Choosing a Business Entity
Maybe you’ve just decided to start a new business out of the blue, or maybe a hobby of yours matured over the years to eventually earn you money. People come to you for your expertise, your support, or your handiwork and they’re paying you for it. Cash is easy to handle, but then you started accepting checks made out to your own name and then PayPal payments linked to your personal bank account. Now it’s grown beyond the point where you can account so casually for the revenue, so you’re thinking about formalizing your business endeavor. Should you form a sole proprietorship, a partnership, a limited liability company, or an S or C corporation? In this article, we’ll discuss some of the pros and cons of the various choices of business entities to help you decide which is best for you. You can always change it later, but the process requires time, effort, and funds, so it’s best to plan ahead for the long term.
The simplest form of business is just you doing the work yourself, under your own name; it’s called a sole proprietorship. You should account for your business income and expenses, but you can comingle the funds with your own. Save receipts for your expenses and keep a tally of your income. If your business is small, this is probably your best choice, as there’s little extra bureaucracy or red tape – you don’t need to register your business, you probably don’t need a lawyer or an accountant, and you can still take your business expenses as a tax deduction on your IRS Schedule C, as long as you make profit more years than not.
If your product or service is taxable in the municipalities in which you sell it, you may need to register with your state or local tax office in order to collect and remit sales & use tax on the goods and services you sell. Here in New York, they let you keep a tiny percentage of the sales tax you collect, to compensate you for the paperwork and recordkeeping incurred. If you perform value-add services on someone else’s taxable goods, such as finishing and reselling unfinished birdhouses, you can get a “resale” certificate to provide to your vendors so that you won’t be charged sales tax on the intermediary goods you purchase for resale. When you buy an unfinished birdhouse for $10, you won’t pay sales tax on it, but when you resell it for $20 you’ll collect and remit sales tax on that amount from the consumer. Remember that you are the consumer of the paintbrushes you use to paint or stain those birdhouses; you can deduct their cost from your profit for income tax purposes, but you’re still required to pay sales tax on them.
There are a few varieties of ways to form a sole proprietorship; as mentioned, the easiest is to simply operate under your own name with your own social security number. If you’d rather establish a separate name for your business (called a “doing business as” or “DBA”), contact your county clerk for the process. If you’d rather establish a separate tax ID for your business (called a “taxpayer identification number,” “employer identification number,” “TIN,” or “EIN”), contact the IRS or visit their Website for the form. There is typically a fee to establish a DBA, but a TIN or EIN is free. When you get the DBA paperwork, bring a copy to your bank to open an account in the business’ name. The sole proprietorship offers a few perks, including deductions for business expenses and lets you create a separately-identified entity under which to conduct business operations, while keeping your paperwork minimal and your legal & accounting costs low. The downside is that you are the business – there is no distinction, legally or financially, between the business’ obligations and your own. If your product injures someone or you damage property while performing services, you are personally liable. If your business commits to financial obligations that it cannot repay, the creditors will pursue you, personally.
The next entity to consider is called a partnership. In a few respects, this is better than a sole proprietorship, but in other ways it’s much worse. A partnership is basically you and one or more people entering into a business endeavor together. You can each invest as much as is agreed, work as much as agreed, and take as much of the profit as is agreed. It’s definitely best to create a separate tax ID for this type of arrangement, and a “doing business as” (rather than using any partner’s own name). When you take your DBA paperwork to the bank to open accounts, you will specify who has signing privileges on the checks and how many signatures are required on each check. The big advantage of a partnership is that together you can do more; you share the management responsibilities and have a greater source of capital than any one of you might have individually. The downside is that each partner has full authority to commit the business to obligations to which every partner is jointly and severally liable. That means that your partner can subscribe to magazines, sign up for a cell phone plan, or take out a loan, and if he stops paying, the creditors can come after you for the money. If your partner disappears, it’s a lot easier for them to get a judgment to levy your savings, garnish your wages, or take a lien on your property than on your absent partner’s. On the other hand, it’s often hard to find good help, so if you and two friends want to open a deli together, it may be more encouraging for each of you to work there as partners, each sharing in the profits, rather than one of you hiring the other two as hourly employees.
The next category of business entities, including corporations and limited liability companies, is a bit more complicated. It dates back to early British seagoing expeditions. Wealthy investors sponsored ships to find new lands rich in resources. If the expeditions went well the ships returned with gold, spices, or slaves, but if the expeditions went poorly, the ships were lost at sea and all hands drowned. The investors rarely embarked on these adventures themselves, instead hiring crews. When the ships returned successfully, the crew was paid and the investors took their cuts of the profit, but when the ships sunk, these investors didn’t want to be sued by the families of the crewmen for the loss of their bread-winning family members. Thus, limited liability companies were born. Investors could buy and sell shares of the company, and while their upside profit potential was theoretically unlimited, their liability for losses was limited to just the amount of their investment. The company could mismanage its ships, property, and other assets, eventually making the shares of ownership worthless, or the company could be sued by the families of lost crews and be required to pay all of their assets out, but in no event would the investors be on the hook for any more than the amount they had already invested. The limited liability company was treated as an entity separate from the investors – a fake person. In fact, that’s loosely what corporation means.
The most important thing to understand about this category of business entity is that these types of businesses are all separated, legally and financially, from the people who own them. This category insulates its owners from the business’ financial and legal obligations. If the business owes more than it earns, the owners are not personally liable. If the business hurts someone or damages property, the owners are not personally liable. There is one caveat, though: just forming one of these business entities does not assure you of this protection; you are responsible for continually maintaining “corporate formalities.” If a plaintiff can demonstrate, for example, that you routinely comingle business funds with your own, personally pay certain business expenses, or have the business pay certain personal expenses, they may be able to convince a judge to “pierce the corporate veil” and treat you and the business as the same. It is up to you to keep proper records, to maintain proper financial accounting, to use business funds to pay business debts, and to hold and formally document annual shareholder and board meetings, even if you’re the only shareholder and board member.
Besides the extra ongoing effort, a corporate veil costs a bit more to establish than forming a non-corporate business entity. You will probably need a lawyer, and you may want an accountant, too. In fact, speak with them first to determine which type of business entity is most appropriate. The corporation can have a separate name from that of the owner(s), and should have a separate TIN or EIN. You’ll receive a filing receipt of some sort from your state’s Division of Corporations – it may be called “Articles of Incorporation” or “Articles of Organization” – and instead of the DBA certificate used for a non-corporate entity, this is the document you’ll need to open bank accounts in the business name.