run his ice cream shop as a smaller operation and is only going to seek funding through smaller private investors or loans, and he doesn’t want to deal with the formalities of a corporation, he should look into forming an LLC.
- Personal liability protection: This is true so long as members observe the formalities.
- Pass-through tax: Generally, members of the LLC will be taxed at the individual level, unless elected otherwise.
- Less paperwork: No annual minutes required like a corporation.
- Annual fee: In California, there's an annual $800 franchise tax.
- More taxes: California has a gross receipts tax starting at $250,000.
- Harder to raise money: The way an LLC is structured doesn't lend itself as easily to raising capital as a corporate structure does.
Again, the owners must observe the formalities of the business in order to get the benefits of personal liability protection. With the advent of the LLC, entities like general partnerships and limited partnership are becoming less common for smaller companies.
While it is possible to change entity types as you go along, it’s always easier, and usually cheaper, to select the right entity at the outset. So make sure you are taking advantage of all the resources available to you to make the right decision.
OPEN Cardmember Dan X. Nguyen, Esq. is Of Counsel to TDL International Law Firm, where he works with entrepreneurs in helping them select the right business structure and guiding them through the legal maze of starting a new business.
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