*The information below is not legal advice.
Solo entrepreneurs, this one’s for you! It takes a lot of time, passion, and money to create the business you envision, but you probably already know that. We’ll show you how to protect the efforts you invested and continue to invest by creating a business entity.
Keep reading because we’ll break down why a business entity is a necessary legal protection. We’ll also cover everything from the types of entities that exist, which one can be right for you, and how to form one. This is your quick guide to entity formations.
Liability Protection
All businesses carry risk–and no, this isn’t meant to scare you out of starting one! But as you create your business and it grows, you might start running into disputes with vendors, disgruntled customers, or debtors. When these disputes come up, you’ll want to have some protection for your business and for yourself. That’s where business entities come into play.
Business entities can create a wall between your personal assets and your business assets. We call this wall of protection, liability protection, which helps protect you and your business. Most entities provide liability protection by shielding your personal assets from business debts and liabilities.
Let’s say you get caught up in a lawsuit with a disgruntled business customer. We don’t like thinking about that, but sometimes it happens! With liability protection, liabilities owed by your business can only be paid out of business assets. This helps to protect you, as an individual, from losing personal assets like your house or car.
On the other hand, say you owe payments on a car loan you bought for personal use. Creditors cannot usually pursue anything related to your business to pay off personal debts like a car loan. But, depending on your state’s law, some exceptions can apply. Some states allow creditors to use “charging orders,” foreclose on an entity, or get a court order to dissolve an entity in cases of personal debts and liabilities.
Despite these creditor remedies, the liability protection provided by different entities can keep much of your assets and your business’s assets protected from unwanted debts and liabilities. Take a look at the structural and tax benefits of the following entities to choose which one can work best for your business.
Types of Business Entities
1. Limited Liability Company
A limited liability company, or an LLC, is one of the most common business entities formed for small businesses and for good reason! LLC’s have simpler organization requirements and can provide better tax advantages for some small businesses.
Simpler Organization Requirements
An LLC does not need shareholders or boards of directors, nor does it have a required number of members. This can be perfect for solo entrepreneurs because one person can create and own the LLC. An LLC’s structure is also flexible enough to add other members in the future if you decide to do so.
Tax Advantages for Small Businesses
LLCs work well for small businesses due to its tax structure. They are not taxed separately like corporations. Instead, the owner or members of an LLC will continue to pay taxes as an individual while including the LLC’s profits as personal income and applying a self-employment tax. This is often preferred by small business owners who do not want to pay an entity-level tax in addition to their individual tax. (We’ll cover more on how tax elections like an s-corps can provide even more tax advantages for LLCs in a future post!)
Overall, a business entity like an LLC can provide a lot of organizational and tax advantages for solo entrepreneurs.
How to Form an LLC in Your State
The steps to forming an LLC may vary depending on your state, but these are the general steps:
- Choose a name for your business. It will need to be unique and include “LLC” or “Limited Liability Company.” You can usually search in your state’s database for business names to ensure that your business name is not already taken.
- File the articles of formation or a certificate of formation (these are different names for the same document).
- Write an operating agreement outlining your business’s structure and any rules. This does not need to be filed, but should be kept in your records.
- Check your state’s Office of the Secretary of State’s website to see if you need any other permits or licenses.
- Apply for an IRS Tax ID or Employer Identification Number.
- Ensure that you understand the tax filing requirements in your state.
Don’t want to deal with the hassle of filing for an LLC? Legalpreneur can file an LLC for you for free inside of our Legalpreneur Membership, or you can purchase just the LLC filing here!
2. Limited Liability Partnerships
Finding like-minded partners is like finding gold! And if you find like-minded partners you want to work with, you might want to create a partnership. There are many types of partnerships (i.e. general partnerships, limited partnerships, and limited liability partnerships), but we’ll focus on limited liability partnerships, or LLPs, because they provide limited liability protection to all partners.
It’s important to note that some states provide less liability protection to the partners of an LLP than what is provided to the members of an LLC. If you are trying to decide between an LLP and an LLC, check your state’s websites or ask an attorney what liability protections an LLP has in your state.
