What Do You Want to Be When You Grow Up?

So . . . you’re starting a business. You’ve decided on a name.  Your next step – figuring out a structure.

Business structures come in several different different flavors. The right one for you depends on who you’re going into business with, what kind of business this will be, what size business you’re planning, what non-business assets you might want to protect, and the founders’ individual tax situations. In general, the more formal and complicated you get, the more protection you get in return – but you have to keep up with the formalities, and pay for the resulting protections.

We’ll look at each, going from simple to complicated.

The simplest entity is the sole proprietorship, because it’s just you – only one person. Typically you set this up by filing a DBA, or “doing business as” form, or something similar, with your county or other local authority – but check the details with your particular jurisdiction, as they can vary. This filing acts like your business’s “birth certificate”, so you’ll need a copy to start a business bank account and apply for any federal or state tax numbers you might need. The paperwork is minimal and cheap. While you should keep your business accounting separate from your personal funds, the business will file and pay federal taxes on your own personal tax return. In return for all this informality, though, if you are sued for something involving the business, your personal assets could be at risk too. However, check with an insurance agent – many of the most common business risks can be mitigated with appropriate insurance policies. As well, if you have minimal personal assets to protect, having them at risk simply won’t matter much.

Almost as simple to start is the general partnership. It’s typically started just like a sole proprietorship, by filing a DBA form with your local jurisdiction – except that instead of one owner, there are two or more. Unless the partners agree otherwise, all are in charge of the business, all share the profits and losses, and all may be personally liable for actions any partner takes on behalf of the business. Each partner is expected to act for the good of the business, and not sacrifice the business to his or her personal interests. And note that phrase “unless the partners agree otherwise”. A written partners’ agreement isn’t often required, and state law will fill in defaults for things you don’t specify – but a written agreement is still a very good idea.

There’s also a variation, called the limited partnership. A limited partner is really a passive investor in a general partnership – while a limited partner does share in the business’s profits, he can’t manage the business, but also isn’t personally liable for the business. A limited partnership is typically started just like a general partnership, but again an written agreement among all the partners, specifying everyone’s status and duties, is an excellent idea.

Sole proprietorships and partnerships are the most informal entities; your state may recognize some other variations, particularly for licensed professionals (like doctors and lawyers). There are also several flavors of more formal entities.

The most formal business form is the corporation. There’s more paperwork, typically filed at the state level. The corporation’s owners, or stockholders, are often separate from its managers (typically a Board of Directors or folks hired by the board), so there must be written agreements specifying such details as the number of shares of stock and how directors are to be chosen. Unlike a sole proprietorship or partnership, a corporation can live forever as an independent entity. It typically pays taxes as an entity, then individual stockholders also pay personal taxes on any profits paid out as dividends (although small corporations, S corporations in IRS-speak, can be taxed purely on their owners’ personal tax returns). In return for all the expensive paperwork, though, you get flexibility and protection. Individual owners generally aren’t liable for the business, as long as they’ve treated the corporation as a separate business. It’s also much easier to buy and sell pieces of the business.

If a partnership doesn’t provide enough protection but a corporation is overkill, another option is the limited liability company, or LLC. In effect, this is a mini corporation, with the same limited liability advantages, but with fewer owners, so it can be run more informally. It pays federal taxes either as a corporation or purely through the individual shareholders – the IRS lets you choose. It’s also simpler to set up, and this is done at the state level. However, some states restrict what kinds of businesses LLCs can engage in – check this before you file your paperwork. And just like a corporation, a written operating agreement is a very good idea.

So how do you choose? You’ll need to ask yourself some basic questions.

What’s your current situation? If you’re starting out on a shoestring by yourself, a sole proprietorship will get you up and running, with some money coming in to bootstrap the business to the next level. If you have partners, but you’re still on a shoestring, use a partnership. If you have more money to invest right now, or have employees (which the business must supervise and be responsible for), you’ll want more up-front formalities and more protection. Also consider your tolerance for formalities and other paperwork – corporations and LLCs require more of it, and if it’s not done properly they can lose their liability protections.

Who are doing business with? Are you comfortable being responsible for your partners’ actions, and are they comfortable being responsible for yours? Then a general partnership might be appropriate. Does anyone have personal assets they need to protect from potential business liability? If so, they’ll want to be a limited partner (and not manage the business), or you’ll need an LLC or corporation to protect everyone.

What are your tax considerations? Sole proprietorships and partnerships are taxed as part of each principal’s personal federal taxes, large corporations are not. LLCs and smaller corporations have the option to go either way. There may be state taxes to consider, on the entity, the principals, or both. You’ll definitely need to crunch some numbers, possibly with an accountant or tax lawyer, to determine the best strategy for your particular situation.

Where are you going? If you’re planning to stay small – perhaps you’ll be selling your own personal services – a formal structure you’ll have to pay to maintain and paperwork you’ll have to file may not be worthwhile. if you’re planning to grow, though, you’ll want the flexibility to raise capital by selling pieces of the business or even going public – for that you’ll need a corporation. If you’re contemplating starting up and then bowing out of the picture, you’ll likely need a corporation as well.

Keep in mind, though – the initial decision isn’t forever. Entities can be converted into one another – it just takes paperwork and money. As well, there may be more than one way to do what you want – accountants, insurance agents, and lawyers (namely us) can all help with strategies. So what are you waiting for – get going!