The first step in establishing a business is to identify the type of entity best suited to your proposed new business. The four most common types of entity are (a) limited liability companies; (b) corporations; (c) partnerships; and (d) sole proprietorships.
Insulation from Personal Liability
Corporations and limited liability companies insulate owners from personal liability, whether for business failure or negligence, beyond the extent of an owner’s investment. If a corporation or limited liability company fails, creditors must seek recovery from the entity, and not from its shareholders, in the case of a corporation, or its members, in the case of a limited liability company. With a partnership or sole proprietorship, the partners or sole proprietor are personally liable for the debts of the entity. Note, however, that many, if not most lenders to small businesses, whether those businesses are organized as corporations or LLCs, will demand a personal guarantee of the shareholders or members. If a corporation or LLC is sued, the shareholders of a corporation or members of an LLC will not be personally liable for a judgment against the entity.
Tax Advantages and Disadvantages
Tax considerations are a big determinant in choosing the right type of entity; each type of entity has advantages and disadvantages.
All of the income of a sole proprietorship is taxed at the personal rate of the proprietor, and all business expenses and losses are deductible from the proprietor’s gross income. Sole proprietors pay a self-employment tax equal to the employer’s and the employee’s shares of federal employment taxes (Social Security and Medicare).
Corporations are subject to double taxation; net income is taxed at the corporate level, and any dividends to shareholders are taxed at the shareholder’s individual tax rate. A business owner who is employed by his or her corporation pays only the employee’s share of employment taxes. With the anticipated reduction in corporate tax rates, the corporate form of organization may become attractive to more small businesses. Note that corporations may elect to be taxed as partnerships by electing S-corp status when filing a federal income tax return.
Partnerships and LLCs are taxed as “pass through” entities; all income is passed through and taxed at the partner’s or member’s individual tax rate, and there is no double taxation. Note, however, that partners and members must recognize and pay taxes at their individual tax rates on undistributed partnership or LLC net income.
Additional Considerations
Selecting the proper entity for a new business is only one of the many decisions faced by start-ups. If the business will need workers, business owners must take care that workers are properly classified as employees or independent contractors. Misclassification of workers as independent contractors can result in fines and penalties, including a requirement that the business owner pay both the employer’s and the employee’s share of employment taxes for the period during which an employee was improperly classified as an independent contractor.
New businesses enter into all kinds of new relationships; with vendors, clients, lenders and landlords. Most of these relationships will be governed by contracts. Contracts can be a boon or a bane. Properly drafted, a contract can ensure that the rights and responsibilities of the parties are clearly stated; that they are enforceable; and that, in the event of a breach, an appropriate and proportionate remedy exists for the non-breaching party.
Leases, software licenses, employment and separation agreements, non-compete, non-disclosure and non-solicitation agreements; loan agreements and insurance contracts figure in the operations of many, if not most businesses.
An experienced attorney can assist a start-up in selecting the appropriate type entity, explain the advantages and disadvantages of different forms of organization, provide guidance on state, federal and local regulations and review, draft and interpret a broad range of contractual agreements. Expert advice and counsel saves time and money, and can provide a foundation for business success.