Start-ups and small businesses could benefit from the advice of legal counsel earlier than later. Many start-ups and small businesses scoff at the idea of engaging the services of a qualified attorney when launching or operating their businesses. Often, start-up entrepreneurs and small business owners are concerned with the bottom line and may not wish to stray too far off their budgets. These are legitimate concerns but they too must be balanced by what an experienced legal advisor could bring to the table. Unfortunately, many choose to avoid attorneys and come to believe that they have avoided all the potholes on the journey. Subsequently, they discover that may be not all potholes were avoided and then realize that they now have more pressing matters at hand that will require the services of an attorney.
For instance, with regards to a start-up business, the correct entity formation can be crucial. It is of paramount concern that business owners understand some of the ideas behind the formation of their vehicle for future success. For instance, the type of documents required to effectuate a formation and operational documents are important concerns for any business that hopes to be successful. Additionally, the number of individuals involved can dictate the taxation and the choice of the entity.
Now, I will only focus on some of the basics concerning some of the more popular business entities. A business may take one of several formations such as: (a) sole proprietorships; (b) [general] partnerships; (c) limited liability companies, or (d) corporations. The ones that I will not address here are (i) limited partnerships, (ii) limited liability partnerships (“LLP”), (iii) limited liability limited partnerships -this is not a typographical error- (“LLLP”), (iv) joint ventures (which is not a per se business entity but a business or commercial arrangement between two or more parties for the purpose of accomplishing a specific goal), and (v) s-corporations (not a true entity formation but is an election that is available to corporations under the Internal Revenue Code). I will reserve these for another discussion.
Sole Proprietorships
A sole proprietorship is an unincorporated business that is owned by a single person. No legal documents are required to start one. It is important to note that sole proprietorships (and general partnerships) unlike other business entities, do not afford their owners limited liability protection. In other words, the business owner is not shielded from the liabilities of the business and may be personally responsible for its debts and liabilities. This last aspect is enough to make this formation less desirable for many start-ups. From a tax perspective, a sole proprietor is responsible paying taxes on the income earned from the sole proprietorship
General Partnerships
A general partnership (“GP”) is an association of two or more people (which in this instance could also mean other legal entities) who have joined together and agreed to engage in a common undertaking and a share of the profits. While the creation of a general partnership can be done by a partnership agreement, no writing is required and no filings are required by the state. However, where sole proprietorships and partnerships elect to use trade names or “doing business as” names, they may be required to file the appropriate documents with the applicable local jurisdiction.
Each partner pays taxes on his or her own share of income received from the partnership. Losses may not be shared equally but may be allocated between the partners, as agreed by them, not in correlation with respect to their respective shares of the profits.
Partnership taxation is a factor to take into consideration when contemplating formation of a general partnership. Whether or not the parties agree on reducing their agreement to writing, it is important to understand the tax consequences of this entity formation. Additionally, each partner could be liable for the actions of other partners that are taken in the name of the partnership. Where individuals are concerned, this may not be the most advantageous vehicle for their business enterprise if liability issues are an important concern.
Corporations
There is almost not a single person alive that is not familiar with corporations in one form or another. The corporation is a creature of statute and comes into existence when promoters file the requisite articles of incorporation with the state. Indeed, corporations are popular and widely used throughout the country and the world because of the limited liability protection afforded to its shareholders.
Under the law, corporations are “legal” persons. Corporations are infamously known for many things and one of those is the dreaded “double-taxation” concept. Corporations are owned by persons known as “shareholder” or stockholders.” One of the rights and privileges of being a shareholder is the receipt of dividends when paid by the corporation. Corporations are required to pay taxes on income earned and some of that income, after taxes, may be paid to shareholders, who in turn are required to pay taxes on those dividends. This is the double-taxation concept. This concept is an important factor when contemplating the formation of a corporation and can play a decisive factor.
Limited Liability Companies
A limited liability company, commonly abbreviated as “LLC”, is also a creature of statute and combines some of the features of a partnership and a corporation. LLC organizers are required to file the requisite legal documents with the state in order to bring the LLC into legal existence. Importantly, an LLC does provide limited liability protection to the members that constitute it. It also could provide some tax advantages but not as many as corporations.
The Internal Revenue Service (“IRS”) treats LLCs as tax pass-through entity. That is, unlike a corporation, an LLC is not a taxable entity and the tax burden falls through to its members. Additionally, single owner LLCs are disregarded and the sole member is taxed as if he or she was operating a sole proprietorship. Not to worry, the limited liability protection is still intact. Where an LLC has more than one member they may elect to be taxed as a corporation by filing with the IRS, Form 8832. If no election is made them the members of the LLC will be taxed as if they were conducting a general partnership and yes, the limited liability component is untarnished.
Conclusion
The distinctions discussed above regarding the various business entities may seem common place and easily understood. However, start-ups and small business owners rarely appreciate the intricacies of each one and how to choose the right one as a vehicle for their businesses. With the exception of sole proprietorships, many would-be business owners understand the other entities to provide them with the most important thing that they seek: limited liability protection. Limited liability protection for any business should be of primary concern but selecting the entity that is most advantageous to a successful business may appear simple but there is more than meets the eye.
Additionally, when contemplating business entities one should also take into consideration the tax implications of such an entity. By tax, I do not only mean income tax liability but payroll tax liability, as well. Each of the entities mentioned above are indeed affected in one way or another by federal and tax laws. While it may be simple for an individual to complete certain forms where necessary regarding his or her choice of entity formation, there is a lot more that should be considered before settling on a business entity choice.
About Andre Wrighte
Andre Wrighte is solo practitioner who focuses his practice on helping his clients to find solutions to problems by advising, counseling and representing them in matters concerning business planning and formation, corporate-related issues, commercial and real estate transactions. André also represent clients in commercial litigation proceedings, real estate transactions and estate planning/probate practice. For more information visit http://www.wrightelaw.com, call (773) 273-9815 or awrighte@wrightelaw.com. Find his blog at The Wrighte Law here.
Disclaimer
The author disclaims all liability and recommends that the reader consult with a competent attorney. Do NOT rely on this article or posting. This article or posting does NOT establish an attorney-client relationship nor does it constitute legal advice.
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