This Web Business IV: Business Entity Options

Back when times were simpler and lawyers weren’t as abundant, all you really needed to do to go into business was to hang a sign outside your shop and tell the world that you were open.  Then, when you finally decided to shut the doors for good, you simply didn’t come to work.  There was very little distinction between the entrepreneur and his business.

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Times, tax laws, and legal precedents have changed, and people going into business for themselves in the 21st century have also had to change how they go about creating a business entity.  Simply hanging the sign outside your door today will probably result in exposure to taxes and legal liability that
shouldn’t apply to you.  To select the business entity that best suits your need, new entrepreneurs should first consider what is most important to them.

  1. Cost: Cost not only refers to the cost of creating your business entity, but also the cost of maintaining it. In some cases, there are annual fees you must pay to the state so they will continue recognizing you as a business and not just someone illegally collecting money.  Other fees may also be required
    depending on state requirements.
  2. Maintenance: This refers to how much work needs to go into maintaining your business.  Some entities don’t require maintenance once they have been established. Others require serious record-keeping effort in order to comply with state regulations.
  3. Tax Liability: Some business entities will allow you to save money on your income taxes by passing the income directly to the owner.  This way, the owner avoids his money being taxed twice (once when paid to the company and once when paid to the owner through a paycheck or dividend.)
  4. Legal Liability: Some business entities protect their owners from personal liability when a client has a claim against the business.
  5. Ownership: Different entities have different rules for how many owners it can have.  This is important to think about if there is a possibility of
    going public at some point.

Business Entity Types#section1

Today, there are several business entity options available for entrepreneurs.  Like anything else, each of them has advantages and drawbacks.

Sole Proprietorship #section2

A sole proprietorship is a business entity that is virtually indistinguishable from its owner.  The cost to create it is frequently only a small one-time fee to the state or county officials to register a fictitious business name and the cost of placing an ad in your local paper to notify the public that you are doing business under that name (i.e., Joe Public is now doing business as “Joe’s Coding Shack”). You may also need a state, county, or city business license, so check withyour local authorities to ensure compliance.

A sole proprietorship has few recurring costs. Since the business and the individual are identical, there is no special maintenance required to keep the business alive, so there should be few recurring costs beyond any state business license fees and fees to maintain your fictitious business name.  As long as you continue to call yourself a business, you are one.

There is a price for this easy set-up, though.  Sole proprietorships cannot take advantage of special business income tax rates since all income is considered individual income.  Sole proprietors are also not protected from personal liability if they get into trouble with a client.  If an upset client decides to sue, they sue the proprietor personally.  If the proprietor must declare his company bankrupt, he files for bankruptcy personally.  And, by definition, a sole proprietorship can have only one owner, and that owner must be a “natural person” (i.e., not a corporation, trust, LLC, or other such entity.) Finally, a sole proprietorship cannot be sold or passed to one’s inheritors.

General Partnership#section3

General partnerships are formed by two or more legal entities (any kind of legal entity can be partner), and each of those entities are individually responsible for the partnership.  This means that each partner is personally liable for the partnership’s debts and legal liabilities.  If one rogue partner makes an enemy of a third party, all partners will come under fire.

For tax purposes, all partners are considered self-employed and claim their share of the partnership’s income on their individual tax returns (the partnership itself pays no taxes).  General partnerships are relatively easy and inexpensive to create and maintain, although the state where the partnership is established usually requires annual renewal filings and fees.  A partnership agreement usually accompanies the formation of a general partnership, though it is not legally required.  Partnership agreements generally cover topics like transferability, duration, and management control.

Limited Partnership#section4

A limited partnership is much like a general partnership in structure.  The main difference is that in a limited partnership, there are two different kinds of partners: general and limited.  A limited partner does not take part in the management of the partnership and is not liable for any more than his individual capital investment.  This distinction is made to encourage investors to become limited partners and so they can share in the profits but not lose more than their own contribution.

“C” Corporation#section5

A “C” corporation is a standard state-formed corporation.  It is a legal entity once it is formed, so it files its own taxes and is responsible for its own dealings.  A “C” corporation can have unlimited numbers of shareholders, and those shareholders can be any kind of legal entity.

Corporations are the most expensive kind of business to begin and maintain.  Not only do they require significant annual filing fees (which, in some states, can add up to several hundred dollars per year,) but they require a good deal of effort on the part of the director(s) to maintain.  A board of directors must be elected, annual meetings must be held, minutes of corporate meetings must be kept, stock must be issued.  And all this applies even if you are the only shareholder in the corporation.  If these formalities aren’t followed, you run the risk of losing your personal liability protection if a court decides that your corporation was just an alter ego of yourself created to keep you safe (sometimes referred to as “piercing the corporate veil”).

