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Five Legal Considerations for Starting a Small Business: Which Type of Entity is Best?

You started your small business yourself – just you and an idea. As time went on, you became more successful. You added employees. You opened a storefront. You started contracting with outside vendors. And while each of these events took place, you added additional liability – liability that could harm you personally as a sole proprietor. That’s exactly why business entities exist; they create a sustainable structure in which to operate while simultaneously shielding you personally from liability, for the most part. Not all business entities are created equal, however, and choosing an entity to organize or incorporate can come with both benefits and consequences.

Double taxation? Self-employment tax? Help!

Tax structure represents one of the primary differences between business entities, and is an important consideration to start off right. There are generally two types of taxation of business entities: taxation at both the entity level and the personal level, and “passthrough” taxation only at the personal level. Standard C corporations are subject to the double tax of both entity and personal taxation, while Limited Liability Companies (“LLCs”), partnerships and S corporations receive passthrough taxation, where the individual with an interest in the entity is taxed personally. There are disadvantages to this latter form of taxation, however, in that members of the LLC might also have to pay self-employment tax if they contribute significant services to the LLC. LLCs also can elect different tax treatment, giving them a serious advantage.

Personal liability vs. small business liability

How much of your personal assets are you willing to risk on this business? LLCs and C and S corporations provide strong protection from personal liability (known as “piercing the veil”). Partnerships, on the other hand, retain personal liability for all partnership debts. Limited partnerships allow a differentiation between general partners who are personally liable for all debts, and limited partners who are only personally liable for partnership debts to the extent of his or her stake in the partnership. Sole proprietorships retain all personal liability for business debts.

Transferring business ownership can be tricky

Changing and transferring ownership is a relatively simple task in a C or S corporation, since ownership is based on shares owned and these merely need to be sold. Partnerships, however, must be terminated to change ownership, and sole proprietorships must be sold outright. LLCs are somewhere in the middle, as membership in the LLC is determined largely through the terms of the operating agreement. Still, ownership interests in an LLC are not as simple to trade out as they are in a C or S corporation.

C corps aren’t simple

A C corporation adheres to rigid and timely formalities, such as annual meetings and annual reports. Failure to perform these administrative tasks may result in dissolution of the corporation, so strict adherence to these tasks is necessary, even if burdensome. LLCs, on the other hand, require very little in the way of formality for continued operation, although there is some structure.

Acquiring capital for your small business

LLCs can become unwieldy with too many members/investors, which is why traditional C corporations are generally a better fit. The structure of an LLC can scare off a lot of potential investors as well, with limitations on liquidity and stock issuance. A C corporation is a more tried-and-true investment vehicle for acquiring capital.

No matter which form you choose, there will be benefits and drawbacks to your business. The best practice is to sit down with a professional who can guide you through the analysis and create an entity that best fits your goals for your business going forward.

Robert T. Watson is a Member of McBrayer law. Mr. Watson focuses his practice in the areas of civil litigation, insurance law and corporate law and enjoys supporting businesses of all sizes from the firm's Louisville office. Contact Mr. Watson at rwatson@mcbrayerfirm.com or (502) 327-5400, ext. 2302,  or reach out to any of the attorneys at McBrayer. We take a team approach to deliver effective counsel to all our clients, so other attorneys in the firm may perform these services as well.

This article does not constitute legal advice.

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