Aug
14
2019

Learn the Differences Between Each Legal Business Entity Type

Your individual state will register your legal business entity, and it’s important to understand that not all states recognize every business entity type. The descriptions below are meant to give you a basic understanding of the differences between entities, but you should check with your local government to see which type of business designation is right for your new venture.

Sole Proprietorships

Most small businesses choose the legal business entity of a “sole proprietorship”, where one person is the only “owner” of the business. Legally, there is no difference between you and your business, and while this business entity type is preferred by some because of the ease in setting it up and registering it, there is a greater legal risk assumed by the owner of a sole proprietorship. For example, if someone sues your business for infringement or fraud, they will be suing you, and your personal assets will be on the line if the case is taken to court – a disadvantage to this kind of legal business entity. This type of situation is rare to be sure, but from a business standpoint, it has the potential to be a risky move.

An advantage of this entity is the fact that you’re the only owner! You can make your own business decisions without having to consider the opinions of a board of directors, or other stakeholders. You receive 100% of the income from your business, and are free to file your profit on your individual tax return at the end of the year – a huge advantage to choosing this legal business entity type.

Partnerships

As the name implies, a partnership is an entity in which two or more people own a business together. Just like a sole proprietorship, there is no legal difference between the owners / members of a partnership and the business itself. As previously stated, choosing this legal business entity can have potentially negative consequences if someone were to file a suit against you or your business. An entity type of this sort carries an additional risk because of the added element of another person. For example, let’s say your business partner did something illegal and the court has decided to penalize your business assets because of his or her mistake. Although you have done nothing wrong, the whole business may be at risk of going under because of the partnership liability. Again, although this is rare, it is important to consider when choosing this kind of legal business entity. Types of considerations like this can protect your investment in the long run.

Speaking of investment, an advantage to a partnership is the ability to raise more funds with the influence of more people. Instead of having to shoulder all of the capital upon startup yourself, a partnership can help business owners divide the cost of operational expenses. And of course, because you’re sharing costs, you and your partner(s) will have to share profits as well. A benefit of this kind of legal business entity is the financial ease achieved by being able to file your profits under your individual tax return at the end of the year.

When starting a partnership, it is important to draw up a legal agreement detailing how costs and profits will be shared, what to do in the event of a partner wanting to leave the business, how to settle disputes about business strategy, etc.

Corporations

Unlike sole proprietorships and partnerships, where the owners are legally the same as their business, corporations offer business owners a unique legal and tax benefit in the sense that corporations are granted their own legal status. Therefore, this business entity type is considered as a separate legal business entity from you, your partners, and your shareholders. If your business were to be sued, it would not put you or your personal assets at any risk. So wait…who are shareholders? Whereas you’re an owner / operator / member of your sole proprietorship or partnership, you become a shareholder in a corporation, because this type of business operates with stock, or partial ownership distributed amongst several people. As a shareholder, you “own” a part of the business, but you also have to routinely answer to a board of directors who steer the direction of the company.

The downside to the legal business entity of a corporation is that you have less individual freedom to make executive business decisions, and you are not in total ownership of your business. This business entity type is more difficult to begin and dissolve, and often must comply with a series of complex federal and state regulations and taxes. However, the obvious benefit to this type of legal business entity is that you have more individual legal protection with the separation of yourself from your business in the event of a lawsuit.

Limited Liability Company (LLC)

Finally, a Limited Liability Company (LLC) is a sort of combination of all of the above business structures. Like the “corporation” business entity type, an LLC offers a legal distinction between a person and their company, but like a sole proprietorship or partnership, it offers the owner or member (we’re back to being called members now) control over business decisions, tax breaks, and offers no stock option. There is no limit to how many members an LLC may have, and it is also possible to just have one member. The obvious upside to this type of legal business entity is that it provides the best parts of both worlds, corporation and non-corporation, but the downside is that it is more difficult to file than a partnership (but is still less difficult than forming a corporation). To date, the federal government does not recognize an LLC as a classification when you file your federal taxes, so you must file either as a sole proprietorship, partnership, or corporation.

