How to Choose an Entity for Your New Business
by Laine Carver, Associate Attorney
After years of dreaming of starting your own business, you have finally decided to take the chance in search of a better life. That’s a big step in the right direction—however, there is still so much to figure out. Among these unknowns is the type of legal entity you should use to structure your business. You’ve done a little research and are aware of corporations, limited liability companies and even limited liability partnerships. However, determining the legal structure that is best for your budding business can be overwhelming, and it is an important decision. This brief article should give you a basic understanding of the different legal entities, but consulting an attorney will always be the best way to ensure you are starting your business on the right foot.
The simplest way to structure your new business is without a legal entity at all. This is what is called a sole proprietorship. A sole proprietorship is an arrangement that is very informal and consists of no organization. The business is the individual themselves. This poses a few legal problems.
First, there is absolutely no liability protection for the individual. For example, if you are an electrician operating as a sole proprietor, and you make a mistake that results in a house burning down, your entire net worth may be at risk in a lawsuit, including your house, vehicle, and retirement. Although you may have insurance, it may not cover all incidents and it may have a policy limit, leaving your personal assets exposed.
Second, sole proprietorships are more difficult to sell to a third party or pass down to your next generation. Because there is no legal entity, there is no business interest that can be sold, like stock or a partnership interest. Instead, there are simply the assets owned by the individual that can be purchased by a third party or passed to the next generation. This can be difficult to coordinate and market, reducing the value of the business. Furthermore, it could have negative tax implications.
For these reasons alone, most attorneys would not generally recommend that a person operate a business as a sole proprietorship.
Corporations, on the other hand, are their own legal entity, completely separate from the individual owners. Corporations are a structure in which the owners of the business own shares of the corporation. The corporation owns the business assets and conducts operations. The corporation income can then be paid out to the shareholders in the form of a dividend. The most commonly known characteristics of a corporation is its liability protection for shareholders and what is commonly known as double-taxation.
Since a corporation is its own legal entity, any claims against the corporation generally end at the corporation level, thus protecting the corporation’s shareholders. Of course, if there is some sort fraudulent action taken by a shareholder, liability could flow to that shareholder. However, in general, corporations protect the shareholders from any liability that may result from the business’s actions.
The major downside to most corporations is the what is commonly referred to as “double-taxation.” When a corporation earns net income, that income is taxed at the corporate level. The rate is currently 21%. However, as mentioned above, the owners of the company do not have access to the corporation’s earnings until the corporation pays the shareholders in a form of a dividend. This dividend is taxable to the shareholder at the shareholder’s personal tax rate. Thus, since the corporation’s income is taxed at the corporation level and the dividend is taxed at the shareholder level, the income is double-taxed. This is not always bad, and can be used to a shareholder’s advantage in certain situations. However, most of the time, double-taxation is best avoided.
Some types of corporations avoid taxation at the corporate level. These are corporations that are allowed to make an election under subchapter S of the Internal Revenue Code. There are many restrictions on so-called “S” corporations, including limitations on the number of shareholders, the types of shareholders, etc.
LIMITED LIABILITY COMPANIES
Limited liability companies (“LLCs”) are a relatively new form of legal entity. They offer liability protection for the owners (“members”), and they can be taxed as a pure “pass-through” entity in which the business itself pays no taxes—only the individual members do. Because of this, LLCs have become extremely popular in the past couple decades.
The liability protection for LLCs is generally regarded as being equal to that of corporations. However, to benefit from the liability protection of an LLC, the business must be structured correctly. The business should have its own bank account. There should be a process for transferring money in and out of the account. Employees should be paid using a payroll system and payroll taxes must be paid accordingly. So long as procedures are installed and followed, the members of the LLC should be completely safe from any liability incurred by the business itself.
The biggest benefit of an LLC is the ability for it to be taxed as a partnership under Subchapter K of the Internal Revenue Code. This allows for the LLC to be a pure pass-through entity in which the LLC itself will not incur income tax. Additionally, setting itself apart from S corporations that are mentioned above, there is much more flexibility in the types of members, the number of members, and different tax strategies that may be used in an LLC compared to the S corporation.
In summation, there are many factors to consider in choosing a business entity type. For that reason, it is better to seek the advice of legal counsel in making such an important determination. If you or someone you know is considering starting a business, feel free to contact our team at Russell Law Offices, S.C. to set up a consultation and help decide what entity is best for you.
What do you need to know about starting a business in Wisconsin?
by Justin Brewer, Associate Attorney
Starting a business is hard work! You may have an excellent product or idea for a future business, but creating and operating a business to capitalize on it takes significant planning. This article will give you a brief primer of the things you need to consider when forming a business, and the legal steps you need to take to make it official.
