Once every year or two I think it’s important to rethink what kind of financial entity your business should be. There are four basic options: sole proprietorship, partnership, corporation, and limited liability company, or LLC, which is a relatively new option. In this post, I’m going to touch on some of the basic advantages and disadvantages of each, which fall into three general categories:
- Personal security
- Hassle factor
Choosing the right business structure is obviously a complicated matter that will ultimately involve your lawyer and (most likely) an outside accountant who specializes in these matters. Today my goal is simply to get you started thinking about the issue. (And if you’re an accountant or lawyer yourself, please don’t cringe as I oversimplify concepts that could be the topic of a long book.)
In my view, sole proprietorships and partnerships are two different versions of the same idea. As a sole proprietor, you basically subtract your expenses from your revenue and pay taxes on the remainder. You are personally responsible for all the debts your business incurs, and if you can’t pay a debt, the creditor can come after your house, your car, your wages, if you get a job, and so on. The main advantage of this form of business is that the record keeping is simple.
A partnership isn’t much different, except there is a formal agreement about what percentage of the business’s assets is owned by each partner. When it comes to debts, the partners are typically “jointly and severally” responsible. This means that you can be held 100 percent responsible for business debts if your partners are not in the picture or simply unable to pay.
The fact that you can lose a boatload of money as a sole proprietor or partner because of a poor business decision or simple bad luck is what makes incorporation so attractive. The so-called corporate veil protects you from creditors if your business fails. Creditors can confiscate and sell tangible business assets, cash that’s in the business’s accounts, and so on, but they can’t touch your personal assets.
Corporations come in two flavors: S corps and C corps. In an S corp, profits pass through to the stockholder level (typically the same people who would be the partners in a partnership), and those individuals pay taxes at whatever their individual rate might be. In a C corp, profits are taxed at an “entity” level, that is, the corporation itself has to pay taxes. In addition, money that you and other owners receive is also taxed. This “double taxation” is seen as a major drawback by many. In a way, it can be seen as the price for security. The other price you have to pay is the hassle involved in corporate paperwork, which is substantial. I’ll talk more about this, and the LLC option, in my next post.