The various options for legal structures for your business vary from country to country and can vary within a country; for example, in the U.S. there can be slight differences from one state to the next.
Liability Is Your First Big Issue
The first core question to think about is liability. If the business cannot pay its debts, including a judgment against it in a potential lawsuit, are you as the owner and other investors, if there are any, willing to be responsible for all of its obligations? If you do not have a legal structure that shields you and other investors from the obligations of the company, then you and the other investors will be liable for any unpaid obligations.
So, for example, if you run your business by yourself without any legal entity, you are essentially running it as what is called a sole proprietorship and you have total responsibility for any unpaid debts of the company. Basically, any of the company’s debts are your debts.
Similarly, if your business is a simple partnership, then you and your partners are totally responsible for any unpaid debts of the company. Furthermore, you need to be aware that each partner individually may be held liable for the total obligation of the company. For example, if you enter business with a partner and your partner goes bankrupt and then your partnership also runs out of money and gets hit with a lawsuit, then you could personally be held responsible for the entire amount.
The traditional alternative to avoid personal liability is to form a corporation. Except in extreme circumstances, all investors, including the founding entrepreneur, would not have any personal liability for the company’s debts. Of course, if you agree to personally guarantee a bank loan or a credit line to a supplier, then you would still be responsible for this debt even if the corporation goes bust.
Another key element in selecting the form of corporation is cost. Setting up and maintaining a corporation does involve some modest costs.
Still another major element is tax consequences. With a traditional corporation, the corporation has to pay taxes on all of its profits. But if a corporation distributes any of its profits to shareholders, then the shareholders most also pay taxes on this distribution. So, a traditional corporation pays taxes on its profits as a corporation, and then when the corporation distributes any profits to shareholders, the shareholders must pay personal taxes on this distribution.
In the U.S., you can get around this most typically by forming a so-called S corporation, which gives you the legal protection of a corporation but allows you to pay taxes like an individual without the double taxation.
Over the last few years, a roughly similar entity, a limited liability company, or LLC, has been allowed in all states, which serves essentially the same purpose.
In addition, there are many different types of partnerships, some of which limit the liability of investors.
My basic advice to you is to spend a couple of bucks with your attorney and your tax accountant and carefully explore the ramifications of your selection of corporate structure. It is possible to change corporate structure—I have done it several times—but it is a mess, it is expensive, and in the U.S. the IRS has rules about how often and under what circumstances changes may be made.
That being said, for a very tiny home business with very little liability risk, I might just form a sole proprietorship, or a partnership if there is more than one investor, even though these options do not limit personal liability. Beyond a very tiny business, I would tend to form an LLC.
Takeaways You Can Use
- A sole proprietorship leaves you without any protection from the company’s debts.
- A partnership could leave you on the hook for not 50 percent but 100 percent of the company’s debts.
- For many small businesses with little liability, a sole proprietorship or partnership is fine.
- Beyond a very tiny business, first consider an LLC.