With unemployment shooting through the roof, more and more people are having to turn to alternative sources in order to generate income. People are doing whatever they can to survive, including freelancing. Some people are taking the plunge into entrepreneurship, starting the business they’ve always dreamed of starting. Starting your own business can potentially be very rewarding. Of course, if you choose to do so, you’re potentially taking on a great deal of risk. Not only the risk that your business could fail, or the fact that you’re on the hook for your own insurance, and of course sometimes you’ll have to go through lean times.
If you decide to go it on your own, I think it’s important that you form some type of business entity. There are a lot of options out there, and I’m going to go through some of the reasons why you need one and what type of business entity to form. In most cases, I think that answer is going to be an LLC (Limited Liability Company).
Types of Entities
You don’t really need to do anything to start a business except say you’re in business. If you hang a sign on the outside of your house that says Todd’s pet grooming, you have a business. The default entity you’d have is known as a sole proprietorship. This is what you’d have if you didn’t do anything at all.
Business entities are basically classified in 3 ways: (1) Incorporated vs. Unincorporated, (2) Tax Classification, and (3) Closely held vs. Publicly Traded. If you decide to go with an incorporated entity, you’ve only got one choice – a corporation. Of course, there are several distinctions, such as a closely held (or family) corporation, statutory closed corporation, professional corporation, a non-profit corporation, and of course a general business corporation.
As for unincorporated entities, there are quite a few to choose from. The first is the aforementioned sole proprietorship, which consists of an individual that hasn’t formed a legal entity. If you have two or more people and don’t want to go the route of incorporation, there are a bevy of partnership options. You might have a general partnership, a limited partnership, a limited liability partnership (LLP), and a limited liability limited partnership (LLLP). A general partnership is the default partnership (like the sole proprietorship), and doesn’t offer you the advantage of what some of the others say right in the name – limited liability. In a general partnership, both partners are equal and are assumed to share in the profits and losses equally. General partners are personally liable for all the debts and liabilities of the corporation.
A limited partnership has at least one general partner and at least one limited partner. The general partners are personally liable for all the companies liabilities, while the limited partners are not – even if they take an active role in the management of the company. Lots of companies were forming a corporation and making it the general partner in a limited partnership in order to avoid having an individual that is personally liable and retain the tax advantages of being a corporation.
Legislatures took notice of the way companies were using a corporate general partner in order to gain partnership tax status and the limited liability of a corporation – so they decided to cut out the middle man and made some entities that offered those attributes. The LLP, LLLP and the LLC.
Tax Classification
One of the downfalls of a corporation are the potential tax ramifications. There are three potential tax classifications for business entities (1) an S Corporation, (2) a C Corporation and (3) partnership status. Both an S Corp (which has very specific requirements) and an LLC are pass through entities, meaning the profits are passed through to the shareholders in their respective ownership shares. A C Corp has unique tax problems. The corporation pays tax on its earning when they are earned, then has to pay taxes again when they distribute the earnings to the shareholders in the form of dividends. This is aptly known as double taxation. In most cases, you would prefer to be taxed as a partnership – with an entity such as the LLC.
Closely Held vs. Publicly Traded
If you’re just starting out, whether to have a closely held or publicly traded is a non-issue. Hopefully your company grows to the point that you have to make these decisions down the road (minimum capitalization to be on the NYSE is 15 million). If you reach this point, please throw me a bone by donating to the site;)
Why you need one
If your business sells a product (or service, it doesn’t matter), and the product injures someone, your company could be liable for their injury. If your business doesn’t have the money/assets to cover the full extent of your liability, you could be personally liable to the person for their injury. Not just injuries, but any liability you might have. If you fail to perform on a contract, you could be personally liable on the contract.
Business entities also require you to define the terms of your agreement. The fact of the matter is, you don’t know whether the business will succeed or fail. Whatever it does, you need to define how profits and losses will be split. You need to spell out what will happen if you disagree. How will you handle disagreements? What will you do if you want out? If there are no assets or value in the company, maybe you just both go your separate ways…but what if your company is successful? Perhaps your brand/name has value. Who gets your client? Who gets the intellectual property? Who gets the rights to the product, the website. One nice thing about forming a business entity is that most business entities have some sort of document that accompanies the formation. If you choose an LLC, for instance, you’ll have an Operating Agreement that lays out the terms of your company.
It’s also really easy to form an entity. In MO, for example, all you really have to do is file the articles of organization with the Secretary of State (but you should still write up an operating agreement). You can get the form right off the Secretary of State’s website. I don’t know how it works in other states – but I would bet it’s just as easy. The ease of starting a business is one of the things that makes America great. Anyway, protect yourself with an entity. The cost is low, and it’s a necessary safeguard. Thanks for reading.
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