There is much more to starting a new business than picking a location, buying equipment and hiring employees. Too often, entrepreneurs focus only on opening the doors and ignore one of the most important aspects of the start-up process: selecting and forming the proper legal entity for the business. Attention to such details in the beginning can save you money and headaches, and even your business, later on.
There are a wide variety of legal entities for running a new business. Often, the choice of entity depends upon certain factors concerning the business. This article will introduce some of those factors and the various business entity choices which logically follow from them.
Sole Proprietorship
The first question a lawyer will usually ask about any proposed business is: "Who will own it." Frequently, businesses are owned and operated by one person. Individually operating a business without the protection of a legal business entity, generally called a "sole proprietorship," leaves the owner personally liable for all debts and obligations flowing from them. For example, if a solely-owned business serves the public, such as a beauty salon or restaurant, the owner is personally exposed to lawsuits from customers for injuries or other damages arising from the operation, or occurring on the premises, of the business. Likewise, the owner will be personally responsible for all tax obligations and debts of the business.
Corporation
An often asked question is: "Can a single person form and own a corporation?" The answer is yes, an individual business owner can form a corporation to own and operate his or her business. Doing so can provide the owner with protection against certain liabilities of the business. There are many different types of corporations, however, and an entrepreneur should consult an attorney in choosing the proper one. Additionally, even when a corporation is formed, if the owner does not carefully comply with the numerous state and federal laws and regulations regarding the formation and continuing operation of that corporation, the owner could remain personally liable for all debts and obligations of her business.
Partnership
If a business is to be owned by two or more persons, the owners should form a legal business entity, typically either a type of corporation or partnership. Again, the choice of which type of corporation or partnership is complicated, and depends upon numerous factors. One such factor is whether the owners will have equal management and ownership rights in the business. If the owners do not want centralized control over the business, but would prefer to have an equal say in all business affairs, some form of partnership may best serve their needs.
Partnerships can allow each partner to have full control over the daily affairs of the business. Such an arrangement also means, however, that the partners will have joint responsibility for all debts and obligations of the business. It is important to note, however, that even certain types of partnerships allow for unequal management and ownership rights, as well as unequal assessment of tax and other liabilities among the owners.
Management Considerations
If, on the other hand, owners want to have centralized management, basically meaning that control over the business is delegated to individuals appointed by the owners (which can be the owners themselves), a type of corporation may be the better choice for their business. In regular business corporations, the owners select directors to run the business, and the directors in turn select officers who manage daily affairs for the business.
Like partnerships, corporations allow owners flexibility in splitting ownership of the business among owners, called "shareholders." However, unlike partnerships, the liabilities of a corporation are generally assessed against the owners only to the extent of their individual capital contributions in the corporation. Thus, shareholders are not generally liable for the debts of a corporation.
Potential Tax Consequences
In addition to management and liability, another important consideration in choosing between some form of partnership and corporation is the tax consequences of such choice to the owners. Generally, a partnership results in the partners being taxed individually for their respective shares of the partnership's income (or losses). This "pass-through" tax typically means that owners are only taxed once at their own individual tax rates for all earnings of the partnership.
On the other hand, regular business corporations generally are taxed separately at a different rate from the owners' individual tax rates. This may result in "double-taxation," since the owner will also be taxed for distributions made to the owner by the corporation.
To avoid a double tax, corporations may pay owners a salary (which is taxed at the owner's individual tax rate and provides the corporation with a business expense deduction) and minimize shareholder distributions which otherwise would also result in tax to the owner. Or, they may elect to be taxed as a small business, or "S" corporation, in which case the income of the business passes through the entity and is taxed directly as income to the shareholders. Check with your legal or tax advisor about the rules applicable to qualify for an "S" corporation.
Liability Concerns
A second question most frequently asked is: "What type of business is it?" Often, the amount of potential liability a business exposes its owner or owners to will dictate what form the business will take. Any business which is open to the public and provides a service gives rise to potential personal injury and other types of lawsuits. Using the beauty salon example again, a customer might sue you for many things ranging from injuries sustained by slipping on the store floor after you mopped it, to pain and suffering from improper beauty treatment. Without the protection of a properly formed and run corporation, you will be personally liable for any judgment awarded to that customer for his claims.
Wrap-up
The above are but a few of the general factors to consider in choosing the proper legal entity which best suits your business needs. Unique problems exist with every new business, and the prudent entrepreneur should discuss those problems and needs with an attorney before embarking on a new business.