Starting a business can be an exciting, albeit stressful, time in one’s life. From choosing a business name to hiring your first employees, the sheer number of decisions that must be made before hanging the OPEN sign is enough to make anyone’s head spin.
While it might not seem so in the beginning, the most important choice an entrepreneur can make is deciding which legal entity the business will take. That decision can have lasting effects on all aspects of the business operations.
Because of the high number of startups in Silicon Valley, let’s compare the California business entity types. California offers a variety of different company types, each with their own pros and cons. The following is a brief breakdown of each type.
A sole proprietorship is the simplest form of business operation a company can take. As a sole proprietor, there exists no separation from the owner and the business. Because of this lack of separation, an owner enjoys all of the company’s profits but is also responsible for its losses and liabilities. This means that the owner’s separate assets, i.e., those earned outside of the operation of the business, can be used by creditors to pay business debts. The business is not taxed separately from the individual and any profits from the business operations are reported on the individual’s tax returns.
Simply conducting business as an individual forms a sole proprietorship and no further steps need to be taken in furtherance of its creation. However, if the business is operating under something other than the individual’s name, the business owner must register the name as a fictitious name with the county where the individual conducts business. The individual might also be responsible for obtaining any and all necessary licenses and permits.
A partnership exists when two or more parties engage in the operation of a business. Generally, the parties enter into a Partnership Agreement that governs the general operations of the business and defines the role that each individual partner will play.
Unlike a corporation or limited liability company, partnerships do not have to be registered with the secretary of state. In addition, all partners are responsible for the profits, losses and liabilities of the business. In addition, each partner is responsible for the actions the other takes on behalf of the company. Like sole proprietorships, each individual partner must include any profits or losses on their individual tax return.
By incorporating, a business owner creates a separate and distinct legal entity from the individual. One of the main benefits for a small business owner in incorporating is that it will generally limit the personal liability for actions taken by the company, thereby shielding the owner’s personal assets from judgment against the company.
Other benefits include increased creditability with vendors, suppliers and customers as well as the businesses capability to exist in the event the owner leaves the business.
A major disadvantage of this type of entity is the cost associated with incorporation and the corporate formalities that must be adhered to in order to maintain the corporate structure. In addition, depending on the type of corporate structure chosen by an entrepreneur (i.e., S corporation or C corporation) certain negative tax implications can occur, including in some cases a “double taxation” scenario whereby profits are taxed at both the corporate and personal level. Business owners should contact legal counsel or a tax expert to determine if incorporation is right for them.
Limited Liability Company
A limited liability company (LLC) is a hybrid entity that takes aspects from both a corporation and partnership form. In particular, an LLC’s members maintain personal protection from liability for LLC actions while allowing for the flexibility in operation that comes from a partnership. Anyone wishing to form an LLC must file the Articles of Organization with the secretary of state. In addition to filing these documents, an operating agreement among the members will serve to govern the business operation and general affairs of the LLC.
Another benefit of an LLC is that its members can choose how the entity is taxed. For tax purposes, an LLC with more than one member will be classified as a partnership, and an LLC with a single individual member will be treated as a sole proprietorship unless the LLC chooses to be classified as a corporation for income tax purposes. As with a corporation, a business owner should consult with an attorney or tax professional before choosing an LLC for the company.
Given the different positive and negative aspects of each type of business entity, a business owner should weigh all options before determining which form is right. This important decision may define a business owner’s rights and obligations in many aspects of the business including personal liability and tax implications. Making an informed choice will allow a new business to thrive and meet the goals and expectations of its owner.
Lisa Allen is an associate attorney at the Lotus Law Center, where she specializes in helping small business clients with their legal needs. The Lotus Law Center was founded as a way to make legal services affordable for all sizes of businesses. Focusing on the practice of business and technology law, the Lotus Law Center provides premium personal and professional responses to the legal needs of business clients at an affordable fixed or hourly rate. Contact her at Lisa@lotuslawcenter.com.