Reprinted with permission from the U.S. Small Business Administration.
When you build a home, you want it to have a solid structure and a quality roof that will keep you warm, cozy, and dry on a rainy day. Similarly, when you build a business, you want that business to have a strong legal structure to protect you and set you up for a thriving and successful future. In order to choose the correct legal entity for your business, you will need to know:
- What the various types of business entities are;
- Which key questions you should ask;
- Which professionals you need on your business team; and
- How to form the business.
Types of Business Entities:
There are four basic types of business entities: sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). Other types of business entities which are beyond the scope of this article include: limited partnerships, professional service corporations, professional limited liability companies, social purpose corporations, and nonprofit corporations.
A sole proprietorship is a common, simple type of business ownership. If you start a business by yourself, by default you become a sole proprietor. For federal income tax purposes, the income from the business flows through to the individual, and is reported on the business owner’s Schedule C. A sole proprietorship offers advantages in terms of how simple it is to create and maintain. However, a sole proprietorship offers no protection from individual liability.
A partnership is similar to a sole proprietorship. If you are in business with at least one person other than your spouse, by default you have formed a partnership.
A partnership tax return (Form 1065) is required, but each individual partner pays his or her share of the business taxes instead of the business itself paying the tax. A partnership offers few advantages. In order to set it up properly, a written partnership agreement prepared by an attorney is recommended. Although legal costs are incurred, just like a sole proprietorship, a partnership offers no protection from individual liability.
A corporation is formed by filing Articles of Incorporation with the Secretary of State’s office. One or more individuals can create a corporation. A key initial decision in forming a corporation is whether it should be a C corporation or an S corporation. A C corporation pays federal taxes when a profit is earned. Additionally, shareholders pay tax on the dividends received. A C corporation offers certain advantages, such as not having any limitation on the number of shareholders. Most new businesses seeking venture capital form as a C corporation. On the other hand, an S corporation is able to pass corporate income, losses, deductions, and credits through to its shareholders. However, certain qualifications must be met in order to register as an S corporation, including certain limitations on the types and numbers of shareholders and a requirement that only one class of stock may be used. S corporations can be a terrific structure for small, closely held domestic businesses that do not intend to seek venture capital or to make a public offering. Corporations, if properly formed and maintained, can protect the owners against individual liability.
A limited liability company, or LLC, is formed by filing a Certificate of Formation with the Secretary of State’s office. One or more individuals can create an LLC. LLCs tend to be a popular choice for many small businesses, due to the tremendous flexibility they offer in relation to how they are set up, managed, and taxed. For example, the owners can decide whether their LLC will be treated as a pass-through entity for tax purposes or whether it should be taxed as a corporation. Also, an LLC can be set up in a myriad of ways in order to best accomplish the goals of the business owners and to precisely define the potentially complex financial relationships and differing business roles of the owners. And again, an LLC that is properly formed and maintained can protect the owners against individual liability.
Key Questions You Should Ask:
In making your decision, some key questions you should ask include:
- What types of potential liabilities does my business face?
- Can I purchase adequate insurance coverage to address these liabilities?
- What are the tax implications, in real dollars, related to my choice of business entity?
- How do I intend to obtain financing for my business?
- Who are the business owners, and what is the nature of their relationships and roles in the business?
Professionals You Need on Your Business Team:
In analyzing the factors related to making the right choice as to business entity, you will need the help of your Business Team consisting of three key professionals: a business attorney, an accountant, and a commercial insurance broker. First, your business attorney will provide advice about the legal implications of your choice. Second, your accountant will assist you with tax concerns and other financial aspects of the decision-making process. Third, your commercial insurance broker will advise you regarding the potential risks faced by your business, and will help you explore the types of coverage available to you.
How to Form the Business:
Once you’ve made your selection, unless you chose to operate your business as a sole proprietorship, you need to work with both your accountant and your business attorney to form your business entity. Many business owners decide to do this work on their own, which is comparable to letting your fourteen-year-old nephew build your new home without supervision! A business attorney can guide you through all of the choices involved, and make sure the appropriate documentation is in place. In the case of a corporation, that work may involve issuing corporate stock; making sure corporate bylaws have been prepared and formally approved by either the incorporators or Board of Directors; creating a corporate Buy-Sell Agreement to govern the relationship between shareholders; and documenting the election of corporate officers per the statutory requirements. Or, in the case of an LLC, that work may involve properly crafting the LLC Operating Agreement to document how voting will be conducted; how new owners will be admitted; how current owners may exit and receive payment for their ownership interests; how ownership rights will be treated if an owner dies or becomes disabled; how to address business disputes, etc. Your accountant will make sure the business is properly registered with all taxing authorities, and will guide you through all aspects of the tax and financial requirements related to the business entity you selected.
With the right business structure in place, just like your perfect home, your business will be set up to support your goals and dreams—rain or shine!
This article is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with an attorney.
Office of the Secretary of State – www.sos.wa.gov/corps
Corporations Division, 360-725-0377; email@example.com
Register a corporation or limited partnership
King County Lawyer Referral Services – 206-623-2551
Tacoma/Pierce County – 253-383-3432
Washington State Bar Association – www.wsba.org
800-945-WSBA or 206-443-WSBA
Entrepreneurial Law Clinic (ELC) – UW School of Law https://www.law.uw.edu/academics/experiential-learning/clinics/entrepreneurial-law
2815 Eastlake Ave E. Suite 300, Seattle, WA 98102 206-336-5616; firstname.lastname@example.org
Legal assistance to low-income entrepreneurs in economically distressed communities, and pre-funded high-tech start ups by a team of law students and pro-bono attorneys. Income determines eligibility.
Idaho State Bar & Idaho Law Foundation, Inc
Business Impact Northwest – https://businessimpactnw.org
SCORE – https://seattle.score.org
Seattle District Office of the U.S. Small Business Administration https://www.sba.gov/offices/district/wa/seattle
Seattle Office of Economic Development
Washington Small Business Guidance
Limited Liability Companies (LLCs):