Starting a Business - Choosing a Legal Entity [2010-04-22]

BUSINESS FORMATION

When starting a small business, you will be faced with many important decisions. The first of these crucial decisions is choosing a legal form of business to best fit the needs of your endeavor. Liability issues and tax concerns should be two of the primary considerations. There are four basic forms that a business can take:

1. Sole proprietorship

2. Partnership

3. Corporation

4. Limited Liability Company

Each entity has specific advantages and disadvantages.

1. Sole proprietorship: A sole proprietorship is a business owned by one individual and is not a separate entity from its owner. This lack of separation between owner and business means that the owner is directly and personally responsible for any debts, liabilities, obligations, or other payments required by the business. It also means that the sole proprietor is directly entitled to full and complete ownership of any funds, or items owned by the business. One additional advantage to being a sole proprietor is that there are no formal organizational or filing requirements except obtaining the necessary local, state, and national licenses, if applicable, for the services to be performed.

2. Partnership: A partnership is a joint effort of two or more persons to act as co-owners of a business for profit. Generally, a simple partnership operates much like a sole proprietorship with all partners being personally responsible for any liabilities or debts of the business. Typically, the partners are considered "jointly" and "severally" liable meaning that any of them could be held responsible for the full amount of debt, or a creditor could seek recovery in equal shares from each partner. General partnerships generally require no filing of organizational documents with the State Corporation Commission, but often will require the filing of a fictitious name certificate. A fictitious name certificate is a document filed, typically with the local Circuit Court, identifying the name that the partnership will be using to carry on the business. Frequently, a general partnership will have some sort of operating agreement so that each of the partners knows their responsibilities, duties, and entitlements in the joint venture.

Some businesses work under a limited partnership arrangement, where one or more of the partners is simply an investor and will not be running the business in the investor partner's responsibility and liability to the third parties is in some form limited. In these limited partnerships, the partner who is actually operating the business typically takes on general liability. In partnership, like a sole proprietorship, in the absence of a written agreement to the contrary, each of the partners is individually responsible for all expenses, debts, and liabilities, but also individually entitled to the ownership of monies and assets, of the business. Limited liability partnerships do exist, and operate very similarly to limited liability companies as described below. Limited liability partnerships do require formal filing of written documents with the State Corporation Commission.

3. Corporations: Corporations are separate legal entities from their owners, employees, and executives. This generally means that the individuals who are investors, employees, and officers of the business have certain protections from direct liability relating to actions taken by the corporation. Ownership in a corporation is defined by stock ownership, and the amount of stock owned by the individual investors. Stockholders typically are not involved in the day to day operations of the business. A corporation is, instead, managed by a Board of Directors. This Board of Directors is charged with running the business and can transfer some or the majority of their authority to certain employees, typically referred to as officers of the corporation. Stockholders typically elect the Board of Directors, who then make decisions about running the business or designate this authority to specific executives (employees). Corporations can either be set up for purposes of earning a profit (similar to Exxon Mobile Corporation) or not for profit (Such as charitable foundations, i.e. the Bill and Melinda Gates Foundation). For purposes of Virginia law, the Virginia State Corporation Commission requires a designation of whether or not the corporation is going to be for profit or a non-profit corporation. Additionally, for profit corporations can elect different forms of tax treatment, commonly referred to as a C-corporation or an S-corporation. These tax designations affect the means by which a corporation is taxed. An S-corporation's profits are passed through to the individual stock holders who then pay taxes on their individual tax returns, as if this profit was direct income to the stock holder. In a C-corporation, the businesses profits are taxed twice, one set of taxes being paid by the corporation, and again by the stockholders, to the extent that they receive any form of dividend issued by the corporaton.

Corporations have certain responsibilities to file documentation with the State Corporation Commission, both at the time of business formation and on an annual basis. A corporation must have bylaws and maintain corporate minutes, and have an annual meeting. These activities are required to ensure that the corporation maintains limited liability for its owners, employees, and executives. The corporation must also maintain a registered agent to receive legal notices from Courts, governments and other quasi-governmental entities. The corporation must also obtain an employer identification number (EIN) which is similar to assigning a social security number to the business. Each of these activities obviously takes time, effort, and requires maintenance of certain records. However, as a benefit, the corporation helps to protect its employees and owners from any responsibility that the corporation has individually (such as debts, judgments, or corporate taxes).

4. Limited Liability Companies: A limited liability company (LLC) is similar to a corporation in its ability to protect its owners and operators from liability for activities of the LLC, and has a reduced annual record keeping of requirements. An LLC must prepare an Articles of Organization and pay an annual fee to the State Corporation Commission. An LLC also must have a registered agent, as the corporation requires, and typically will be required to obtain an employer identification number. An LLC can also be taxed in a similar form to a corporation, either paying corporate taxation, or past through taxation as indicated above. There are certain limitations and different deductions that are taken by an LLC that occasionally provides a tax benefit to form a corporation. LLC's are more common with smaller businesses and are also used for more passive investments, such as ownership of rental real estate or common stock investment groups.

5. Final considerations: It is important to remember as a small business that when you form a Corporation or LLC, the owner is no longer acting solely for his own benefit, but must also keep in mind the independent needs of the business and act in a manner that is consistent with the independent best interests of the business entity. Owners, operators, and employees of the business when signing legal documents or transacting business on behalf of a corporation or LLC (or Limited liability partnership) should ensure that they endorse the documents clearly indicating their position within the business, to clearly indicate to the creditor or other individual with whom the contract is made, that the individual signing is acting on behalf of the business, and are not individually responsible.

The selection of a specific form for your business, at the time of business formation is an important decision, from day one, and affects how your business will be run, taxed, and how assets and profits will be distributed. It is important that you speak to experienced professionals to ensure you are making the correct selection. Meeting with both an attorney, and an accountant to identify your needs and goals will help to ensure that you select the means that your business formation should take.

***DISCLAIMER: THIS ARTICLE IS PROVIDED AS GENERAL INFORMATION ONLY AND SHOULD NOT BE RELIED UPON IN PLACE OF RECEIVING ADVICE DIRECTLY FROM AN ATTORNEY LICENSED TO PRACTICE LAW IN THE STATE HAVING JURISDICTION OVER YOUR BUSINESS. THE INFORMATION PROVIDED IS INTENDED SOLELY TO ENCOURAGE INDIVIDUALS TO SEEK THE ADVICE OF AN ATTORNEY, AND DOES NOT, IN AND OF IT SELF, CONSTITUTE ADVICE TO THE READER, OR FORM AN ATTORNEY/CLIENT RELATIONSHIP. ***