While it is possible to conduct business in your personal capacity, in most cases, it is strongly advised to create an entity, separate from yourself, when conducting business.
While it is possible to conduct business in your personal capacity, in most cases, it is strongly advised to create an entity, separate from yourself, when conducting business. One of the most important reasons to create a separate business entity is to protect yourself from personal liability for the acts of the business. For example, if your company becomes the subject of a personal injury claim and you did not create a separate entity for your business, the plaintiff can come after your personal assets as well as the assets of your business. However, if you created a business entity and properly maintained the distinction between yourself and your business entity, the plaintiff can be restricted to only the assets of the business. Another reason to create a business entity is to simplify management and governance of the business organization. A business that involves more than one owner means there will be ownership shares and rights particular to each person. It is much easier to have an organizational document that stipulates the rights and responsibilities of owners as opposed to having separate and complicated contracts to define the relationships between the parties. Also, entity formation is typically a requirement if your business intends to raise outside capital. The business entity facilitates this by pooling all the business assets and liabilities into the organization instead of dealing with the finances and claims of everyone involved. Lastly, business formation greatly increases your level of professionalism in dealing with the public; it bolsters confidence in your business so that your clients and customers can rely on the stability of your business.
The different types of business entities are sole proprietorship, partnerships, corporations, and limited liability companies.
Sole Proprietorship: This type of business form is the simplest form of business entity. It is run by a single individual for that individual’s sole benefit. Sole proprietorships are not separate legal entities and do not exist apart from the owner. The owner is personally liable for all debts and claims of the business. Sole proprietorships are however considered separate entities for accounting purposes so that financial activities of the business must be separately maintained from the proprietor’s personal finances unrelated to the business. Sole proprietorships terminate upon the owner’s death.
Partnership: A partnership is formed when two or more people associate for the purpose of carrying on a business for a profit. Partnerships can be based on express, implied or oral agreements between the parties. Each partner contributes property, money, labor or skill to the partnership and shares equally in the profits and losses of the business, unless stipulated by agreement. Each partner is also personally liable, individually and severally, for the debts and liabilities of the business. Partners are taxed on their share of the business and profits are filed on their individual tax returns. Learn more (link to partnership basics).
Corporations: Corporations are separate legal entities governed by state law. To create a corporation, Articles of Incorporation must be filed with the Secretary of State. Owners of a corporation (shareholders) are shielded from personal liability for corporate acts. The majority of corporations are Subchapter C Corporations (C-Corps), and they are subject to double taxation: corporate profits are taxed first and capital gains are taxed when shareholders receive their dividends. Subchapter S Corporations (S-Corps) are closely held corporations with a small number of owners. S-Corp status is obtained through the Internal Revenue Service (IRS) and where certain IRS requirements are met, these S-Corps are not subject to double taxation and are instead taxed like partnerships. Taxes on the corporate level are eliminated altogether and the individual owners report profits on their individual tax returns, thereby avoiding double taxation. Learn more (link to Corporations).
Limited Liability Company (LLC): Limited Liability Companies are a favored business form for small businesses. They contain qualities of a corporation and a partnership. The management and governance of LLC’s has the same flexibility as a partnership, while maintaining the same limited personal liability as a corporation.
There are advantages and disadvantages to each business organization. The choice of business entity is shaped largely by how you intend to finance the business, the likelihood of major profits, and the number of people involved in the business. Other factors to consider are the flexibility of maintaining the business entity and taxation. Consultation with a tax professional is strongly advised.
A DBA, “Doing Business As”, is a fictitious business name filing, stating the name that the company operates under, when it is different from the legal name of the company. Some states require DBA filings because they are made in order to protect consumers who conduct business with the company. DBA’s are common in sole proprietorships or partnerships, to provide a name for your business separate from your own. Some banks require DBA’s in order to open and operate a business account. The procedures for filing a DBA vary among the jurisdictions, but it generally requires a visit to your local county clerk’s office where you pay a registration fee. Some states require publication in a local paper for a certain period of time as well, to put the public on notice of your intent to do business under your selected business name.
