Choosing Your New Venture Legal Entity

In the first post of the series The Ultimate Checklist for Entrepreneurs, Innovators and Micro-enterprises the importance of doing good market research was discussed. The next step is to determine the type of business you want to be and then set up the correct legal entity to begin new business operations. Do this before you set up bank accounts or begin public operations even if you plan on being a home based business.

Which Path Will Your Micro-Enterprise Take

Which Path Will Your Micro-Enterprise Take

Setting up a Your New Venture – Pre-Legal Entity Selection Questions

By now you have done a fair amount of market research and have determined the method in which your new venture marketing plans will be carried out. With this information, now you need to determine what type of business that you want to have. Not everyone wants to be a corporate mogul or is seeking part-time income. In fact, many serial entrepreneurs enjoy setting up a company and then moving on to the next idea. Obviously, there are many questions that need to be asked, the key is to determine what is best for you. To help determine what is best for you answer the following questions first:

What Type of Business Do You Want to Have

  • Are you looking to create a lifestyle business? These are usually micro-enterprises or home based businesses designed to either enhance income or create a new venture that can support
    a particular lifestyle choice. Examples include, home and web based businesses, manufacturer/import-export of promotional items, new technology consulting and small professional
    practices. New ventures that are a lifestyle choice are normally a Sole Proprietor, Partnership or Sub-chapter S corporation.
  • Are you wanting to create a new business that you can pass on to family members when you retire? Each State has different laws for inheritance and estate planning. Make sure you
    speak with a qualified attorney first. For example, if you are an older entrepreneur and are looking to create something to pass along to family, then a sole proprietor may be not be the
    best way.
  • Do you enjoy working with people or want to have employees? Some entrepreneurs are not comfortable managing employees. The ability to work and manage people is a skill which should be taken into consideration.
  • What is your personal tax situation? Will extra income put you in a new tax undesirable tax bracket? Each type of business entity handles income and taxes differently.
  • Where is your personal risk level and personal debt level at? The different legal entities handle personal liability issues differently. You will always want to consult a qualified accountant first to make sure where you stand on divorce, personal debt, and the risk associated with your business idea.
  • How much on start up money do you have or are getting from outside sources? For example, new and disruptive technology ventures are often funded with the knowledge that the
    innovation or Intellectual Property (IP) will be brought to market by a team of competent professionals. This automatically rules out a Sole Proprietorship as investors will seek a return on their investment as well as an equity stake in the company.

Setting up Your New Venture – Choosing a Legal Entity

Once you have determined how your new venture is going to be run it is time to select a legal form of conducting business. Establishing a legal business entity is generally required by most
states in order to obtain licenses, collection of sales tax etc. Filing for a Legal Entity is required by the Government if you are going to withhold and pay payroll taxes or participate in certain government sponsored programs. There are three major categories of legal entities listed below and some have multiple variations, they are as follows;

Type of Legal Entities

  • Sole Proprietorship: A one owner micro-enterprise. You may have or use contractors or outsource work but there are NO employees. State laws differ but you may be required to register a fictitious name with the State. For example, you may be the sole proprietor but call your business AAA Cleaning services. You would register the name AAA Cleaning services with whatever local or State agencies that require this where you live.

    A Sole Proprietorship is the easiest to set up and can be changed to a partnership or corporation at a later point in time if needed. A Sole Proprietorship offers the least amount of protection from personal liability if you are sued or have unpaid debts. To be clear on this, if you are sued and lose, it is possible and probable that creditors will take your personal assets to cover the debt.

    There are no annual returns but individuals are required to file a Schedule C with their Federal income tax returns. Sole Proprietorships are common for lifestyle choice businesses or companies with no employees and low risk products and services.

  • Partnership: A Partnership is when a business has two or more owners. Profits and losses flow directly to partners and are taxed via personal income tax returns. Partnerships come in several forms such as a General Partnership, Limited Partnership, Joint Venture and Limited Liability partnership. Partnerships are similar to a Sole Proprietor in that all owners are liable for debts and liabilities. The different types of partnerships are all various configurations of the way profits, debts and liability are distributed among the partners. Two of the most common are:
  • Limited Partnership – General Partners have unlimited liability but passive investors that do not participate are liable only for the extent of their investment. This is a common arrangement for silent investors.
  • Limited Liability Partnership – Often used for managing Professional Practices such as Attorneys or Accountants. Generally speaking, partners have unlimited liability for their own actions but not for the actions of other partners depending on their investment in the company.

Partnerships should always be in writing and specify the terms of the agreement, reasons for termination of partnership, who makes what decisions, specific responsibilities, how new partners are added or subtracted and so on. A bad agreement will have many unwanted surprises. Always have a qualified experienced attorney draft the agreement.

  • Corporation: A corporation is a company that has a legal existence separate that is distinct from its owners. A corporation can act like an individual in that it can buy, sell or enter into contracts as well as incur liability. Individuals have far less liability exposure that in a Partnership or Sole Proprietorship and a corporation provides the best vehicle for transferring ownership at a given point in time. Two common types of corporation are:
    • S Corporation – Characterized by having fewer owners than a full blown corporation, income is reported by owners on their personal tax returns, but personal liability is less that a Sole Proprietor or Partnership for company debts. Filing for a S corporation is generally not difficult or expensive. There are annual returns required for S Corporations.
    • C Corporation – The most common form of corporation offering the most protection for owners (now called shareholders). Corporations file their own tax returns and can be subject to government regulations such as Sarbanes-Oxley, SEC trade rules, and so on. Owners are effectively taxed twice, once at the corporate level (Corporate Tax Returns) and then again of income at the personal level. Larger Start ups often start as a C-Corporation because of the intricacies of issuing stocks and raising capital.

    Filing for a legal entity can be done by yourself and there are several free resources that can help you such as SBDC or SCORE. However, if you are unsure of which legal entity to choose, it is best to consult with a qualified Attorney or Accountant that can provide legal or tax advice respectively.

    We hope that you have found this informative and our next article in this series will be about Why it is important to choose the right name for your company, domain and social media profiles. If you liked this article you may also enjoy reading: