Laying Down the Law: Choosing an Entity Type

This post is the first installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs.  

When starting a business, one of the first major decisions you will make involves selecting an entity type for your business.  While you may think there are other, more important things to worry about, not setting up your business correctly from the beginning can have dire consequences.  On the other hand, figuring out which entity type offers your company the best advantages can be a great way to start out on the right foot.  So what factors should you consider when deciding between different entities?  There are many, but we will focus on three of the most important factors to consider: limitation of personal liability, management structure, and tax considerations.

Limited Liability

Generally, when you start a business and do not make a specific decision as to what entity type your business will be, if the business has only one owner it will be classified as a Sole Proprietorship.  If there are two or more owners, the business will be classified as a General Partnership.

For the most part, operating your business as a Sole Proprietorship or a General Partnership is not advisable.  One of the most critical reasons to avoid these entity types is the fact that they do not offer limited liability protection for the owners.  Limited liability is a feature of other entity types (including LLCs, Corporations, and certain partnerships), that protects the owners from personal liability for the debts and liabilities of the company.

For example, imagine your company is sued and a court determines the company owes money to another party.  If the company is set up as one of the entity types that includes limited liability protection, the other party can only go after the assets of the company, not your personal home, automobiles, retirement accounts, etc.  However, maintaining limited liability protection also requires you to operate your business in a way that maintains separation between yourself as an individual and your business.  This means you must do things such as:

• Have a separate business bank account
• Only pay for business expenses through your business, no personal expenses
• Include “LLC” in your LLC’s name
• Include “Inc.,” “Co.,” “Ltd.” Etc. in your corporation’s name
• Follow corporate/LLC formalities
• Start and maintain the company with adequate capital
• Maintain accurate financial records
• This list is not comprehensive, but should give you a general sense of how you must operate your business to maintain limited liability protection.

Management Structure

Another factor to consider is how you want your company to be managed.  One attractive quality of Sole Proprietorships, most General Partnerships and LLCs is that the owners of the company are also able to manage the company.

Although Corporations offer you limited liability protection, the management of a corporation is vested in a Board of Directors, while the owners of the company, the shareholders, do not take part in any of the day-to-day management (assuming the shareholders are not also members of the Board of Directors).

This can sometimes create what is called an “agency problem” where the personal interests of the owners and the personal interests of the managers differ.  You can read more about the concept of the “agency problem” here.

Tax Considerations

Finally – the exciting information you’ve been holding your breath for – tax considerations.

All jokes aside, tax considerations will play a huge role in determining what entity structure you choose.  Sole Proprietorships, General Partnerships, and most LLCs are taxed as “flow-through” entities, meaning that the company itself does not pay tax on its income, and instead that income will flow-through to the owners, and the owners will pay taxes individually on their share of the company’s income.

On the other hand, Corporations are considered a separate entity for tax purposes, and all of the income of the Corporation is taxed at the corporate tax rate.  Then, when the Corporation distributes its profits to the owners, the owners must also pay tax on the amount of income they received from the Corporation.  This creates what is known as a “double-tax,” meaning the same income is taxed twice instead of just once, and is one of the biggest detriments to choosing to run your business as a Corporation.

While this is not meant to be a comprehensive overview of everything that can go in to your choice of entity type, it should provide a good overview of some of the most important factors to consider.  You can check out a great chart here that summarizes a lot of this information and compares different entity types in an easily digestible format.

Keep in mind that there are many other considerations when choosing an entity type as well as more complex, multi-tiered entity structures that may provide great value to your company.  It can be very beneficial to consult a business attorney if your company is in a position where doing so makes sense financially.

Check back in January for our next blog post, which will focus on outside investment and when it may be right for your business.