When starting a new enterprise, it’s always wise to choose the right form of business. Right off, I should say that it is always wise to have a good attorney and a good CPA to guide you. This article will touch on some major guidelines, but it should be used neither as a tax guide nor as a legal guide. Your attorney or CPA can best advise you when you are choosing a form of business enterprise.
That said, four well-known forms of business are the sole proprietorship, partnership, corporation, and limited liability company. My simple answer to whether or not you should incorporate your startup is that you should choose any form of business that protects your personal assets. This simply means, choose any form of business except a sole proprietorship or a general partnership. Your goal is to protect your personal assets from any lawsuits that emanate from your business activities.
Brief History of Forms of Business
For many years, the entrepreneur would generally have three forms of business to choose from: the sole proprietorship, the partnership or the corporation. The form that would give the entrepreneur the most personal protection was the corporation. It is still a very viable way to form a business.
- Sole Proprietorship
- Limited Liability Company, LLC
The sole proprietorship is the easiest type of business to start because, absent any licensing requirements, one merely has to “hang a shingle” with the name of the business– e.g., “John Smith, Printer.” The second thing that one must do, at least from an accounting point of view, is to develop a bookkeeping system to account for your company’s revenues and expenses. Then, you’re “ready for business.” The main problem with this form of business is that you are completely exposed to liabilities created by the business. Therefore, if you are running up legitimate but hefty debt in your business, you are personally liable for all debt so created.
The main thing going for this form of business is ease of formation. Another somewhat attractive feature is that the annual financial results of your business can be folded into your federal 1040 tax return under the heading of Schedule C. Besides these two positives that I have sited, I can’t think of much more to say on a positive note about this type of business formation. It is fraught with potential personal liability and should generally be roundly avoided.
A partnership has been defined as an association of two or more individuals to carry on as co-owners of a business for profit. We can attribute the same positives to this type of business organization as to the sole proprietorship — namely ease of formation and ease of tax reporting.
Still, this type of business organization can be scarier than a sole proprietorship. The reason for this is that any general partner can bind the partnership. Put another way, any general partner can enter into a contract that will bind all of the partners. This feature is called joint and several liability. That is, not only are all of the partners jointly liable for the debts of the partnership — the individual partners are equally liable. Simply put, if something goes wrong with the partnership and its total debts amount to US$1,000,000, then the creditors can go after all of the partners jointly or each partner individually. So, if only one of the partners has personal wealth, that partner could be responsible for the entire $1,000,000!
The late Chief Justice Marshall of the U.S. Supreme Court defined a corporation as “… an artificial being, invisible, intangible and existing only in contemplation of the law… .” Simply put, it means that a corporation stands on its own, separate and apart from its shareholders. Therefore, if a corporation runs up tremendous debt and files for bankruptcy protection, the creditors generally can only look to the corporation for satisfaction of their debt. For this reason, this form of business has been extremely popular.
Additionally, there is a way for certain qualifying corporations to transfer the financial results (net income or net loss) from the corporation to the individual shareholders’ tax returns when a special tax form, called the 1120S, is filed. This eliminates the burden of double taxation, that is, being taxed once on the corporate level and once on the individual level when dividends are distributed to shareholders.
We must also consider the limited liability company, also called the LLC.
During the last 15 years or so, the LLC has become quite popular. Wikipedia defines this company as a “… legal form of business company that provides limited liability to its owners …” and “… is a hybrid business entity having certain characteristics of both a corporation and a partnership or sole proprietorship.”
Though the above definition might sound a bit ponderous, it merely depicts a flexible form of business entity that protects the interest holders by limiting their liability to the amount that they invested in the company. In other words, if you invested $5,000 in a limited liability company and the company ran up substantial debt, you would generally only stand to lose your original investment. So, for all intents and purposes, the LLC is quite similar to a corporation in that your personal exposure to loss is limited to your original investment.
Loopholes Can Hurt You
Of course, there are exceptions to so many things, even when it comes to the corporation or the LLC. I’ll just provide you with one rather common exception or loophole that’s called “piercing the corporate veil.” This simply means that because of certain acts that you performed as a corporate officer or director, a creditor or aggrieved party can pierce the corporate veil and go after you, personally. I mention this loophole so that you won’t become callous or blas about the protection that a corporation or LLC can provide you.
Once again I must repeat the caveat that I stated at the beginning of this column: Competent legal and accounting advice is invaluable when you are choosing a form of business entity. Whatever form of business you choose, I wish you Good Luck!
Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.