Business Formation: Which Structure is the Right Fit for You?
In the advanced and adaptable era that we live in, starting a business is a common American consideration. Our world is full of new products and ideas, and innovation and risk are standards that individuals are ready to tackle more than ever. If you think it’s time to make your own entrepreneurial move, then business formation will likely be your first major step. A smart entrepreneur will not only take into consideration where to locate, who their customers will be, who their competition is, etcetera; they will minimize their risk by making an informed choice about which business type to form. The tax implications, legal protections, number of owners and employees, cost to form, and financing options will vary with the entity you form. Deciding which structure to develop is very important, but it does not have to be intimidating if you understand your choices.
Sole Proprietorship: This option is the simplest structure to form, and the common choice for freelancers or independent contractors. In California, you don’t have to file any paperwork with the California Secretary of State or pay fees; you must choose a business name, file a Doing Business As name application with your county recorder if you are using a trade name other than your legal name to run your business, apply for any necessary permits or licenses (find the ones that pertain to your business at the California Governor’s Office of Business and Economic Development), and obtain an Employer Identification Number if you plan to hire any employees. From there, you are ready to run your business.
Your personal finances as a sole proprietor are synonymous with your business’s finances and you file your personal and business taxes under your Social Security Number or (Employer Identification Number if you have employees). While this seems straightforward, it means that there are no legal protections in a sole proprietorship. Any lawsuits or grievances will be brought against you and only you, risking your personal assets. Depending on the type of product or service you are offering, this exposure may be a trivial consideration for you, and for others, choosing an option with more liability protection will be deemed necessary.
Partnership: A partnership is formed by two or more individuals. These structures will require the same easy set-up steps as sole proprietorships, with additional requirements depending on the type of partnership created: general, limited, or limited liability. In any partnership it is critical to sign a partnership agreement spelling out profit and loss allocation, financial contribution and liability of the partners, decision-making authority, etc. before beginning operations.
General Partnership: The appeal of a general partnership is its easy formation and taxation, and that each partner actively runs the business and can make management and legal decisions, rather like two sole proprietors working on the same venture. However, as mentioned, without a well-thought-out partnership agreement, even this basic type of formation can be tricky down the road. As both partners assume full legal responsibility for, invest in, and manage the business equally, both of their financial resources and personal assets are at stake with every decision that either partner makes. They are “jointly and severably liable” for everything they have invested and more.
Limited Partnership: In a limited partnership, certain partners may choose to invest in the business and forego a role in decision-making, thus limiting their participation in the running of the company but remaining eligible to reap profits. There will be at least one general partner and at least one limited partner. This structure is usually used when raising investments, like family estate-planning or if you have a business you want complete control of as the general partner, but need investors to help gather capital. The major drawback to this option is that the general partner assumes complete legal, operational, and financial liability while the limited partners only risk their investment. If a limited partner assumes any sort of management role in the business, they can lose their status as a limited partner and become liable for company actions as well. General partnerships or limited liability partnerships are more common choices for most businesses.
Limited Liability Partnership (LLP): A limited liability partnership comprises a blend of general and limited partnership traits. In this structure, all partners contribute resources such as a client base, employees, workspace, and of course, capital, but their personal assets are protected from business debt or other partners’ misconduct. This format requires certain paperwork to be filed with the state of California because of the complexity of splitting income, payroll, etc. and determining shares of profit and loss (read more on the State of California Franchise Tax Board website).
An LLP registers in California as a pass-through entity; the business pays no income taxes, so each partner pays personal taxes on their share of the profit. Each partner takes part in running the business and has voting rights proportional to the amount of their contribution or on the guidelines of the partnership agreement.
In California, only individuals who work in architecture, law, or public accountancy can form an LLP, but in January of 2019, engineers and land surveyors will also be eligible to form LLPs. Generally, LLPs are formed by multiple partners and allow for a great deal of flexibility as well as accountability in the format and running of the business.