So What do I do Now?

As with any kind of legal decision, deciding which business entity type is right for your business is a big decision that requires a lot of thought. This is just an overview of the primary differences between each major legal business entity, so before making a decision, check with your lawyer or accountant to decide which is best for your financial and business interests. It seems complicated at first, but once you get registered with the state, you’ll be on your way toward owning and operating your own business!

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Aug
06
2019

Why You Need A Business Entity

When starting or expanding a business, many owners wonder if they should form a business entity and, if so, which one they should use. There is a wide variety of information and “pitches” being made on the Internet regarding the benefits of certain entities versus others. When you cut through the flak, however, the primary reason for forming a business entity is to create protection from personal liability arising from your business activities.

It is well established that up to eighty percent of businesses will fail in their first two years. Many of these businesses, and probably yours, carry a high level of personal risk for their owners. If you are not using the correct entity for your particular business, you are going to be personally liable if the business fails. Do you want to expose your home, car and other assets? How about the assets owned by your spouse or their paycheck from a regular job? Selecting the correct entity for your business prevents such nightmares from occurring. More importantly, you can sleep at night knowing that the worst thing that can happen is losing your investment in the business, not your home.

Business Structures

There are a number of business structure options that exist in the modern corporate world. Following is a short explanation of the most common business structures.

Corporations

Corporations come in two basic forms, a “C” corporation and an “S” corporation. There are a variety of differences, but the central one is a tax issue. Briefly put, “C” corporations are taxed on their revenues and you are then taxed separately on any money you take out of the corporation. An “S” corporation “passes through” all taxes to the shareholders with the information being reported on your personal tax returns.

Regardless of the tax classification, a corporation is considered an independent entity from a legal standpoint. This independent status acts as a shield between the activities of the business and your personal assets. As a practical example, Kmart recently filed bankruptcy. The individual shareholders were not required to file bankruptcy and lost nothing more than their investment in the stock of the company. Forming and using a corporation for your business activities will have the same effect, to wit, your personal assets will not be wiped out if the business fails.

Limited Liability Company

A limited liability company, or “LLC” as it is better known, was a very popular entity choice in the early 1990s. LLCs are similar to corporations, but can be taxed as a partnership. In California, the LLC can have either one owner or two. Regardless of the number, these owners carry the legal title of “member.” The LLC provides a shield for your personal assets just like a corporation.

Partnerships

In my opinion, it is better to have died a small child then be in a partnership. Unfortunately, many business owners form partnerships and don’t even know it. This occurs when they go into business with another person. If no business entity is formed, the law considers the business to be a partnership and treats it accordingly.

Partnerships are dangerous for one primary reason: a partnership does not provide any protection from liability and, in many ways, invites personal liability. Under well-established law, most partnerships are classified as “general”. This simply means that all the partners are contributing to the administration and running of the partnership business. This classification can have grisly results.

In a general partnership, each partner is jointly liable for the debts of any other partner arising from the business. For instance, you and your partner go to a business dinner with a client. Your partner has a drink and then a few more. They then get into an accident on the way home. Each of the partners is liable for the damages claimed by the injured people. That means YOU! Even if you were not in the car, did not rent the car, never saw the car and don’t drink!

Partnerships are a recipe for disaster. Stay away from them whenever possible.

Limited Partnerships

Limited Partnerships ["LP"] are perhaps the most misunderstood business entity. A limited partnership is similar to a general partnership, but allows a number of the partners to limit their liability by being limited partners. It is critical to note that these limited partners are restricted to simply making a capital [cash, content, equipment] contribution to the partnership. They cannot be involved in actively running the business. If they are, they lose any protection from partnership debts. Many limited partnerships end disastrously. If you are married to the idea of pursuing a limited partnership, you must do so in combination with corporations. That particular strategy is well beyond the scope of this article, but feel free to contact me if you wish to pursue a limited partnership.

Business owners should protect themselves by forming entities for their business activities. The real issue is identifying the structure that is best for your particular situation.

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