Another common mistake made by new businesses, is not taking the time to determine the legal entity to operate the business. Often, founders start operations before consulting with an attorney or tax accountant and have to incur a higher tax liability as a result. Simple planning at the outset can avoid higher costs later on.
Some common business/legal entities to operate your business include:
- Sole Proprietorships. This is by far the easiest model to set up. In general, initiating a sole proprietorship does not require any legal documentation, fees or filings with the State. This type of organization can only be formed when there is one owner and no outside investors. Furthermore, a sole proprietorship provides no protection to the founder against creditors of the business (creditors can directly sue the founder). This organization offers no real protection against the founder in the event of legal liability either. Therefore, I do not recommend a sole proprietorship for a startup business.
- General Partnerships. A general partnership is very similar to a sole proprietorship, except that this type of entity involves more than one founder. The founders agree on a partnership and delineate the agreement among the founders. However, if the founders do not agree on a partnership agreement, state laws will supply rules in the absence of an agreement. However, much like a sole proprietorship, personal assets are exposed to creditors and founders are generally personally liable for business debts. Again, I do not recommend this type of formation for startups.
- C corporations. These are formed under state law, usually in the sate where the business will initially operate or in a state that is known for its well-developed corporate law, commonly Delaware. Most venture capital backed companies are C corporations.
- S corporations. These are formed under state law like C corporations but have favorable tax treatment for closely held (not more than 100 shareholders) corporations under federal and state tax laws. I recommend this formation for a small business so that they can take advantage of self-employment tax deductions.
- LLCs. These are formed under state law and are a hybrid form of corporation and limited partnership and have certain tax advantages over C corporations. I recommend this for small businesses who are just getting going and want to establish an easy and efficient formation. Filing fees are inexpensive and the process is relatively simple.
- Limited partnerships. These are formed under state law and are often formed to hold investment real estate and also are often the “investment vehicle of choice” for private equity firms and hedge funds. I highly recommend anyone with investment properties set up a limited partnership and place all of those properties under that name.
Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. It is advisable that all documents be drafted and filed by an attorney to ensure accuracy. A tax accountant should also be consulted. Please contact Keirnes Law Firm for any questions regarding business formation.