written on October 16, 2008 by James K Roosa
One of the initial and most fundamental decisions for a new business owner is: What legal entity should I use for my new business (if any)? The purpose of this three-part series is to (i) explain the basic types of available business structures, (ii) compare and contrast the most commonly chosen structures, and (iii) discuss some of the legal steps required in order to actually form the most popular forms of doing business in Ohio.
1. Sole proprietor: This is the default form of doing business for individuals. Advantages: Simplicity; no paperwork and no expenses of setting up a corporation or limited liability company. All revenues and expenses show up on the individual owner's personal tax return. Disadvantages: A Sole Proprietor is personally responsible for all liabilities of the business, including those not covered by insurance. Take the example of John Smith Consulting. John owns and operates this business as a Sole Proprietor, which means that he is the business. There is no legal entity separate and apart from John. A customer who is unhappy with advice that John has given sues; John Smith Consulting; and obtains a judgment against John, personally. The customer uses the court's decision to obtain a lien against John's personal residence: he then forecloses on the lien and John's house is sold to satisfy the judgment.
2. General Partnership: John Smith Consulting now takes on two new consultants who are also co-owners of the business. Still, there is no separate legal entity. This is the default form of doing business for two or more individuals. Advantages; Simplicity; the only added paperwork is a partnership agreement that states how profits/losses are divided. All profits and losses are allocated among the partners and reported to the IRS on each partner's individual tax return. Disadvantages: Now, not only is each partner personally liable for his or her own conduct, each is also personally liable for the conduct of the other partners. In many ways, this is even worse than a Sole Proprietor, from a liability standpoint.
3. Corporation: John and his partners decide to form a corporation called John Smith Consulting, Incorporated. As a result, the owners now own shares in a separate legal entity that operates the business and is responsible for all liabilities of the business. Advantages: As long as the corporation is properly formed and maintained, the owners are not personally liable; instead, creditors claims can only be satisfied from the assets of the corporation itself. Also, because the owners have elected to be treated by the IRS as a Subchapter small business corporation, all profits and losses are allocated directly to the stockholders, and the corporation itself pays no income tax. Disadvantages: Specific set up tasks are required.
4. Limited Liability Company: John and his co-owners decide to form a separate legal entity known as a limited liability company LLC. Advantages: An LLC has the flexibility of a partnership to divide profits and losses between the partners (for instance, since John Smith contributed most of the & sweat equity to get the business going, he is entitled to a slightly larger piece of the pie). By contrast, corporations generally must divide profits based on the relative share ownership of each stockholder. Also, members of an LLC (that is what owners of an LLC are called) are insulated from personal liability for business-related activities, just like a corporation. Finally, all profits and losses are allocated directly to the members, and the LLC itself pays no income tax. Disadvantages: Specific set up tasks are required.
Stay tuned for Part II of this series.