Legal Entities

Chapter 4: Starting a Business - Page 4.6

The Business Entity

The pros and cons of different business formations are worth understanding. They vary by state — this is not a good area for guesswork, and not a good place to save money — so please go through this with an attorney you can trust. The following is for background information.

Although the details vary, it starts with the choice between sole proprietorship, partnership, corporation, or the more trendy Limited Liability Company, LLC. Within the corporation classification you have some additional choices, between the standard C corporation or the small business S corporation.

Sole Proprietorship

Simply put, your business is a sole proprietorship if you don't create a separate legal entity for it. This is true whether you operate it in your own name, or under a trade name. If it isn't your own name, then you register a company name as a "Fictitious business name," also called a DBA ("Doing Business As"). Depending on your state, you can usually obtain this through the county government. The cost is no more than a small registration fee plus a required newspaper ad, for a total of less than $100 in most states.

The main disadvantage of the sole proprietorship is the lack of a separate entity, which means you have personal responsibility for it. If the business fails, then its creditors can go after your personal assets.

Tax treatment is quite simple; your profit and loss goes straight through to your personal taxes. Your business income is normally on Schedule C of your tax return. This can be good or bad for your tax situation, depending on where you stand with other income.

Partnerships

Partnerships are harder to describe because they change so much. They are governed by state laws, but a Uniform Partnership Act has become the law in most states. That act, however, mostly sets the specific partnership agreement as the real legal core of the partnership, so the legal details can vary widely. Usually the income or loss from partnerships passes through to the partners, without any partnership tax.

The agreements can define different levels of risk, which is why you'll read about some partnerships that have general partners and limited partners, with different levels of risk for each. The agreement should also define:

What happens if a partner withdraws
Buy and sell arrangements for partners
Liquidation arrangements, should that becomes necessary

If you think a partnership might work for your business, make sure you do this right. Find an attorney with experience in partnerships, and check for references of present and past clients. This is a complicated area and a mistake in the agreement can cause a lot of problems.

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