Which type of business entity should I be?
Many of my clients ask me whether there is a ‘correct’ business entity. Or if being one business entity is better than others. The answer that I give which is a famous legal response to client questions is, “It depends.” I don’t tell them this to be a smart ass, but because it’s definitely true. Choosing a business entity will depend on where you are at with you business (ie. starting out or a few years old), what kind of business you have, what kind of liabilities you may potentially face because of your business, and a myriad of other factors. Because of this, I like to not only talk to a client about the different business types, but learn about their projects, goals, and current business processes.
Sole Proprietor
Everyone from someone selling t-shirts to someone doing marketing consultant starts as a sole proprietor. A sole proprietor is essentially/formally not a business entity. It is a person who owns a business and is personally liable for the debts of the business. Meaning, if something for your business needs to be purchased, it comes out of your personal bank account. If someone is owed money, it comes out of your personal bank account. And, if someone sues your business, there is no corporate or business liability shield---they can go after your personal finances.
Can you start out as a sole proprietor and stay a sole proprietor for the duration of the time you own your business? Yes.
Is being a sole proprietor wrong or less than. No, absolutely not.
Meaning, if being a sole proprietor and not forming an entity is right for you, then so be it. Do not become something else just to do it.
Partnership
A partnership is similar to a sole proprietorship in the sense that there is no corporate or business liability shield. So personal liability may be a concern. In this business type, two or more people or organizations agree to formalize their relationship in order to manage and operate a business. Partners in a partnership share profits and losses.
Partnerships do not pay income tax as a company. Instead, profits and losses pass through to individual partners. Both a partnership tax return and individual returns are filed. A partner will report his or her share on their own personal taxes.
The assumption is always that partners share 50/50 in profits and losses unless otherwise agreed to in a partnership agreement.
You may have heard discussions on different kinds of partnerships. For example, a general partnership is one where both partners typically manage the business and both share liability. In a limited partnership, one partner is usually a financial investor (and sometimes planner). As a result of their contribution and their desire for limited liability, they are held to be a limited partner.
On a side note, a partnership can also be an LLC (LLCs are discussed in more detail in a bit). I tell you this because I frequently get asked about this.
Limited Liability Company (LLC)
An LLC in the State of Oregon can consist of just one person. This is often why small business owners who want to make the transition from sole proprietor to another business structure often choose it. It is also a business structure that gives you personally the limited liability of a corporation while having pass through taxation like a sole proprietorship or partnership.
LLC ownership is often discussed as interests or membership interests as opposed to shares or shares of stock like a corporation.
There are of course positives and negatives of everything. And, there is not enough time or space to write everything. That said, some positives of LLCs are: They do not require as much paperwork as a corporation. There is no citizen restriction of members (in corporations all must be U.S. Citizens; there is no limit to the number of members of an LLC).
Some possible disadvantages or negatives of LLCs are: Some investors may want to only invest in a corporation as it would have stock options, an initial public offering that could raise the value of their investment, etc. The management of an LLC may appear (or be) disjointed if a clear operating agreement is not written and followed. Because there is not a board with distinct roles like in a corporation, all involved have to make sure to assess project completion and accountability.
Corporation
A corporation is a business that has separate legal existence from its owners. Owners are shareholders who share in profits and losses. Similar to an LLC, corporations are filed at the state level.
Simply put, corporations have a board of directors, officers, and members. In theory, members own and control the corporation. Another way to look at it is that a person who owns a 25% share of the corporation, owns 25% of the corporation itself.
Some take-aways are that for corporations, owners must be United States Citizens. For LLCs, citizenship is not a requirement. LLCs have less formalities, less reporting, and more simplicity overall (in comparison to corporations). Corporations are more likely to garner investors because of not just limited liability but because they would have ownership over the company as shareholders and possibly have a chance of larger profit gains in up turn markets or business successes. Again, not an exhaustive list of examples.
Nonprofit
Nonprofits are a type of corporation. Unlike an LLC, which, in Oregon, can exist of one member, a nonprofit must have a board. Nonprofits call their operating agreement is essentially insteaad the nonprofit’s bylaws.
Nonprofits are formed at the state level and are an organization dedicated to a particular community or social cause. In a for profit corporation, profits usually go to raises, bonuses, or stockholders (if there is stock). In a nonprofit, after overhead, expenses, and staff all get paid, any left over profits go to the nonprofit’s mission. In Oregon, a nonprofit is formed with the Secretary of State. Then once approved, a nonprofit can if desired file for a federal tax exemption (501)(c3) with the IRS (Internal Revenue Service of the United States).
Professionals Can Help You
While business attorneys like myself do entity formation, contract review and drafting, and a variety of other services, we don’t all do tax law or know a great deal about tax structures. I would recommend that if you have questions on how being one entity or another relates to your taxes talking to either a tax attorney, certified public accountant, or bookkeeper. Or all three as the need arises.
If you would like to talk more about business entity formation and about business law in general, we offer free 30 minute consults for all new clients. Feel free to reach out and schedule an appointment.