What type of entity should I form for my business? This question feels like the first one you should answer when you decide to start your own business. But answering this question requires you to have developed several aspects of your business plan.
Where you want to go will help you decide where you should start.
The most common business structures are sole proprietorship, partnership, limited liability company, and corporation.
What distinguishes one from another?
Sole Proprietorship
A sole proprietorship is you. You do not form any entity and manage and run your business without any additional administrative burden imposed by an entity structure. Simply doing the activity of your business will automatically make your business a sole proprietorship. You will be liable for any debts of the business or any damages your business may cause to other parties.
If your business is not likely to subject you to liability, a sole proprietorship may be appropriate for your business. Selling artwork you produce in your home on ETSY is an example of a business that may not require liability protection – assuming your artwork does not involve small pieces a child may choke on.
If your business involves products or services that may subject you to liability for the failure of a product or service or even because customers may visit your physical location, you will benefit from a business form that provides a shield to protect you, the owner, from liabilities that your business may incur.
Given the relative simplicity of forming an entity for your business, and the surprising ways liabilities can arise, we generally advise people starting a business to form an entity to house the business.
Partnership
A partnership is an agreement by two or more parties to operate a business. Partnerships are flexible and the partners may agree how to allocate profits and losses among them. The partnership itself does not pay taxes. A partnership has “pass-through” taxation. Profits (or losses) of the partnership are reported on each partner’s tax return.
Partnerships may be structured as general partnerships, limited partnerships, or limited liability limited partnerships. In a general partnership, each partner has liability for the liabilities of the business, as with a sole proprietorship. Limited partnerships have a general partner with unlimited liability for partnership obligations, but limited partners who are shielded from those liabilities by the partnership form. Limited liability limited partnerships permit all partners to enjoy limited liability. Given the relative simplicity of limited liability companies (described below), general partnerships are less common than other entity structures, and limited partnerships and limited liability partnerships are used in specific contexts usually driven by tax considerations or industry custom.
Limited Liability Company
A limited liability company (LLC) is a hybrid of a corporate and partnership business structure. An LLC is formed by filing Articles of Organization with the state (in Arizona, with the Arizona Corporation Commission). LLC’s have pass-through taxation, like a partnership, and owners of the LLC (members) report the profits or losses of the LLC on their individual tax returns. Members of an LLC enjoy limited liability and are not personally liable for the obligations of the LLC absent evidence that the LLC is not truly an entity separate from its owners (how that is determined is another blog post).
LLCs are a good choice for administrative simplicity, personal asset protection and when losses are anticipated in the early years and members can realize a tax benefit from those losses.
Corporation
A corporation is a legal entity separate from its owners (shareholders). Shareholders are not liable for the obligations of the corporation, subject to the same potential defeat of this limited liability protection by evidence that the shareholders are not managing the corporation as a separate entity as described above.
A corporation files a tax return and pays tax on its profits. The corporation’s shareholders are also taxed on any money distributed to them from the corporation, such as a dividend. This tax structure is commonly called “double taxation.” The corporation is taxed on profits, and then if the corporation distributes those profits to shareholders, the shareholders are taxed on those dividends. Shareholders of a corporation may elect to have the corporation taxed as an S-corporation and enjoy similar pass-through tax treatment as a limited liability company, if certain requirements (including only individual shareholders) are met.
A corporation can be a good choice for businesses that intend to raise capital from outside investors (these investors often prefer the corporate form) and the corporate form may provide investors with additional tax benefits if the corporation meets certain requirements. A corporation is also a good choice for a business that intends to compensate employees with equity in the business.
This brief summary provides a high – level overview of the types of business forms available to any business. Every business is unique, and a careful consideration of the advantages and disadvantages of each business form in light of the risks attendant to the business is a critical step in your business planning.
Shelley is a go-to attorney for corporations of all types and sizes, entrepreneurs to large private and public companies, from formation through exit. She provides informed guidance on a variety of business matters including commercial contracts, loan agreements, licensing agreements, supply and distribution agreements, and the acquisition and sale of assets and securities.