Establishing a Legal Identity

After you've established your business name, it's time to consider the legal identity of your business. You have several choices, depending upon the type of company you want, tax considerations, and the necessity of outside funding. We take a look at each one here so you can review their advantages and disadvantages as they apply to your particular business situation.

Basically, five legal types of businesses exist:

• Sole proprietorship

• Partnership

• Subchapter S corporation

• C corporation

• LLC corporation

Sole Proprietorship

If you're starting and running a business all by yourself, a sole proprietorship is one you might choose. The advantage of establishing a sole proprietorship is that it's inexpensive and simple. There are no papers to sign or file with the government. Legally, by just being in business, your company is considered a sole proprietorship.

The sole proprietorship is not a legal entity. It simply refers to a person who owns the business and is personally responsible for its debts. A sole proprietorship can operate under the name of its owner, or it can do business under a fictitious name, such as Bob's Auto Repair. The fictitious name is simply a trade name; it does not create a legal entity separate from the sole proprietor owner.

To be ready for business, a sole proprietor needs only register his or her name and secure local licenses. A distinct disadvantage, however, is that the owner of a sole proprietorship remains personally liable for all the business's debts. So, if a sole proprietor business runs into financial trouble, creditors can bring lawsuits against the business owner personally. If such suits are successful, the owner must pay the business debts with his or her own money, automobile, savings, and home.

Tip: Tax Consequences of Your Choice

Keep in mind that your company type has tax and financial and legal liability consequences. Choose the one that best fits your personal situation.

This book is in no way intended to provide or suggest legal or accounting advice, written or implied. Before you make any decisions regarding the type of corporation that is right for you, your type of business, and the state in which you operate, we strongly urge you to seek professional counsel.

Here's another thing to keep in mind. Whether or not you take the earnings out of the business for living expenses, you are personally taxed on the income. Of course, you can deduct your business expenses on your personal tax returns.

Partnership

Going it alone can be a scary endeavor. That's why many businesses are formed under a partnership. If you have a partner in your new business but don't want to incorporate, the partnership form of business might be the way to go. The advantage of a partnership is that it's simpler and less expensive to establish than setting up a corporation. You and your partner (or partners) retain personal liability for the actions of your business, and you are not shielded from a personal tax on the business earnings, although you can deduct your percentage of the business expenses.

Incorporation

The last form of business entity is the corporation, and it comes in three types:

• C corporation

• Subchapter S corporation

• LLC (limited liability corporation)

If personal liability and tax issues are of concern, then you should consider forming a corporation of some type. A corporation is considered a legal entity. In the vernacular of the field, a corporation creates a veil between you and the corporation that protects you personally from any of its legal activities. Notice the word legal: A corporation will not protect its members if the business performs an illegal act. If that happens, the members and/or executive team of the corporation can be sued or taken to courtand jailed. The recent ENRON, TYCO, and WorldCom debacles are a prime example. This is called piercing the corporate veil.

Let's look at the C corporation.

Forming a C corporation limits your personal liability for business debts, and the earnings of the corporation do not pass directly into your personal tax return. Being a legal entity, the C corporation pays salaries and taxes and deducts expenses like any other entity or "person." The shareholders pay personal income tax only on money that is paid to them as salary, bonuses, or dividends (income). But running a corporation is not cheap, and it takes work. Meetings must be held, minutes recorded, tax forms filed, and so on; it all takes time away from running your business. In addition, you must pay separate income taxes, both state and federal.

A lighter version of the C corporation is the Subchapter S corporation. The S corporation is a corporation and gives you the limited liability of a corporate shareholder. The difference is that as a corporate shareholder, you pay taxes in the same way a sole proprietor or a partner does.

Finally, there's the LLC (limited liability corporation).

Since the establishment of the LLC as an alternative C corporate entity, the S corporation has lost much of its appeal and has been replaced in most cases by the LLC.

The LLC is a combination of the best parts of a C corporation, a sole proprietorship, and a partnership. What makes it so desirable is that it includes limited personal liability, as with a C corporation, but, as with partnerships and sole proprietorships, the LLC is not a separate taxable entity. The tax situation for an LLC is the same as for a partnership or sole proprietorship: Business earnings and losses are reported on the owner's personal income tax return.

Web Resource: Learn More About Legal Entities

There is little space in this book to go further into the forms of legal entities for companies. The Nolo website (www.nolo.com) is a great resource for information on the different forms of business entities and how to form them.