By Dean ‘Mac’ Nichols, Attorney
When starting a business, one of the most important—and at times, most difficult—decisions involves determining what kind of legal structure is the best fit for your company. This decision will impact many aspects of your business: how much you pay in taxes, whether or not you are personally liable, your ability to raise funds, and the amount and type of paperwork your business must complete.
Because the type of business you have affects so many aspects of your professional—and potentially personal—life, it is important to make an informed decision in choosing the legal structure that makes the most sense for you.
Below are the four most common types of business entities and the differences among them.
• Sole Proprietorship
This is the most common form of business organization. A sole proprietorship is relatively easy to form. As the owner of this type of business, you have complete managerial control, but you are also personally liable for any and all of a sole proprietorship’s financial obligations.
• Partnership
Partnerships typically involve two (or more) people sharing the profits or losses of the business. Like a sole proprietorship, a business classified as a partnership also leaves the owners personally liable for the business’s financial obligations. However, the advantage of this type of business is that the partnership entity is not responsible for the tax burden of profits nor does it get the benefit of losses, as these are passed to the owners, who report them on their individual income tax returns.
• Corporation
A separate, legal entity created by the Commonwealth of Virginia, this must be filed and maintained with the State Corporation Commission. A corporation is a separate entity from the person or persons who founded it. It can turn a profit, and it can also be taxed and held legally responsible for its actions. Creating a corporation means the avoidance of personal liability of the owners for the business liabilities, but corporations can be more costly to form. Double-taxation has been cited as the largest disadvantage to operating in the corporate form. However, this can be avoided with an S corporation, a popular variant of the regular C corporation.
• Limited Liability Company (LLC)
Limited liability companies, or LLCs, are quickly gaining popularity in the entrepreneurship sector because these business entities allow for the benefits of both corporations and partnerships. The profits and losses of an LLC are passed to the owner without the business itself being taxed, but owners are shielded from personal liability. The earnings of an LLC are generally subject to self-employment tax for the members.
When deciding what type of business entity to use, evaluate the following questions:
• Legal Liability—how insulated do you need to be from legal liability? If you have passive investors, it may be vital that you and your investors don’t risk being held personally liable for potential losses.
• Tax Implications—what’s the best way for you to minimize taxation? Corporations offer more tax options than sole proprietorships or partnerships.
• Cost of Formation and Administration—do the tax benefits outweigh the formation costs and the costs of administration?
• Flexibility—as the potential business owner, what structure maximizes the flexibility in the ownership structure and balances your personal needs?
• Future Needs—what do you want this business to look like three, five, or ten years down the road?
The business structure you choose now may not be the best fit for you later on. However, your business can evolve from one business structure to another as your needs change. The bottom line is to consider the current needs of your business and what makes the most sense for you right now. For more details on an S corporation, C corporation and LLC, read our next three blogs.
