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Mauve Morpho Business and Actionstep Consulting

Choosing a Legal Entity for your Business

By Nic Perry, last updated August 16, 2021

What is a legal entity?

When you have a business, whether you know it or not, you are always operating as an entity. The entity is what people are contracting with and what they will sue if anything goes wrong. Which entity you have determines how you are taxed, how you can be sued, and what you have at risk, as well as more advanced features like having partners, shareholders, and other investors.

If you are already doing business and haven't set up anything with your state, you are operating as a Sole Proprietor, but is that what you want?

Entity side note: These are the basic entity types, but different states have different other options and special categories. Talking to Mauve Morpho or a CPA is a great way to make sure you are looking at the right entity type for your business and don't miss special options in your state like a Professional Corporation.

Sole Proprietor - Single personal entity

In a Sole Proprietorship, you are doing business as yourself. Even if you say you have a business name or have a "Doing Business as" (DBA), at the end of the day, your business is just you. All contracts are with you personally, your taxes are your personal taxes, and you are personally on the hook for any and all issues/lawsuits against your business. In theory, if you make a big enough mistake, you could lose everything, including personal assets like your house. On the plus side, this is by far the easiest business to set up and run. For most people, I do not suggest this method because of the risk.

If you are doing something very low risk though, especially at small scale, it might be fine for you. For instance, if all you do is sell plants at a farmer's market, mow lawns, or give walking tours of a museum, your risk is pretty low. Even if a disgruntled client were to sue you, it's unlikely they would be suing you for anything more than small claims court for some new grass or a couple replacement plants. Think about the absolute worst thing that could happen and how expensive of a problem that could be, including emotional damage (If I was a dog walker for mixed breed dogs only the $ value might be low, but the emotional value could still be really expensive). If that worst case is more expensive then you would be willing to pay or have your insurance cover, then you should probably look for something with some liability protection.

Parternship - Plural personal entity

A partnership is almost the same as a sole proprietorship, except for more than one person owning and running the business. A partnership needs some sort of partnership agreement to clarify how much of the business each of you owns, but at the end of the day, it's nearly the same as a sole proprietorship, just with another person to share the burden of any losses.

Since it's so similar, look at the same criteria around risk from the Sole Proprietor section - if the maximum you could see someone suing for is more than the two of you are willing to cover, then you should look for something with liability protection.

Limited Liability Company - LLC - single or plural separate entity

A LLC is a completely separate legal entity. Mauve Morpho LLC is a legal entity. If properly set up and maintained, an LLC protects your personal assets and is very flexible in how exactly it is set up and taxed. Because of this, for most businesses, some variety of LLC is an excellent choice. There is an annual filing in most states, but it's usually very straightforward at the most basic.

Single Member vs Multi-Member

The owners of an LLC are "Members" you can create an LLC by yourself which would be a single-member, or with a few friends as a multi-member. Either way you will create an operating agreement that makes it clear what assets now belong to the LLC and how profits, losses, and disagreements will be handled. Assuming you follow all the guidelines for an LLC and don't do anything grossly negligent where a court decides to waive your protections, the most you are able to lose with an LLC is whatever the operating agreement says the LLC owns.

Taxed as:

LLCs can be taxed at least 3 ways. A single member LLC can be taxed as a sole proprietorship, meaning all the taxes are just part of your personal taxes, even though you still get liability protection. If you have multiple members it can be taxed as a partnership, which will have a basic tax form for the partnership, but effectively be the same for each of you as a sole proprietorship. The third way is the unique one: an LLC can choose to be taxed as an S-Corporation. This is still a "Pass-through" meaning the owners still pay taxes on every dollar of income, but with an S-corp, you can pay yourself a reasonable salary during the year, and any extra profit can be categorized as investment income, which is usually taxed at a lower rate for most taxpayers. If your business barely makes enough to pay you a reasonable wage, then it probably isn't worth it, but if you have quite a bit of extra income, you might be able to save quite a bit being taxed as an S-Corp.

Corporation

A corporation is legally considered it's own person, it files taxes completely separate from the owners. If you have a corporation, you can pay yourself as an employee and take dividends on the profits. The most important part of a corporation is the ability to raise money through selling stock, which is selling portions of your company to others to share in the dividends. Long term, corporations can also "go public" and have their shares listed with one of the stock market exchanges. A corporation is an excellent choice if you plan to leave most or all profits with the company for growth, plan to raise money from investors, or want to be able to easily sell a portion of your company later. All of these cases are going to work better with bigger scale companies, it's not very likely that a house painting business is going to be able to see many of the benefits of a corporation, but it is much more likely if you create a product, whether that is physical, digital, or a software.

Non-Profit

When you hear non-profit, you might think "No profit" but that isn't exactly accurate. Non-profits are run by a board, you will not "own" your company, but a non-profit can still pay you well as an employee or board member. If your company is out to help, and not something you expect to ever make you rich, a non-profit can be a great option that makes your company more likely to receive grants and able to receive tax deductible donations. A few examples of businesses that would be a good fit are businesses that train or educate, but lots of other businesses could still be set up this way. I've thought about opening a rock gym as a non-profit, hopefully structured in a way to make annual passes tax deductible, since it wouldn't be my primary business and is unlikely to be all that profitable, it's a great fit. A 501c3 is the usual non-profit designation to be able to receive tax deductible donations, so you can look into that and see if it feels like a good fit.

Public Benefit Corporation

NOT ALL STATES HAVE THIS OPTION, over half do, but details vary in the states that do.

If you are interested in a corporation, and your company is or will be providing something that benefits the world or your community, like recycling, healthcare, or even just contributing to your community in a meaningful way, a benefit corporation might give you some extra tax breaks to thank you for helping without limiting your profit potential. Some BCs don't provide a benefit with their normal business activities, but earmark a substantial portion of their profits to helping public causes. This could also just be an important signal to you, that your company is out to do better than others and help the community rather than just profit off of it.

Changing your entity

Obviously there is a lot to consider, and while this is a very important choice, you can change your form later if your business changes enough to change the best choice. Usually changing your company type will involve creating a new entity, "selling" everything to it from the old one, and closing your old entity, the biggest exceptions are when you move out of being a sole proprietor (since the company is just you personally) and electing S-corporation as an LLC (you can't change back and forth too frequently, but you can change, because you aren't changing the entity itself, just how the government taxes it.

Need help picking your entity type?

Obviously there is quite a bit to consider, you may have read through this list and felt like the answer was obvious, but it is more likely that you are still a little unsure. If you are, schedule a call, we can talk about the particulars of your business and variables that could change which entity works best for you.

Need some help?

Set up a call so we can talk about your business.


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