When you choose to open a business or have an idea that you want to execute, you have to consider forming a legal entity for the sake of that business. There are different types of legal entities. Each one has its regulations, concepts, and specifications. The truth is all of them are good and should be considered as an option, but here the question raised is:
Which legal entity should I choose, or is it best for me?
The answer is it depends. It depends on your choice and your goal.
The different types of legal entities are the following:
- Sole proprietorship:
In this kind of entity, the company’s name consists of your name. There is no legal separation between your assets and the company’s. All payables due to the company are paid from your expenses.
This type of company has a lot of disadvantages since it is not separated from your assets. In other words, if your company is not doing well and therefore indebted, you will be personally responsible and liable for the debt. In this case, the creditor can call you on all your assets, not just the company’s, since your company is part of your assets. It does not have an independent legal structure.
If you decide to bring in a partner, you will have to sign a partnership agreement, which goal is to govern their relationship. In a partnership, all management duties, expenses, liabilities, and profits are shared between them. Partnerships don’t have to pay business tax. Instead, they should file a tax return to report the losses and profits to the Internal Revenue Service (IRS).
In a general partnership, all partners are responsible and liable in their assets to cover the company’s debts. If the company has obligations and can’t fulfill them. In that case, the partners are personally responsible for fulfilling the company’s obligations, so their assets can be taken from them to pay the company’s debts.
- Limited Partnership:
In the case of a limited partnership, you will still have general partners that will be personally responsible and liable for the company’s obligations. Still, investors can purchase a limited partnership interest.
The obligations and the position of a limited partner (LP) differ from general partners’ obligations. LPs are only responsible for the scope of their investment. The worst thing that can happen to them is to lose the amount they invested. After all, their partnership is limited, and therefore, their liability is limited to their investment.
You can’t have a limited partnership without at least one general partner since general partners are the only ones responsible for the company’s management.
- Limited Liability Company (LLC):
This type of company offers you a legal shield, and your assets are separated from the company’s. It is an independent legal structure. In an LLC, each member’s liability is limited to the amount he/she has contributed to the company. There is no specific limit or restriction on the number of members in an LLC and no obligation to have annual meetings or record minutes.
The main advantage of this legal entity is that if the company is incapable of fulfilling its duties, the members won’t be responsible for their assets but only in the scope of their contribution to the company.
- C Corporation (C corp):
There is a separation between your assets and the company’s tax, profits, and debts in this type of legal entity. It limits the investors’ and owners’ liability since the worst thing that can happen is the loss of their invested amount. It is considered a good structure for Venture Capital (VC) to invest in. A-C corp has several obligations to do such as having annual meetings, hold record minutes, keep a record of the votes, name of directors and shareholders, etc.
The corporation has to pay a corporate tax on earnings before distributing the remaining amount to the shareholders in the form of dividends. Then the shareholders have to pay a tax on the dividends they receive. This creates a double taxation situation, which may be considered as a disadvantage.
- S Corporation (S Subchapter):
This corporation does not pay tax on the entity level. Shareholders report income, losses on the individual tax returns and pay taxes on the ordinary tax rate. This corporation may pass the income directly to the shareholders and avoid double taxation. If dividends exceed a shareholder’s stock basis, the excess is taxed as capital gains.
This type of corporation limits the number of shareholders to 100. It must consist of only individuals, specific trusts and estates, or certain tax-exempted organizations. Corporations, Partnerships, and nonresident aliens cannot be part of an S corporation as shareholders.
This is an excellent option for you if you are fine limiting the number of shareholders and needing liability protection. An S corporation separates your assets from your company’s debts and offers some tax benefits to the shareholders.