So you have (or want to start) a business! Awesome! As you embark on your entrepreneurial journey, one of the first questions you may have is what kind of business organization (if any) you want or need. Do you want to incorporate your business and operate as a low-hassle sole proprietorship, or is a corporation the better option? How about a limited liability company, or even a partnership?
Looking to Incorporate Your Business? Pros and Cons of Each Type
This post is written by a fellow blogger, Miguel S., the Florida lawyer behind The Rich Miser blog, where he and his wife Lily share practical tips, life hacks, and reviews to help you get the most from your money.
Don’t despair about how to incorporate your business. In this article, I’ll give you a comprehensive overview of the different ways to organize your business. At the end of this post, you’ll know all about the different business organizations, when each one is useful, and which option is best for you!
What Is A Business Entity?
This is kind of a weird idea. A business entity is something that laws allow you to create to do business. Allow me to explain with an example.
If you go buy some pants from Target but then return them, who did you do business with? You paid Target, and Target gave you your money back, right? It wasn’t the employees you dealt with, in the sense that you didn’t pay them personally, and they didn’t refund you with their own money.
By the same token, if you incorporate your business, your clients and customers aren’t doing business with you, personally (even if it’s you who’s providing a service). Technically, they’re dealing with the corporation, which is an intangible entity that the state allows to do business.
Why Even Bother?
For small businesses, there are at least three big reasons: liability, getting investments, and taxes. Let’s get into them.
Suppose you have a pest control business. Someone needs a lawn spray, and you send out one of your drivers. However, he has a newborn baby and didn’t get much sleep the night before; he falls asleep at the wheel and causes a car accident.
In many states, not only can the victim sue your driver, but also you, the business owner. And that’s why it can be wise to incorporate your business – because it can shield you, personally, from liability. In other words, the corporation is the one who can get sued, and may have to pay any damages from corporate assets or insurance.
It works the same way for debts. If the corporation takes out a business loan, only the corporation has to repay it. It’s not your personal debt, unless you personally guaranteed it.
A big caveat, though: incorporating your business normally won’t shield you from liability for the damages you personally cause. For example, if you’re a doctor, it’s unlikely to protect you from medical malpractice liability, though it would protect you if someone slips and falls in your office because an employee spilled water on the floor.
Put another way, both the person who causes damages and his/her employer are liable. That’s why a corporation can help, since the employer liability doesn’t go past the corporation to reach its owner(s).
When you get to the point where it’s time to grow and you need money, you might want to take on outside investments. Oftentimes, however, your potential investors may want a share of the business or a decision-making role in its operations. A business entity makes this easier.
For instance, a corporation can issue shares of stock, which you can sell to investors that then become part owners. Depending on the specifics, this may also allow them influence in decision-making by giving them votes in choosing the people who run the business.
This is a biggie. Here’s what incorporating your business can do for your tax situation.
The Corporation as a Taxpayer (C-Corporation)
There are two big tax situations for corporations. The first is when the corporation acts as a person, for tax purposes (also called a C-corporation). It has to file its own tax returns and deal with the IRS and state tax collectors. If you choose to become its employee, it’ll pay you a salary, and may issue dividends to its shareholders.
This is where the so-called “double taxation” problem comes up. Say that you’ve set up a corporation where you’re both an employee and the sole shareholder. Also say that the corporation operates for a year, and, after paying you your salary and other expenses, generates a pretax “profit” of $10,000. Awesome, right?
Yes and no.
From a taxation point of view, that money will probably be taxable by the state and federal governments, at a combined corporate tax rate of around 25% (according to the Tax Foundation). So, the corporation would have about $7,500 left, after taxes. If it uses that after-tax profit to pay a dividend, the person who received that dividend (you) will have to pay taxes on it, at a rate which generally would range from 0-20%, depending on your income tax bracket.
So, by the time you get that money, it could have been taxed down to around $6,000, with Uncle Sam and your state getting $4,000 (40%).
That’s above the current highest tax bracket for individuals, which now stands at 37%. However, dividends would likely not be subject to payroll taxes, so that might be a benefit (as well as an issue if it reduces your future Social Security payouts).
Overall, the salary vs. dividends topic is complex and depends on many factors. I would recommend that you discuss it with a tax attorney or CPA to find the best course for your particular situation.
The Pass-Through Entity (S-Corporation)
On the other hand, there is what is called a pass-through entity (or S-corporation or disregarded entity). What it does is avoid most taxation at the corporate level, such that the income and expenses “pass-through” and are treated as your own, personally. In other words, the corporation is ignored, for tax purposes.
This could result in lower taxes, and avoid some of the hassle of filing corporate tax returns. (It does have to file an informational return, and may have to file other forms with the IRS and state).