Organization Requirements
In a limited liability partnership, two or more persons must agree to be co-owners of a business. The ownership can be divided in any way, as long as the ownership adds up to 100% among the partners. Termination of a partnership can also be set by a date or goal. But if one partner leaves a two-person partnership, then the partnership will automatically dissolve.
Requirements for licenses, reporting, insurances, and filings can be more intensive for LLPs and will vary state by state. Some states also have specific requirements about who can create a limited liability partnership. For example, California only allows limited liability partnerships to be created by certain professionals like doctors, accountants, or attorneys.
Tax Structure
Limited liability partnerships are taxed similarly to LLCs because they are not subject to an entity tax. The profits of the LLP pass through to the partners as personal income and each partner will pay their taxes according to self-employment rates. Like an LLC, this structure can be beneficial for business owners who want to avoid double taxation.
Overall, LLPs can be a good starting point if you and your partners provide professional services. Each state’s LLP requirements and protections can vary, so careful consideration is needed. An LLP can also be converted to an LLC in the future, if that fits your business needs.
How to Form an LLP
- Check your state’s websites like the Office of Secretary of State’s website to determine if LLPs can be formed in your state and whether you are eligible to form one.
- Choose a name and check your state’s business name database to ensure it’s not taken. You will likely need to include “limited liability partnership” or “LLP” at the end of your name.
- Draft a limited liability partnership agreement outlining ownership, terms of dissolution, and other agreements between the partners.
- File the appropriate notice or Certificate of Limited Liability Partnership with the state, usually through the Office of the Secretary of State website.
- Apply for an Employer Identification Number.
- Check your state’s Office of the Secretary of State’s website to see if there are any other licenses, permits, or insurances required. LLP’s can often require malpractice insurance, specific filings, and publications under state law.
- Ensure that you understand the tax filing requirements in your state.
You can schedule a consultation with a lawyer like Andrea Sager to determine whether an LLP or an LLC fits your business best.
3. Corporations
Corporations are considered an independent legal entity owned not by individuals, but by shareholders. The requirements for a corporation are more complex, but these complexities can be great for exponential growth. Let’s take a look at the organization requirements and tax structure.
Complex Organization Requirements
A corporation requires a board of directors, shareholders, and corporate officers. Ownership in a corporation is divided by shares among shareholders. Management requirements, federal compliance, and overall operating costs of a corporation can be substantial and expensive for small business owners. If you have the resources, a projection of growth, and/or investors, then this type of entity may be worth considering.
Double Tax Structure
A corporation is subject to something called a double tax, or an entity-level tax. This means that the corporation is first taxed at a rate of 21% and any profits or dividends passed to the shareholders are taxed a second time as personal income. Depending on the revenue and profits a small business makes, a double tax may not be desirable.
Overall, this type of entity can make sense for entrepreneurs who intend to grow quickly and have the resources to manage a corporation.
How to Form a Corporation in Your State
- Choose a unique name for your corporation. It will need to end with “Corporation,” “Limited,” or “Incorporated.” You can usually search in your state’s database for business names to ensure that your business name is not already taken. Your state may have specific naming requirements.
- File the articles of incorporation or certificate of incorporation with your state’s Secretary of State.
- Appoint your corporate directors.
- Draft the bylaws. This outlines the rules that govern the corporation’s day-to-day operations.
- Hold a meeting with your board of directors.
- Issue corporate stock to your shareholders. If you have more than one shareholder, you will need to draft a shareholder’s agreement.
- Apply for an Employer Identification Number.
- Check your state’s Office of Secretary of State’s website for any additional licenses and permits necessary to operate your specific business.
- Ensure that you understand the tax filing requirements in your state.
Not sure how to draft these documents? Find an attorney in your state to draft the bylaws and shareholder’s agreements.
We’ve now covered the most common entity formations for small businesses! Choosing the right entity can depend on the size of your business, the organizational flexibility you want, and a beneficial tax structure. Most of all, these entities give you the liability protection you need to protect you and your business!