A partnership is an association of two or more people carrying on a business for a profit. This is the easiest and cheapest legal entity to set up. Partnerships are created by default whenever two or more people go into business together without setting up a formal legal entity with the Secretary of State. They are created by express, oral or implied terms between the parties. Without a written agreement to the contrary, partners share equally in the management and control of the partnership. Each partner contributes property, time, skill, money or some contribution to the partnership. Partners also share equally in the gains and losses of the partnership, and they are jointly, severally and individually liable for the debts and liabilities of the partnership unless otherwise stipulated in writing. This means that a person suing a partnership, can go after one or more partners and also reach their personal assets outside of the partnership. This entity offers no protection from liability. The Partnership Agreement is the document that governs the partnership, distribution of assets, duties of the partners, and termination of the partnership. The main benefit of a partnership is that it offers pass through taxation whereby the partnership is not taxed and the partners are only taxed on their share of the business, so their profits are filed on their individual tax returns.
Types of Partnerships:
Corporations are governed by state law. They are created by filing Articles of Incorporation with your Secretary of State (“SOS”) and paying the associated fees. Depending on your state, additional documents may need to be filed with the SOS as well, so be sure to check your state’s requirements to be in compliance. Generally, corporations are owned by its shareholders, governed by its Board of Directors and run by its officers. The Shareholder’s Agreement is an internal document that governs the corporation and includes information regarding the purpose of the corporation, ownership shares, voting for new members officers and the Board, capital and contribution, allocation of profits and losses, roles and duties of officers, shareholders and the Board, and dissolution. In addition to the Shareholder’s Agreement, the corporation must have employment agreements between the corporation and those employed by the corporation.
Corporations are required to maintain corporate formalities as required by the state of its establishment. There is a requisite number of Board members and roles to be held by the Board. Annual meetings of the shareholders must be held in strict compliance with notice and meeting procedures and protocols. Meeting minutes must be taken and kept on file at the principal place of business for a certain period of time. These are just some of the corporate formalities that are uniform across the states, but it is important that you inquire into what your state’s corporate requirements are and to do all acts to maintain the separation between you as an individual and you as a business owner.
The main advantage of a corporation is that it offers limited liability to its owners, meaning that the shareholders are not individually responsible for the debts of the company. Where a corporation is sued, the plaintiff may only go after the debts of the corporation and cannot reach the assets of the individual owners of the corporation. Corporations undergo double taxation, meaning that taxes are paid once on the corporate level and again on the personal level when shareholders receive their dividends. Because there are so many corporate formalities (which may vary by state law), corporations are more expensive to set up and maintain. People usually set up their corporations in the state in which they reside or plan to do business, but there is a trend for larger companies to incorporate in Delaware or Nevada due to their low costs and minimal taxes.
Failure to maintain the separation between yourself and your entity will expose you to individual personal liability. Where a party can show that you created a corporation for the sole purpose of avoiding individual personal liability, the corporate veil can be pierced, and you will be subject to personal liability. In laymen’s terms, if you create a business and run the business as an extension of yourself, and your business is sued, and the other party can prove that your business is really a sham - as you are just incurring debts and liabilities in the name of a company that does not really exist, then not only can that party come after all of the assets of your business, but it can come after you and all of your personal assets as well. If the business is sued, a grieving party only has rights to what the business has, so if your business has $48 of assets, that’s all they’re getting. But if the business is sued and corporate formalities were not maintained, and the corporate veil is pierced, a grieving party can come after you, your house, your car, your bank account, and your dog (lol, you get the point).
Types of Corporations
There are three (3) different types of corporations, and they are for profit corporations, non-profit corporations and closely held corporations. Profit Corporations are the ones previously described hereinabove, and they may or may not sell shares in an open market. Non-Profit Corporations typically run to further an ideal or goal and are less centered on making a profit. They usually serve the interests of the public interest. Some non-profits do engage in private sector activities. Closely Held Corporations are corporations with a limited number of shareholders. These are usually family owned business where the owners actually operate the business from day to day. There are limits on the number of shares of stock and strict rules against transferability.
Corporations can additionally be divided into two (2) categories: C-Corporations and S-Corporations. C-Corp’s are the ones I’ve just previously described. The majority of corporations fall into this category. C-corps are subject to double taxation where funds are taxed first at the corporate level and again once dividends are distributed to its owners (shareholders). Then we have S-Corps. S-Corps are not registered with the SOS, instead they are filed with the Internal Revenue Service. S-Corp is a tax designation that can be granted to a corporation or limited liability company. If certain requirements are met, and S-Corp status is granted and maintained, corporations can avoid double taxation and be taxed the same manner as partnerships. The requirements of S-Corp status are:
The benefits of an S-Corp include:
There are some drawbacks to S-Corp status, and they include:
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