Although this avoids the double taxation problem, a downside is that the corporation may not be able to issue dividends. Instead, it could issue distributions, but the shareholders are taxed on profits whether there is a distribution or not. That is to say, if the corporation chooses to keep the profits rather than distributing them, the shareholders may still have to pay taxes as if they had received a distribution, since the corporation is ignored for tax purposes.
The lack of dividends may be a problem in some situations, such as if there are shareholders who don’t want to be getting tax bills without having received a distribution. So, again, it’s important to talk to a tax professional before choosing an S or C corporation (especially since you may be forced to make a selection soon after creating the corporation, and it may be impossible to undo that choice).
Specific Ways to Organize a Business
Sole Proprietorships or DBAs
You can incorporate your business as a sole proprietor or DBA (doing business as), but these really aren’t corporations at all. It’s just you, doing business as you. You can usually have a business bank account and credit card, and even a name, like “Jack’s Home Painting” (called a “fictitious name” or DBA). Your state may allow you to register the fictitious name or even require it. And it may provide a measure of protection against someone else using it.
- Simplicity. Sometimes, all you need to do to get started is to register a DBA on a state website, and sometimes not even that.
- Low cost. You don’t have to deal with corporate accounting and records, or hire someone to do so.
- Low hassle. Entities require paperwork and are a bit of a pain. For example, corporations usually have to file a short annual report with the state, and may have to file some financial statements (especially a bigger business).
- Liability. Any liabilities (debts, lawsuits, etc.) are on you, personally. You can usually get insurance to help with this, but you can still get personally sued, as may be your spouse (especially if you are in a community property state).
- Probably impossible to get equity financing/investing. You can likely still get commercial loans, though.
- It may be harder to get taken seriously, in some situations. For example, if you have a retail store, a mall landlord might prefer (or demand) to deal with an incorporated entity.
This is the classic. A traditional corporation, the “ACME, Inc.” we all know. It has a basic structure, with three important groups of people.
The first is the shareholders, which are the owners of the corporation. The same as if you buy shares of Microsoft – whoever owns shares, owns a piece of the corporation.
Second, we have the board of directors, which is elected by the shareholders. Directors set out the general direction of a corporation and make big decisions.
Third, there are the officers, who run the day-to-day affairs of the corporation. The directors choose the officers.
Now this is just to give you an overview of corporate governance. If you’re a small business, you may be a one-person corporation (if your state allows it), where you are the sole shareholder, director, and officer. You can wear all three hats at the same time. The bigger your business gets, the more complex it gets, until you reach the level of Apple or GE, with millions of shareholders, multiple directors, and many executives.
- For bigger businesses, allows for sophisticated corporate governance, with all sorts of options (like different classes of stock and whatnot).
- Time-tested, with many years of well-developed laws and court decisions to provide certainty and predictability in the event of ownership and governance disputes.
- Probably a better structure if you’re looking to sell shares to investors.
- Easier to have perpetual existence (with other structures, for example, it may be messier to deal with the death of an owner).
- Relatively complex to operate, when compared to other forms of organization.
- Less operational flexibility, since, for instance, you may need to put people in defined roles, like director or officer.
- May be “overkill” for some small businesses.
- Must file documents with the state to create, as well as other paperwork every year.
A partnership is not a corporation at all; it’s actually what the word suggests: the operation of a business by two or more people. However, depending on the state, it can be an entity separate from the partners, but normally does not offer the liability protection of a corporation (though it can own property). Even worse, some partnerships can actually create what is called joint and several liability between the partners. That means that if your partner takes out a business loan for $10,000, the creditor can collect the entire loan from either you or him.
Partnerships can be very easy to form – to the point that, in some states, even your behavior can create one. So, if you’re conducting business with someone else, you may fall into a partnership and not even know it.
- Confidentiality – some partnerships don’t require filing public documents with the state.
- Simplicity and ease, in the sense that some states may not require annual reports or other corporate formalities.
- You can usually form it just by signing a contract with another partner.
- Pass-through taxation, if that’s what you’re looking for.
- More freedom and less formality in terms of management and corporate governance.
- It may be easier to move money into and out of the business (no dealing with shares and dividends and whatnot).
- Personal liability of the partners.
- Inability to issue shares of stock.
- Limited (or no) corporate personhood (depending on the state).
- Possible joint and several liability of partners.
Some states have created variations on partnerships, such as limited partnerships (LPs) and limited liability partnerships (LLPs). In such cases, for example, one partner may not be personally liable for the actions of another partner (no joint and several liability), or there may even be corporation-level liability protection. But this can vary a lot by state, so it’s important to check with an attorney in your state if you’re interested in setting one of these up.
In any case, my personal observation is that you tend to see a lot of partnerships in professional-services businesses, such as law practices. Less often have I seen a partnership for a business like a restaurant or retail store. There, limited liability companies and corporations seem to predominate.