Limited Liability Company (LLC): Limited liability companies are essentially hybrids of sole proprietorships, partnerships, and corporations. Members of an LLC, like limited partners or corporate shareholders, are protected from lawsuits due to each other’s mistakes or negligence. They only stand to lose what they have contributed to the company, except in certain situations including fraud, unmet reporting requirements, or if members do not keep their personal finances separate from the company bank account.
The taxation and structure of an LLC is flexible in that with multiple members it can follow the pass-through tax format like a partnership or an S corporation. An LLC can also consist of one person and file taxes like a sole proprietorship.
An LLC can dissolve with the bankruptcy, expulsion, or resignation of any member, unless other guidelines for these cases are agreed upon in Articles of Organization that are filed with the Secretary of State. Other formalities of LLC formation include creating an Operating Agreement between members and finding a registered agent to accept services on your LLCs behalf (subpoenas, etc.). Since LLCs have some variability in the way they operate and are set up, drawing up this paperwork is legally required and having member meetings is recommended to keep everyone up-to-date.
Corporation: Structuring your business as a corporation ensures separation of personal assets from business liabilities. A corporation essentially allows a group of people to be legally treated as a single person or entity. One or more “incorporators” follow the legal processes to form the corporation, shareholders invest in and own the corporation, directors oversee the general operations and objectives of the corporation, and officers run the corporation with employees. This general structure varies widely depending on how many people and how much capital is involved; shareholders can occupy director, officer, and employee capacities in smaller companies or can have no active responsibility at all in larger ones.
There are two types of corporations, named after the subchapter of the Internal Revenue Code that their taxes fall under. Choosing between incorporating as an S corporation or a C corporation comes down to taxes. C corporations, which are generally incorporated as larger businesses, pay state and federal income taxes as independent entities, while S corporations use the pass-through method to owners’ tax returns. As with other business entities, it is possible to “pierce the corporate veil” and put personal assets at risk in cases of fraud, use of company funds for personal means, and wrongful conduct by an owner. As a company grows, generally so does the level of shareholder protection due to the separation of roles and responsibility.
To form a corporation, you’ll need to file Articles of Corporation, specify and report incorporators, directors, and a registered agent, write and report a Corporate Purpose, and create incorporation bylaws specific to your company conduct, meetings, election of directors, etc. To find out more about incorporation requirements, or any business formation for that matter, visit the California Secretary of State website.
Franchise: A franchise is not technically a business structure that one would create for a venture; it is a license granted by an existing company to a franchisee (usually a partnership, LLC, or S corporation) to allow for expansion. The company’s name, operations, branding, and products or services are provided to the franchisee to run their business. In return, the franchisee pays an initial fee and royalties to the franchisor and continues to market and sell the brand at their location. The relationship and obligations between franchisor and franchisee is the most important thing to consider when opening a franchise, as well as start-up costs, fees, and royalties.
Nonprofit Organization: Nonprofit organizations are businesses that do not seek to put money in their owners’, investors’, or shareholders’ pockets from profits. The most common type of nonprofit is called a 501(c)(3), named after a section of the IRS code that designates them as religious, charitable, scientific, literary, or educational companies that are tax-exempt. They use any sales revenue, grants, or donations to pay their owners and employees and continue to develop and provide their service.
Nonprofit business-starters file Articles of Incorporation and create bylaws like corporations do, but also fill out IRS Form 1023 to gain federal tax exemption. After this, they may apply in the state of California for state tax exemption as well.
In conclusion: It is worth noting that if you plan to take out a business loan or lease a workspace, you may need to sign a personal guarantee, essentially co-signing to guarantee that the bank will get paid back if your loan defaults. However, many business structures, as discussed, are built to keep your personal assets as protected as possible.
Every business entity has its pros and cons, as well as variables that should be considered. Depending on the type of product or service you are selling, your business structure can help or hinder you. Meeting with an attorney and an accountant to discuss your personal liabilities, formation requirements, finance options, long-term costs, taxes, and next steps is a great way to get started on the right foot.
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