How to start a business series – Chapter 1 – The legal entity

One of the first things to consider before taking the entrepreneurship road is the legal entity. The form of business you select will dictate which tax form it is filed. Moreover, your choice will impose what kind of protection it will have under the law, as well as which rules and regulations you must follow. Independently of the type of business you are starting, your decision will have a direct effect on the company.

It is recommended that you consult a certified public accountant (CPA) or someone qualified, before making your final decision. As for the remainder of the process – filing paperwork and local procedures – you can easily do it on your own.

For my businesses, I have used IncFile. It is a service that covers all state registration needs. They are not only a very reliable company with reasonable prices.

While you may modify your business structure in the future, there might be local restrictions depending on your location. It could impact your taxes and even unintended dissolution, among many other complications.

Again, consulting with a professional is highly recommended. This article is for informational purposes only, and you should not base your decision solely by reading it.

Sole proprietorship

A sole proprietorship is the simplest form of business and gives you full control of it. If you do business activities but do not register as any other entity, you are automatically considered a sole proprietor.

In this particular form, your business assets and liabilities are not separate from your personal assets and liabilities. You are personally held liable for all of the debts and commitments of the business. Sole proprietors are still able to obtain a trade name. It is tough to raise funds under this entity, as you are not able to sell stocks, and banks are skeptical about lending money.

A sole proprietorship is an excellent choice for low-risk businesses and for owners who are testing a business idea before forming an official company.

Partnership

It is a structure used for two or more people to own a business. There are two common kinds of partnership:

Limited partnerships. Only one of the partners have unlimited liability, while all the others have limited liability. Partners with limited accountability also have limited control over the company, and it should be documented in the partnership agreement. Profits are reported on the personal tax return of the general partner – the one with unlimited liability. Moreover, the principal has to pay self-employment taxes.

Limited liability partnership. In essence, it is very similar to the limited partnership, with the exception that every partner has limited liability.

Partnerships are an excellent choice for business with multiple owners, or professional groups, like attorneys.

Limited liability company (LLC)

An LLC allows you to take advantage of both the corporation and partnership business structure and its benefits.

Under an LLC, your personal assets – such as vehicles, house, savings, etc. – are not at risk in case of a bankruptcy or lawsuits.

The profits are part of your personal income without corporate taxes. Members of the LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security.

Though this format might seem appealing in many cases, it is essential to do your research prior to choosing this route. Some states might require the LLC to be dissolved or re-formed in the event a member joins or leaves.

An LLC can be an exceptional choice for medium or high-risk business. Additionally, owners with significant personal assets may choose this route. Their property is protected, and tax rates are significantly lower than a corporation.

Corporation

C Corp

It is a legal entity that is separate from its owners. A corporation can make a profit, be taxed, and be held legally liable. Unlike the other structures mentioned above, corporations pay their own income taxes on their earnings. In some cases, gains are taxed twice – first, on the initial company profit, and second when dividends are paid to shareholders on their personal tax return.

These types of companies offer the most robust protection to their owners in terms of personal liability. The downside is that the cost is much higher than other structures. Moreover, it requires extensive record-keeping, as well as reporting.

C Corps have an unrelated life from its shareholders. If someone leaves the company or sells his or her shares, business goes on practically undisturbed.

Furthermore, corporations have a significant advantage when it comes to raising money. Through the sales of stock, a company can quickly obtain serious capital, and it can also be beneficial when seeking employees.

Corporations are a viable option for people trying to raise funds or plan to go public or eventually sell out.

S Corps

An S Corp is a distinct type of corporation to avoid double taxation. It allows profits, and some losses to be passed to the owner’s personal income without being subjected to corporate taxes.

Not all states recognize S Corp the same way the federal government does, and shareholders taxes could defer depending on the location. Some states view S corp the same as C corp, while others tax on profits that exceed an imposed limit.

S Corps are filed with the IRS to get its status, but it is a different process when registering in their host state.

When it comes to S corps, there are a set of special rules and limitations. All of its shareholders must be U.S. Citizens, and must not exceed one hundred. Moreover, you will still have to follow the strict filing and operational process of a C corp.

S corps can be a primary choice for business that would be a C corp but meet the requirements for an S corp.

B Corp

A benefit corporation, often referred to as B corp, is a for-profit organization, and most states recognize it. While b corps are different from C corps in purpose, accountability, and transparency, they are for different on how they are taxed.

B corps are driven by mission and profit. Shareholders expect the company to provide public benefit as well as financial profit. In some states, B corps have to provide an annual benefit report verifying its contribution to the public.

Close corporation

A close corporation is similar to B corp, but with a less traditional corporate structure. Many of the formalities that govern corporations are discarded in this case.

State rules may vary, but the principle is the same, trading publically its shares is usually not allowed. Small groups of shareholders often run close corporations without a board of directors.

Nonprofit organizations

Nonprofit organizations are structured to do charity, education, religion, or scientific work. Because their work solely benefits the public, they can receive tax-exempt status. In other words, they do not have to pay state or federal taxes or income taxes on any gains.

Similar to a B Corp, a nonprofit has to file with IRS to acquire tax-exemption, while the state filing is a different process.

Nonprofits must follow similar organizational rules and regulations as C corp. Additionally, they must follow special guidelines on any profits earned.

Many often call nonprofits as 501(c)(3) – this is in reference to the section of the IRS code that grants them tax-exempt status.

Cooperative

Last but not least, a cooperative is a business organization owned and operated for the benefit of those using its services. Profits generated are distributed amongst its members, also known as user-owners. Generally, a board of directors is elected, and officers run the business while members have voting power to control the direction of the company. While someone can become a member by purchasing shares, the amount of stocks does not impact the weight of their vote.