Limited Liability Companies (LLCs)
This is a relatively new form of business organization, and is technically not a corporation at all. It does not issue shares of stock, but rather is owned by what are called its members (who can – and probably should- have an operating agreement to set out how they’re going to run the company).
The great thing about LLCs is that they offer the liability protection of corporations, without a lot of the corporate-governance complexity. They kind of resemble a partnership in that sense (in how they’re run), but are formed by registering them with the state and have more liability protection than most partnerships offer.
- Probably best for smaller businesses which are not looking to sell shares of stock to investors.
- Corporation-grade liability protection.
- Simpler to operate than corporations.
- By default, usually treated as a pass-through entity for taxation, though there is an option to elect taxation like a C-corporation.
- Inability to issue shares of stock.
- Does not provide the sophisticated corporate governance structure of a corporation.
- May make it harder to seek outside equity investment, as compared with a corporation.
- Requires more paperwork and filings than a partnership or sole proprietorship.
Normally, LLCs distribute profits to members via distributions. If they’re pass-through entities, the tax treatment would be like an S-corporation (with taxes assessed on profits, regardless of whether they’re actually distributed). If they choose not to be “pass-throughs”, then they pay corporate taxes like a C-corporation, but members would not personally pay taxes on distributions until the distributions actually take place.
How to Set Up A Business Entity or Get A Fictitious Name
Honestly, my suggestion is that you hire a lawyer to incorporate your business, even if it’s through an online service like LegalZoom. But I’ll tell you a secret: nowadays it’s usually a matter of filing a few forms online with the state and shouldn’t take more than a few hours, so you shouldn’t be charged a lot of money for a basic incorporation.
However, it’s important to do it right, and so I think it’s worth paying a lawyer. (For partnerships, there’s usually no need to file documents with the state, but you should still get a lawyer to draw up partnership papers).
Oh, and by the way, these documents are usually public, though there are ways to obscure ownership. In other words, the existence of the entity will be a matter of public record (except for some partnerships). Who is behind the entity may not be, depending on the state and on the specifics.
Don’t Get Pierced!
I don’t mean you. I mean what they call the “corporate veil”.
There’s a legal doctrine called “piercing the corporate veil” which allows a court to find that an entity is, basically, a sham meant to shield its owner(s) from personal liability. If put into effect, the court will ignore the entity and make the owners liable.
It’s incredibly hard to get a judge to pierce the corporate veil. However, it does happen, especially when the owner simply creates the entity but then acts as if it doesn’t exist. For example, if you register a corporation but then never open a corporate bank account, or use the corporation’s name, or file corporate tax returns, you are giving the judge facts that he/she can use to find that the entity was just a sham. So, liability protection is not as simple as creating an LLC and then forgetting about it. You actually have to “use” it.
So What Kind of Business Entity Do I Need?
As I see it, if you’re running a really low-risk business, you may not need to incorporate your business at all, especially if you’ve got insurance. For example, if you’re a romance novelist or food critic, you might not need to bother. However, if you run a restaurant or medical practice, you probably do need an entity.
Although you should consult with a lawyer for your particular situation, in general:
Factors in Favor of a Sole Proprietorship or Partnership
- Single-person or very small business (few or no employees).
- Low-risk activity.
- Low-capital line of business (little or no equipment or machinery).
- Little or no need for outside investment.
Factors in Favor of a Corporation or LLC
- Bigger business with multiple employees.
- Higher-risk activity, including anything open to the public.
- Need for equipment or machinery.
- Need for outside investment.
The more your business “scores” on these last factors, the more I’d move towards a corporation, as opposed to an LLC. Although, if you’ve got a professional services business, an LP or LLP may be the better choice. There are also other specific kinds of entities and ways of doing business that some states have and some don’t, such as PLLC (professional limited liability company), PC (professional corporation), or PA (professional association).
That’s why I really recommend seeking legal advice for your specific situation, especially since laws vary by state, and not every entity exists in every state. Also, laws change, and what is “good law” today may be repealed tomorrow. So, it’s a good idea to spend a little bit up front to start off right, rather than having to spend more later to fix a problem.
Summing It Up
There you have it! These are the basic forms of business organization. Like I said, there are other, more exotic entities, like PLLCs and PCs and whatnot, but this article should give you a good idea of what the big ones are. And remember that these are general legal principles, and the law in your state could be different. So, I highly recommend checking with a business lawyer in your area before taking any action.
So what about you? How will you incorporate your business?
Even though I am a lawyer, this is not legal advice. It’s a discussion of general legal concepts. Laws on business entities and taxes are complex, can vary from state to state, and change. Therefore, if you need legal advice, I strongly suggest that you consult a lawyer who practices law in your city or state. (And for a basic business setup, it shouldn’t be that expensive).
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.