How to Pick The Right Legal Entity for Your Business or Investment
So you’re starting a business. You’ve got that great idea, you’ve found that perfect piece of property, and you want to make sure that you do everything perfectly out of the gate. First of all, pat yourself on the back for taking the right approach – a stitch in time truly does save nine. Now, to the all-important first questions: 1) Do I need to bother forming a legal entity – can’t I just proceed under my own name? 2) If I do need to form one, which entity should I pick for my new venture?
The short answer to each question is 1) Almost certainly yes; and 2) It depends (read on).
Choosing the right legal entity
Why form an entity at all? Well, simply put, because conducting your business under your own name (also known as “sole proprietorship”) puts you at serious risk of personal liability, and it might preclude you from certain tax benefits available to business owners. Going into business as a sole proprietor means that any debts or liabilities you incur, including a judgment against your venture in litigation, would be collectible against your personal assets. On the tax side, using a business entity opens up the range of tax credits and deductions available to you that would otherwise not be available if you operated as a sole proprietor.
So, what type of legal entity should you form? This depends on what you’re trying to accomplish.
We see several folks who default to a general partnership when going into business with other people (as is often the case with most businesses). These are relatively easy to form and do not need to be registered with any government authority. But that’s where the advantages end. The chief problem with general partnerships is that each partner is personally liable for the debts & liabilities of the partnership, which leaves partners exposed to potentially huge personal losses from risks such as a market reversal, dodgy business dealings by the other partners, or simply poor business decisions.
Limited liability companies
That leaves limited liability companies (LLCs) and corporations (typically C-Corporations). Of these, LLCs are the most common for small-to-medium-sized businesses for a few reasons. First, they’re easier to set up as they are less regulated than corporations. Second, they’re cheaper to set up and administer because there are fewer required governing documents and government approvals. Thirdly, in most instances, LLCs are only taxed once – as pass-through income to their respective members. On the other hand, corporate dollars are, in most instances, taxed twice: once at the corporate level and then again upon being remitted as distributions or dividends to shareholders.
Corporations, though, do have their advantages, too. The primary advantage to a corporation is the ease with which they can raise money among more sophisticated or institutional investors. These types of investors often require their targets to be C-Corporations because the tax implications to the investor in a C-Corp. are far more favorable, and it’s often easier for a Corporation to add new owners (“shareholders”) than it is for an LLC (“members”).
Experts often recommend small businesses use an LLC for their simplicity and flexibility. But, each situation should be carefully examined on its own merits to determine the best course of action. Other important questions must be addressed, such as: where to set up the entity and how to take advantage of multiple entities in best structuring your investments.
About the Author
Michele Leonelli is a CA-licensed, Phoenix-based lawyer that loves working with entrepreneurs, startups, and small-medium sized businesses with Phocus Law. His specialties are corporate M&A (including entity formation and structuring), drafting, reviewing, and negotiating all manner of contracts. As outside general counsel to a variety of companies, he also handles a range of other legal needs for his clients and their businesses. Michele is also one of the vetted partners for the Legal Hotline available to our members. Reach out to Pavilion Career Services to connect.
Keep an eye out for more legal advice from Michele on the Pavilion blog soon.
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