Before trying to create a legal entity for your business, or registering it with the State of Wisconsin, you need to put considerable thought into a business plan. First off you should pick a name, and a location to conduct your business. This may involve checking if your preferred name is already taken, and looking into areas you could establish a store front or office space. You should also conduct market research – who wants your product or service, how can you market it to them, and what are your competitors in the field?
Perhaps most important is creating a business plan. You should think about how you want to develop your product or service, how you want to sell and market it, and who will be a part of your business. You also need to know what your business’s financial requirements and burdens will be, and how much you need to sell in order to have a successful operation.
This is an incredibly important step – every entrepreneur needs a plan for growing their business and ensuring its long-term success and stability. Once you have a plan, you can begin to consider the legal business entities that are available to you, and how they match your needs.
What type of entity is right for you?
There are lots of different entity options for entrepreneurs. Depending on how direct you want your profits to be, or how much tax and other financial liabilities you want to expose yourself to, you should consider several options. One of the first questions is whether you want to incorporate your business or not.
Non-incorporated entities include sole proprietorships, and partnerships:
Sole Proprietorship – a sole proprietorship is an informal business entity that treats the business and its owner as one and the same. The profits of sole proprietorships go directly to the owner of the business. However, any liabilities for the business, financial or otherwise, also fall directly on the owner.
Partnerships – partnerships are like sole proprietorships, but with more business members. Generally, profits from the partnership are split directly by the partners, but like a sole proprietorship, the liabilities of the partnership are the responsibility of the partners. Wisconsin does allow limited liability partnerships (LLPs) in certain circumstances, which can help provide liability protections, while offering a partnership structure.
Non-incorporated entities like these provide maximum profit flow, and the simplest taxation structure – profits are taxed as personal income for the owner. However, the benefits of profit flow are balanced out by the direct exposure that owners have to legal and financial liabilities. They are a double-edged sword.
Incorporated entities include LLCs, and various types of corporations, statutory-closed corporations, and non-profit corporations:
Limited Liability Company (LLCs) – an LLC is an incorporated business entity, that has limited liability protections in place for the owners and managers of the LLC. LLCs are easy to maintain, and have good tax structures – company profits are passed through to the owners, and are taxed as personal income, which avoids double taxation. You can have an LLC be managed by the owners, or by a hired or elected management group.
Corporations – Full corporations are more complicated business entities. They can choose between S and C corporation status, which affects how the company and its owners are taxed. They require more filings with the state, and require more maintenance by the owners.
Incorporated entities are more closely regulated by state laws. LLCs are taxed only once, but some types of corporations can be taxed twice – once at the corporate level, and again at the personal income level. Corporations shield their owners from the financial and legal liabilities of the company, as long as the owners and managers don’t abuse the company for their own personal financial use.
The business structure you choose will depend on the unique characteristics of your business. For many small business owners, especially sole-owners, the LLC is a great option, but you should consult with a business lawyer to see what the best option is for your business.
What do you need to register?
Once you have picked a structure for your business, you need to take the appropriate steps to create and register the business. All businesses will need to name their business, choose a registered agent that will accept taxes and legal documents on behalf of the business, acquire an Employer Identification Number.
If you are creating a corporation, you also have to file articles of incorporation with the Department of Financial Institutions. Once you pay a filing fee, and submit the articles of incorporation and other basic business information, you have a registered business!
What else do you need to consider?
After registering your business, there are still several things to consider. Corporations and LLCs need to make annual filings with the State.
You should quickly create an operating agreement or corporate bylaws that will create guidelines for your partners, shareholders, and managers. Many small businesses register with the state, and then fail to create rules that govern their own corporations. Operating agreements, and bylaws create rules that govern how your business will function, and are the best way to deal with potential conflict between managers and owners before they happen. Attempting to resolve disputes without clear business rules can be expensive, and sometime fatal to the company.
Your business may need insurance, or special licenses. For example, bars are required to obtain liquor licenses among other things. Before you begin operating, make sure you have obtained all the proper licenses for business sector. You should also consider obtaining business banking and financial accounts, in order to keep a level of separation between you and your business, and to keep your business financials running smoothly.
If you have employees, you should consider compiling an employee handbook that establishes the rules your employees need to follow, and creates drug abuse and harassment policies. Properly managing your employees, and establishing protocols to manage employee conflicts will save your business money and headaches down the line.
Ultimately, starting a business is a complicated process, but with the right help, you can get your business off to a great start. If you want help forming a business, the experienced attorneys at Russell Law Offices, S.C. are here to help.