< Return to article listing

Starting Your Business: Choosing an Entity Tailored to Your Needs

One of the least considered steps in starting your own business is the legal form your business will take. All too often, novice entrepreneurs simply start their business by selling their product or service to their customers. In the legal world, this arrangement is known as a "sole proprietorship" — a single individual who does not spend a great deal of time nor effort in separating his or her personal life from business activities. Payments from business customers may be deposited in the bank account which is used to pay for the groceries or babysitter.

While a sole proprietorship may be the simplest business form, it may also be one of the most dangerous. The most serious problem with this arrangement is an individual's personal liability for accidents which occur in the business realm. For example, let us suppose that our friend Jerry owns a candy store which he operates as a sole proprietorship. One day, a customer buys some of Jerry's homemade gumdrops which, unbeknownst to Jerry, had been accidentally tainted with a household cleanser. Naturally, the customer becomes violently ill, is rushed to the hospital and is told in no uncertain terms that she was poisoned by the nefarious gumdrop. Enter the lawyers.

The problem with Jerry's business arrangement is that the customer's lawyers are literally going to sue Jerry for all he's worth. In other words, Jerry's bank accounts, boat, Rolex and 1909 Honus Wagner T-206 baseball card are all fair game. Just as Jerry's profits from the candy store went directly into his pockets, all judgments against his business will be taken directly out of them.

Fortunately, a little thought and planning prior to opening a business can prevent situations in which an individual is personally liable for his or her business activities. There are many entities which may be appropriate for your planned venture, so it is important that you speak with a qualified attorney before choosing one. The remainder of this article will focus on two of the most popular business entities — the corporation and the limited liability company.

The Corporation

When most people think of a corporation, they think of vast businesses with diverse products and thousands of shareholders buying and selling stock in the stock market. However, the majority of corporations are formed by a few people who want to embark on a business venture together. Many times, a single person will be the sole shareholder of a corporation — Jerry could have been the sole shareholder of Jerry's Candy, Inc. A corporation can have any number of shareholders, although it must have a minimum of one.

The main attribute of a corporation is that it is a separate legal entity. Just as Jerry is assigned a Social Security number by the IRS to identify him for tax purposes, a corporation is assigned an Employer Identification Number by the IRS. The corporation is, for all intents and purposes, a separate "person" under the law.

Corporations are managed by a Board of Directors. The Board is normally made up of a number of general directors and a few officers — President, Vice President, Secretary and Treasurer. The Board of Directors passes resolutions which are official statements of how the corporation will manage its business. For example, a Board of Directors may pass a resolution which authorizes the corporation to open a bank account or enter into a specific contract. Luckily, just as the corporation need only have one shareholder, the Board of Directors can be run by a single person who serves President, Secretary and Treasurer.

The main advantage of conducting your business in a corporation, as opposed to a sole proprietorship, is found in the degree of liability faced by the owners. Had Jerry created Jerry's Candy, Inc. prior to embarking on his business venture, the gumdrop incident would not have resulted in the loss of his 1928 Tiffany Favrile Lily Lamp. Instead, let us assume that Jerry's Candy, Inc. maintains one bank account from which it pays its suppliers, creditors and bills and that all the equipment in the candy store is owned by Jerry's Candy, Inc. In this oversimplified scenario, when the gumdrop customer's attorneys come knocking on the door, the only thing they will be able to acquire to satisfy a judgment would be the corporation's assets — the equipment, bank account, etc. Note that under a sole proprietorship the attorneys could get these items plus nearly everything which Jerry owned. Now his personal assets are sheltered from judgments rendered against his business.

The other side of the coin is taxation. The IRS classifies a corporation as either a "C" or an "S" corporation. The best way to think of the two is that a "C" corporation is normally a vast business with thousands of shareholders, while an "S" corporation has relatively few shareholders. All corporations begin their lives as "C" corporations. A company can only become an "S" corporation if a number of criteria are fulfilled and the shareholders fill out a special IRS form.

The main difference between a "C" corporation and an "S" corporation is the manner in which they are treated for tax purposes. A "C" corporation, such as a company on the stock exchange, must pay tax on its profits every year. When a shareholder receives a dividend, her or she must also pay tax on the dividend as income. Thus, to a certain extent, the stockholders of a "C" corporation are taxed twice — once at the corporate level and once on a personal income level.

On the other hand, an "S" corporation is only taxed once. Because it has few stockholders, the IRS allows what is called "pass through" income. Instead of taxing the corporation's profits at the corporate level, the IRS allows the profit to "pass through" directly to the shareholders to be taxed as income. Thus, a properly created and maintained "S" corporation will allow an entrepreneur to shelter his or her assets from liability for the business while being taxed in a manner similar to a sole proprietorship.

The Limited Liability Company

A Limited Liability Company, or LLC, is a relatively new species of legal business entity. The general idea behind an LLC is to create an entity which is very similar to the "S" corporation, but without some of the legal restrictions imposed by the IRS regarding the number of shareholders and the legal formalities in determining the business' actions.

Whereas a corporation has shareholders who own stock, an LLC has "members" who own "membership interests." In a common LLC with four members, each member may have a 25% interest in the LLC's assets and profits. Thus, when a distribution is made to the members, the total amount to be distributed is divided into four equal parts.

While a corporation is run by a Board of Directors who pass resolutions, an LLC is run by a specified management team. In most instances, this management team is simply designated as the members of the LLC. Accordingly, a corporation may have to abide by certain legal formalities such as board meetings and shareholder meetings, the LLC is a bit more flexible in permitting the members to come to an agreement regarding what endeavors the LLC will embark upon.

One problem faced by an LLC is that it is a new creature. The IRS has had decades to determine the manner in which it will tax corporations. Corporate law is now rather predictable. However, the LLC has only come into widespread use in the last twenty years. While the IRS has adopted regulations regarding the manner in which the LLC is taxed, there is a certain degree of concern that the IRS may alter the taxation of the entity as time progresses.

Conclusion

As is evident by the above discussion, there are two main concerns in entering into a business venture — taxation and liability. Discussing the various business entities with an attorney prior to entering into a new venture will allow you to determine the correct entity for your purposes. Other entities — such as a Partnership or a Limited Liability Partnership — may be appropriate. The cost of an initial consultation regarding your business entity is insignificant when compared to the possibility that choosing the wrong entity could result in the loss of your treasured baseball card or grandma's lamp. Finally, choosing the correct entity when your business is just starting out will certainly avoid many headaches when it achieves the degree of success to which you aspire.