What Factors Should You Consider when Choosing Your Business Entity?
One main factor that you should consider when choosing a business entity is whether you are considering outside investment as a financing option for your business. If you are looking to bring in funding from third parties whom you don’t know, a classic corporation structure may be best. The corporate structure is more rigid and can require more formality under the various state corporation acts to be compliant with applicable law. Corporations often require a board of directors, officers, and shareholders – even if only a single person serves in all three roles.
This said, many clients believe that they must structure their business as a corporation when this is not the case. Normally, a corporation is not my first choice for a business. Instead, I usually recommend a limited liability company (LLC). An LLC is simpler to set up and easier to operate. It’s also cheaper to maintain, less information is necessary to get it set up, and it is more malleable from a tax perspective. An LLC, unlike any other entity out there, can be taxed as an S Corp, C Corp, partnership, sole proprietorship, or a non-stock corporation. That flexibility is really important, particularly for a new business, because it gives you the ability to move, change, and grow at different points in the business lifecycle when a different tax status may be more advantageous.
While S Corp status is often best for a new business, I sometimes recommend a partnership election when there will be just one or two active members of the company, and other passive members. Consider a real estate venture with an active builder and several other non-active investors. We would set the business up as an LLC that elects to be taxed as a partnership. This way, the active member is able to get a greater share of the profits even though they own an equal share in the business – which wouldn’t be possible if the company was taxed as an S Corp.
Note that a partnership election for tax purposes is different from a legal partnership entity – which is the default, common law entity created when two or more people join in business with the intent to share profits. Common law partnerships come about automatically – no formal filing is needed to create one – but they carry significant risks; acts of one partner may be imputed to the other even if the other partner didn’t know about the act, and if no partnership agreement is put in place, all partners share equally in the partnership’s profits and losses irrespective of their level of involvement with the business.
I don’t recommend sole proprietorships in nearly any case. Sole proprietorships expose the owner and her personal assets if something goes wrong. Creditors can go after the owner’s house, car, and bank accounts if the company can’t cover its debts since the owner and the business are viewed as one and the same in the eyes of the law.
Ironically, sole proprietorships are the default if you are a singular person in the business. Many of my clients come to me six months to two years after they have started their businesses to ask whether there is anything that needs to be fixed, altered, or updated. If the client is running a sole proprietorship, the very first thing to do is create a corporate entity to raise a “corporate veil” between the business and its owner to keep the owner’s personal assets out of the reach of creditors.
The last major entity type that my firm handles is the non-stock corporation. A non-stock corporation is normally a good fit for someone who’s starting a charity. Whether the client is a successful businessperson who wants to start a charity on the side or an arts organization that is not looking to turn a profit but wants to have the corporate formality in place to protect themselves, non-stock corporations can provide structure and protection. This type of entity is not difficult to set up, but the associated process of applying for tax-exempt status with the state and the federal government can be more challenging. The process entails figuring out what kind of information the government needs before it will recognize the non-stock corporation as a tax-exempt organization and making sure that the business engages only in the activity that will maintain this status after it is granted.
For more information on Choosing a Business Entity in Virginia, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (571) 660-4077.
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