What Kind of Legal Entity Should I Form?
It’s one of the first—and biggest—decisions you’ll make.
A business entity is an organization that has a separate legal identity from its owners or members. Choosing an entity type is one of the most important decisions that an aspiring business owner must make.
While owners are not legally required to form an entity, formalizing a business may lessen the owner’s risk of losing personal assets to pay debts and claims against the business. The legal entity can essentially create a shield between the actions of the owner and the activity of the business.
When choosing an entity, business owners should consider several factors, including the nature of business activity, the protections of limited liability, the requirements for corporate formalities and the tax consequences.
Understanding Limited Liability
When considering which entity type to establish, it is important to understand the limits of an owner’s liability exposure.
Ideally, business owners want a business entity that offers limited liability protection. It stipulates that the owners’ loss exposure is limited to their investment in the business and that their personal assets will generally not be used to satisfy any claims, obligations or debts of the business if the business itself is unable to pay.
This protection, however, is not absolute.
For starters, not all entity types offer limited liability protection. Depending on the entity and its structure, owners could be held personally liable, or jointly and severally liable in the case of multiple owners.
» To be held personally liable means that satisfaction of claims, obligations or debts of the business can be taken both from an owner’s investment in the business and from an owner’s personal assets outside of the business.
» Joint and several liability applies when there is more than one owner in the business. In this case, claims, obligations or debts can be collected entirely from one partner, and then the partner has the legal right to seek proportionate contributions from the other.
While limited liability allows owners to feel comfortable operating their business, there are some exceptions to this protection. For example, contractual guarantees by the owners, failure to pay payroll taxes or file annual documentation, or personal negligence can cause liability to extend beyond entity protections.
Types of Entities
The most common types of entities are sole proprietorships, limited liability companies, partnerships, corporations and nonprofits.
» Sole proprietorships are businesses that are not registered with a secretary of state’s office. They are the easiest to form because they are unincorporated, but there is no limit to an owner’s liability. If the business has an obligation or debt that it cannot pay, an owner’s personal assets will be used to satisfy the obligations.
» Partnerships are associations of two or more people as co-owners of a business for profit. This entity provides limited liability protection to all owners, but when that liability is exceeded, owners are jointly and severally liable for obligations and liabilities, unless they contractually agree to different arrangements.
» Limited liability companies are the most common legal entity. This entity choice provides the limited liability protection of a corporation and the ease of a partnership for on-going corporate formalities.
» Corporations offer a higher level of liability protection, but have significantly more corporate formalities. For instance, most states require corporations to have annual shareholder meetings, a board of directors and annual filings.
» Nonprofits are entities created for a charitable purpose. The designation as a nonprofit does not mean that the business does not intend to make a profit, but that the organization has no “owners” and that money generated will not be used to benefit any organizers.
When selecting a legal entity for your venture, you also should have a conversation with an accountant about tax implications. Different entities will handle their tax obligations in a different way.
» Pass-through taxation occurs when the business entity itself does not pay taxes on its earnings. Rather, that money is “passed through” to its owners, who then record the profits (or losses) on their personal tax returns. This tax structure generally applies to sole proprietorships, limited liability companies, partnerships and S-Corporations.
» Double taxation stipulates that taxes must be paid on the entity level and also again when owners or shareholders receive distributions by paying tax on the income. C-Corporations follow this format.
Choosing an entity type is one of the most important first decisions for a business, and it’s one with long-lasting implications. Work with your attorney to decide which entity type works best for your venture, to develop the necessary corporate governing documents and to obtain any other necessary permits or licenses for your scope of work.