Week 3: Ok you convinced me. But what kind of entity should I form?

Hey y'all I'm back. It's been a wash of turkey, stuffing, head colds and lots of billable work (yay) so it is what it is, but let's get to it.

OK, so now that you know whether or not you should form an entity (mostly I say yes) and why I think forming an entity is important in most cases, let’s look at what our options are for which entity to form.

Most legal issues classes spend a lot of time going through the various types of legal entities with pros and cons. While if you are a law student, another attorney or really interested this can be useful, I often think it is a waste of time for my clients for whom the LLC is almost always the appropriate structure. Of course, on an individual basis (or if I were teaching a continuing legal education series on business entities), I may delve more deeply- that's why you need your own attorney!

Ok- unless you are really far from launching your business, or you have an “industry disrupting idea” that you think will be huge like the next Facebook or Airbnb, or that will otherwise attract major dollars from venture capitalists and or angel investors relatively straight away, most likely a limited liability company (aka an LLC) will be the best option (maybe not though- remember this is not specific legal advice). 

Just so I am familiarizing you guys with the different options so that you can sound educated and feel empowered when discussing them with your attorney, here’s a basic overview:

Sole Proprietor- that is what you are if you are a single person operating a business under your name or a tradename. No filings are required to be this. You do not have any liability protection. You file your business expenses on a schedule to your personal tax return. It is simple but risky, especially when LLC’s are pretty simple too. I almost always advise against this- especially if you have any assets at all that you would not like to lose. Maybe I would agree that this was the right option if you were just selling something small to 5 close friends, or were far from actually launching your business, but otherwise probably not.

A note here- maybe you are thinking- well my business doesn’t make much money, or isn’t going to make much money. I think a) that is a self-defeating prophesy, and b) that your business plan needs some work (also your confidence could probably use a boost).

Partnership- A partnership is like two sole proprietors working together- well kind of. It would be you and your partner doing a business together. Again, without forming an LLC (or a corporation) a partnership has NO liability protection. You file a partnership tax return, so your taxes are governed by partnership tax rules and law, but you and your assets are on the hook/exposed if there’s an issue. If you are serious enough to have a business partner, you should be serious enough to protect yourself by forming a limited liability entity for your business.  There are some structures that allow some partners limited liability, and others not, but that is beyond the scope of this series.

Corporation- Back in the day, this was pretty much the only option if you wanted liability protection. Corporations can be taxed either as a C-corporation or as an S-corporation. If you want to learn more about taxation (we may talk about this in a subsequent post IDK) here is an overview (full disclosure: I don’t know this firm, but their explanation of the two forms of taxation is solid. Investors often prefer corporations, because the owners of corporations (shareholders) hold shares of stock, and that is something that investors can often wrap their heads around and are comfortable with (there are other reasons as well that are beyond the scope of this article). The thing is, it is possible to convert your LLC into a corporation prior to a round of investment if that is what your potential investors want.

And last but not least-

Limited Liability Company- When properly formed, the LLC gives its owners personal asset protection from most business creditors and most judgments (more on this another time). An LLC has members who own membership interests in the company (sometimes these membership interests are reflected as “units” to more closely approximate “shares”). A single member LLC is a “disregarded entity” for tax purposes, meaning that the owner of a single member LLC (unless they elect otherwise- more later) is taxed as a sole proprietor. A multimember LLC is taxed as a partnership, unless the members elect to be taxed as a corporation. LLC’s are relatively inexpensive to form, and easy to maintain. We will get into the steps in setting up your company in a subsequent post.

So to answer my own question: What kind of entity should I form? I’d say probably an LLC unless you have a legitimate reason not to (which is why you need your own attorney).

If you want to learn more about the different kinds of entities, here’s a great overview from the Small Business Administration.