Additionally, since corporations are taxed on their income and shareholders have to claim dividends as taxable income themselves, shareholders of a “C” corporation are “double taxed” on their dividend income.  One way to avoid this is to not issue dividends and simply re-invest your income back in the company.  Spending your income on items that are tax-deductible is another way.  You could also look into forming an “S” corporation.

“S” Corporation#section6

An “S” corporation is much like a “C” corporation in that it is also its own legal entity, protects its shareholders from legal liability, and requires a significant amount of effort and money to start and maintain.  However, an “S” corporation allows shareholders to claim their share of the corporation’s income directly on their personal tax return.  This gets around the “double taxation” problem of a “C” corporation.  The only drawbacks of an “S” corporation are that they may cost a little more to form and they are generally limited to a maximum of 75 shareholders.  This makes going public with an “S” corporation practically impossible.  However, if your intention is to keep your business relatively small, this is an excellent option.

Limited Liability Company#section7

A limited liability company (LLC) is essentially a hybrid of a corporation and a partnership.  An LLC provides the same kind of tax and liability benefits as a corporation, but has the same management structure as a partnership. In the past, LLCs have had more restrictions on them than corporations.  For example, at least two people were needed to form an LLC and an LLC’s duration was specifically limited.  However, in the last few years, states have started loosening these restrictions.

Forming an LLC is about as complicated as forming a corporation.  The LLC comes into existence when the Articles of Organization are submitted to the state (and the appropriate fee is paid.)  The LLC members must also have an Operating Agreement, but it is not necessary to file it with the state.  In fact, in most states, it can be verbal.

It’s as easy as one, two, three#section8

Regardless of the entity you choose, the steps to forming it are essentially the same:

  1. Decide which state you want to form your company in. Some states are more business-friendly than others. You’ll need to either be physically present in the state you choose, or hire a registered agent who is.
  2. Choose a name for your company.  You’ll need to pick something that isn’t already taken in the state you have chosen.  The attached Excel workbook has links to every state’s Secretary of State website, most of which have online name-search abilities.  It’s probably a good idea to also check with the Patent and Trademark Office to make sure that your company name doesn’t infringe on someone else’s trademarked catchphrase.
  3. Follow the instructions for your state to form your company!

Congratulations, you’re in business.  Reward yourself and purchase that sign to hang outside your shop now.

And after you spend the money on your sign, you’ll need to record that expense somewhere.  Which is why we’re going to discuss accounting software next time.

17 Reader Comments

  1. I have a pipe dream about going freelance, or even setting up my own teeny tiny web business, so I was very pleased to read this article (and rediscover the earlier ones in the series). It’s nice to see that A List Apart keeps covering all bases relevant to the webnik.

    While I appreciate that A List Apart is “made in America” and the majority of its audience probably hails from that nation, however, I was wondering whether anyone can suggest sources of similar business-type knowledge for non-US websters. Hint: I’m British, so any UK info will be much appreciated.

  2. Dear,
    My name is Honza Seifert. I am from Czech republic. I have a company and make web sides in Czech. My intention is find company in America who are interested us to making web sides for them. We produce really quality graphics art for much lower money than amerivan makers can offer. If you are interested about our graphics art or web sides,please contact me .The best regards J. Seifert

  3. I was a bit annoyed by the US-centric approach of this article. i have no problem with reading an article about how to set up a business in the US, but the fact that the author never even mentions he’s talking about a specific country, and just assumes whoever reads it will be from the US is taking a very narrow view of the readership, in my opinion.

  4. Hey Kemie,

    While I agree with what you are saying, it’s a little unfair. The majority here are Americans, and also that information is gonna be quite a bit different depending on which country you’re in. An American viewpoint was the right choice because it’s (more than likely) what he knew, what most others wanted, and what made the most since from where he was sitting.

  5. I understand your point. The reason I don’t explain these things more thoroughly comes from a history of writing bad fiction in college. Everytime I would write a story for a class, there would invariably be areas circled in thick red marker with the letters “SDT” written next to them. SDT stands for “Show, don’t tell.” I would be explaining, for example, how a person in my story is a really bad guy and worthy of the reader’s hatred. But my professor wanted me to have the reader come to that conclusion on their own by demonstrating my character’s evilness through actions. So I got used to explaining less. In my mind, you should understand that the article is meant for US businesses because that’s all I discuss.

    Sorry ’bout that. I will be more explicit in describing who future articles are meant for. I certainly didn’t mean to annoy or offend anyone.

    For the record, all of my articles dealing with law are only useful in the United States. The finance stuff you can probably use in any country.

  6. Not meaning to sound too righteous about an article that on the whole was a good read… but:

    Just as a good web site should cater for browsers other than what “most” and the “majority” use, so too should a good web article cater for more than just US readers.

