You Are Not Your Business - Choosing a Business Entity

Okay, sometimes you are. But we’ll get to that.

Time Commitment: About 5 minutes if you go quickly

The law gives you lots of ways to organize your business into an entity distinct from you as an individual. Almost too many. There are tons of intricacies to consider when choosing which type of entity to establish, but two of the biggest considerations are taxes and limiting liability. There are others that might be more important in your situation (e.g., options in issuing stock), but taxes and limiting liability tend to make you lean towards one type of entity over another. Just to save you some time, if your business is a silicon valley style startup that will be courting venture capital, I’ve heard that investors are only interested in C corporations, particularly if they’re incorporated in Delaware. Don’t take my word for it, but that’s my impression. For the rest of us, here’s a rundown of your options.

Sole Proprietorships

This is just a fancy way to say you really are your business. With a sole proprietorship, you essentially conduct business using your personal identity. You don’t have partners and no one invests in you. You are a lonesome capitalist soul. The advantage is in most types of businesses you don’t have to file any paperwork or get any special license for a sole proprietorship. You also are generally only taxed once on your earnings (as opposed to corporations where you are taxed twice; more on that in a moment).

The advantages of sole proprietorships sort of end there. Many people start out this way, but the unlimited personal liability tends to push people away from sole proprietorships as soon as they either start making serious money or start doing things that could have major consequences. The free enterprise side of me loves that sole proprietorships are legitimate, but the lawyer in me can’t help but want to put an asterisk on legitimate* because in most instances a sole proprietorship is not the optimal way to conduct business.

Partnerships

Partnerships are a funny thing because there are several different types and there can be a wide variance among them. These differences can be hard to discuss because of a lack of creativity in naming the different types. There is the general partnership, the limited partnership (“LP”), the limited liability partnership (“LLP”), and the limited liability limited partnership (“LLLP”). To avoid details that you probably don’t care to know, the biggest differences in these types lie in the liability each kind of partner carries. The unifying thing among them is that they generally involve more than one owner and partnerships are all taxed similarly. Partnerships are “Pass-through entities,” meaning they aren’t taxed as entities themselves. The earnings and losses are “passed on” to the partners according to the partnership’s arrangement.

Of note, the general partnership is analogous to the sole proprietorship, but with more than one person having ownership in the business. If you are operating a business with other people and you don’t pick which type of entity you want to be or file the necessary paperwork, this is the default the law gives you. And it sucks.

General partnerships have a huge disadvantage: unlimited liability, not just for your mistakes, but for your partners’ mistakes too. So one of your partners can screw up and you can be left holding the bag with no shield to protect your personal assets. This is probably the worst type of business to operate as. Like the sole proprietorship, it’s nice that you don’t have much or any paperwork to file and you don’t get taxed twice, but do you really want to be on the hook for you partners’ mistakes? Didn’t think so.

Limited Liability Companies

The Limited Liability Company (“LLC”) is probably the most versatile entity on the list. Members and employees typically enjoy limited liability, and LLCs can generally be taxed either like a partnership or like a corporation. Despite its versatility, the LLC is not optimal for every business. Depending on the arrangements you want between the owners, the default provisions for one of the partnership types may be a better fit, which means lower legal fees in making the entity conform to your intent. Also, unlike a corporation, LLCs generally can only issue one class of equity to its members, which can be a deal breaker for some investors.

Corporations

Corporations are the granddaddy of entities for limiting liability. Like LLCs, Corporations are a legal fiction that creates a “person” distinct from the owners, directors, and operators of the business. Corporations are fancy and complicated, both to start and to maintain. They also have a huge disadvantage: double taxation. Earnings of the corporation are taxable for the organization, then whatever profit an owner realizes is taxed again as personal income. There are a host of reasons to organize as a corporation instead of a particular type of partnership or LLC, including the relative durability of a corporation and the more extensive funding options. You need to decide whether these advantages offset the increased tax burden.

Lots more to talk about.

I guess we can stop there for now, but there’s lots left to talk about, including the limits of limited liability, the importance of default provisions for the type of entity you choose, dissolution, and more. I feel a follow-up post coming up pretty soon.