Knowhow: Legal Entities | How choosing the right business type can help or hurt you
Deciding the type of business entity for your new business requires advice from your lawyer and accountant. Key concerns include whether you require liability protection, tax effects, and flexibility in management.
You will need to evaluate the risks in your business. What are the risks that you will become personally liable for your business activities? When insurance cannot protect against these risks, business owners typically form a corporation or limited liability company.
Multiple owners should enter into written agreements to describe each owner’s rights and obligations. Depending on the type of entity, these agreements take the form of partnership agreements, shareholder agreements, or operating agreements.
If you choose the wrong entity form, you may not be protected against creditors, or you or your business will be required to pay additional taxes. Below is a brief review of common business forms.
Sole Proprietorships
A sole proprietorship is owned by an individual and is typically designated by a “dba.” A sole proprietorship must register its business for a small fee in the city or town where the business is located. No additional filing is required.
An individual who operates a sole proprietorship has no liability protection. For tax purposes, profits and losses are reflected in the individual’s own tax return.
Partnerships
General partnerships are created automatically when partners share in a business’s profits and losses. Only a local business registration is required.
General partnerships have no liability protection. To achieve some liability protection, general partnerships may become limited liability partnerships (LLPs) or be in the form of limited partnerships (LPs), by filing certificates with the Secretary of State.
Your accountant will need to prepare a tax return, but all profits and losses are recognized only at the partner level.
Corporations
A corporation is formed by filing articles of organization with the Secretary of State. Corporations must have directors and officers, pursuant to bylaws. Stockholders should elect directors annually. Most public or larger companies are corporations.
Stockholders who do not follow the formal requirements of a corporation, or who do not keep separate books and records, risk their liability protection to creditors who “pierce the corporate veil.”
Corporate profits are taxed at the entity level. If the remaining profits are distributed to the shareholders, they are taxed again as a dividend.
Corporations may avoid this double tax by promptly filing for “S corporation” status with the IRS. For tax purposes, S corporations are like partnerships; however, S corporations are very limited as to the number and type of stockholders, and the type of stock that is issued.
Limited Liability Companies
LLCs became popular throughout the 1990s and have the same liability protection as corporations but are more flexible. An LLC is formed by filing a certificate of organization with the Secretary of State.
LLCs have few rules and can be managed by one person, a committee, a board, or officers. Managers may be owners, called “members,” or outside parties. LLCs may have one or more members without any of the S corporation limitations.
Multi-member LLCs are taxed like partnerships. Single member LLCs are taxed like sole proprietorships. LLCs may “check the box” to be taxed differently.
Michael Refolo is a partner of Mirick O’Connell. He can be reached at mrefolo@mirickoconnell.com.
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