    Besides, never make assumptions about your users including that of their origins.

  7. When speaking on a topic (or multiple topics as in this article) it is important to state the good and the bad, and not just the bad, which is what I saw when Scott spoke about some of these entities and business structures. All of the listed business structures are used at different times, and can be used in conjunction to create great legal protection, as well as unbelievable tax advantages.

    For instance, You can split your services into multiple LLC companies (ie. Hosting, Web Design, Print, etc.) and have a corporation hold all of them. So, your corporation needs a website… Have your Web Design company create it and manage it. Need brochures? No Prob. You own a Graphic Design Company that deals in print. So basically, you just spent $3,000 on a Web Site and some brochures, and your money (that is, your companies money) just went from one bank account to another. So What… So you didn’t really spend any money and you get to write-off $3,000 dollars!

    Also, by creating multiple entities, you create businesses that are more specialized, you can sub any work that you get through one company to another, and most importantly, you generate more exposure by creating seperate entities.

    Listen, bottom line is this. You are probobly a web designer/developer/whatever. You need to know a little about everything (business, websites, taxes, law, sales, etc.) but have people that know everthing about little (that meens 1 thing like taxes or law) that guide you in the right direction.

    To the author, I mean no ill will. You and the guys/girls at ALA take a lot of crap after spending so much time trying to help us. Thanks to all of you.

    A business man who owns a web firm.

  8. One thing that is important in any venture, business or otherwise, is to do a little research before starting out. The differences among cities, counties, states, provinces, countries are significant & will greatly impact your decisions in setting up shop.

    One place to start, if you are in the States, is to contact your local small business center (most communities have them) and get details on steps for setting up a business in the area that you live in. The next step would be to pick the brains of your friends & collegues about parts of this that they would be able to help you with–accountants, lawyers & other small business owners would be ideal. & finally, I would recommend checking with the powers that be–those who will care whether you earn income through your venture or not & found out what their guidelines are. In the States I would check with the IRS, your state business office & any local institutions involved in collecting taxes.

    I cannot emphasis this enough.

    A few years ago I looked into setting up a small Web development firm but decided against it. I still did freelance gigs & simply submitted federal and state taxes via 1099’s. I felt fine about it all. Then I was dragged before the Philadelphia tax discovery unit & told that I owed not only city wage tax, which I could understand being liable for, but business previlege tax as well. When I argued that I was not a business, I was told that my legal status as a corporation or company did not matter to the city. What mattered was that I was generating income, of which they wanted a slice.

    Currently I am facing paying the missed taxes, plus a huge plenty of up to 60%. Had I know that the City of Philadelphia considers me a business, I probably would have found an accountant to take care of this stuff for me (DIY did not pay off this time) & would have charged my clients at least 10% more per job to cover the taxes.

  9. OK, let’s say I have a Web Design LLC (A) and a Graphic Design LLC (B).
    (A) spends $3,000 on brochures with (B). (A) can write-off $3,000. Cool! But (B) have ta declare $3,000 income at the same time. So what’s the advantage of moving my money from one bank account to another?

  10. First off, everyone read “Do your Homework” above. This is unfortunately a common occurance. Please contact proffesionals to handle setting up your company, even if you think you can do it. And if you already have set one up on your own, pay someone to look over all of your documents. Make sure your foundation is secure. With that said>>>

    The advantage is the ability to zero out your taxable income, which to my knowledge, can only be done in conjunction with a corporation (or with just the use of one corporation).

    The point of business is to make money. Lets say you profit after all expenses $110,000 for the year. Congradulations! You can now give a large chunk back because you are now in the highest tax bracket.

    Now, the trick is to spend all of that money and get yourself into the lowest tax bracket (or a lower tax bracket) by spending the money on assets (things that make you more money). This can be done in many ways (401k’s for business owners, realestate, etc.) If your making enough to get out of the lowest tax bracket in one year, than the money getting you out of that bracket should be invested and written off. You invest in your other businesses, and those businesses send almost all of their income to that one corp. It’s something hard to grasp, but done everyday. Just look at any fortune 500 company and see how many smaller companies they own. I even heard Time Warner paid only something like $7,000 in taxes for one year (I don’t know if it’s true).

    Having more than one company allows you to channel money more effectively to do this, and protects you legally in many ways.

    Again, you really need to speek to a CPA (not just an accountant. Acountants count and that’s about it. They are usually poor themselves just like brokers). And have an attorney that is well rounded in your needs. The firm I use has a dept. for my real estate companies, Web company, Graphic Design company, and my personal Corporation which holds all of my companies. This structure was constructed by my CPA over many years in order to give me both legal coverage as well as financial leverage over tax laws.

    Sorry If this isn’t the exact answer that you wanted, but to be honest,

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