Legal Entity Formation

In this article, we will be discussing legal entity formation. We will explore several examples of legal entities, including sole proprietorships, partnerships, corporations, and limited liability companies. Each type of entity comes with different legal implications insofar as business operation and taxes are concerned. If you are a business owner, understanding which type of legal entity makes sense for you is paramount. 

Sole Proprietorship 

Sole proprietorship refers to a business that is unincorporated and owned by an individual. The owner of a sole proprietorship pays personal income tax on any profit their business earns. Oftentimes, a sole proprietor will conduct business with their own individual name. Depending on your business, the creation of a distinct business or trade name may or may not be required. 

Sole proprietorships are arguably the most accessible type of legal entity to form because they are not heavily regulated by the government. If you are the sole owner of a business, an independent contractor, or a consultant, a proprietorship is a sensible option. Small business operations frequently begin in the form of sole proprietorships. From that point, owners can either remain as such or shift into another type of legal entity if the business is growing. 

A sole proprietorship is not registered, so the liability or legal responsibility falls on the owner. When an individual starts to conduct business, their sole proprietorship commences. State and federal forms are not required and this entity type has a minimal amount of regulation. For anyone who is self-employed and at the beginning of that venture, a sole proprietorship makes sense. 

The Accessibility of a Sole Proprietorship

There are several benefits to forming a sole proprietorship. To start with, it comes with pass-through tax advantages. Any income earned from a pass-through entity is reported on your personal income tax return. Meaning, a sole proprietorship is subjected to only a single layer of income tax, versus double taxation on revenue and proceeds. Pass-through entities are able to potentially deduct 20% of business income, which can save owners a substantial amount of money. You also do not need an employer identification number (EIN) from the Internal Revenue Service (IRS). Sole proprietors can either use an EIN, if preferred, or their social security number (SSN) to pay taxes. Additionally, owners who use this legal entity option may handle financial transactions with their personal checking account – it is not required that they have a business checking account. 

The unlimited liability of a sole proprietorship is one disadvantage. For example, if a sole proprietor has debt, their personal assets may be affected. Obtaining bank loans, trying to raise capital by selling shares, and getting lines of credit are also difficult. 

Limited Liability Company (LLC) 

A limited liability company or LLC is a type of legal entity that provides owners with protection against individual responsibility for any liability or debt. Each state has different regulations regarding the governance of LLCs. Broadly speaking, the owners of an LLC are referred to as members. Banks and insurance companies are prohibited from forming LLCs, but ownership/membership is available for individuals, corporations, foreign entities, and other LLCs. 

In order to form an LLC, owners must select a name and file articles of organization with the state in which the LLC is formed. The liabilities, duties, rights etc. of each member of the LLC are determined in the articles of organization. It also establishes the address and name of each member, the name of a registered agent, and a statement of purpose for the business. Filing articles of organization and obtaining an employer identification number (EIN) for an LLC requires fees. 

The limitation of the personal liability for owners makes LLCs popular among businesses. An LLC is also a pass through entity, so profits generated by the business are taxed as a part of the owners’ personal income (no double taxation). However, owners are not held personally responsible for any debts incurred by their company. Furthermore, if a company is sued or files for bankruptcy, owners’ personal assets are not affected. 

Corporations

A corporation is a legal entity that exists independent of the owners. A corporation is formed when an individual or group of shareholders who have shared ownership incorporate. Stock shares represent the distribution of ownership of a corporation. The majority of corporations have the option of returning profits to those shareholders, but some corporations are non-profit by design. By and large, when incorporating, owners have to file articles of organization with their state and then give the shareholders company stock. From there, the shareholders must select a board of a directors, settle on by-laws, and make an operating agreement. These aspects of a corporation lay down the rules and guidelines of the company. 

Corporation shareholders usually get a vote per share they own and have at least one meeting per year to elect the board of directors. This board hires management who then handle the corporation’s daily operations. The board also have to create a business plan for the corporation. The owners of corporations are not responsible for its debts. Corporations may borrow money, be sued or file lawsuits, and have assets.  

Partnerships

With a partnership business, two or more individuals enter into a formal agreement to operate and manage a business and share profit. In terms of businesses that are for profit, you can form a limited liability partnership, a limited partnership, or a general partnership. 

A limited liability partnership (LLP) is usually the legal entity structure used by lawyers, accountants, and other professionals. Essentially, an LLP limits the personal liability for each partner, which protects the assets of each partner and lowers risk. 

A general partnership is between two or more parties who share an equal amount of financial and legal liability. Profits are shared equally, and each individual in the partnership is personally responsible for any debts. In a written partnership agreement, you can state exactly how profits will be shared. The agreement should also include an expulsion clause, which specifies how and/or for what cause will a partner be expelled from the partnership. 

A limited partnership refers to an arrangement that has a general partner and a silent partner. A general partner takes full personal responsibility for any debt incurred by the partnership. Whereas a silent partner’s liability is limited to the amount they have invested in the partnership. 

By combining resources and labor, a partnership can greatly assist businesses grow and succeed. Indeed, partners share profits, but they are also personally liable for the business loss or debt of the partnership. In any type of partnership, the partners must have a contractual agreement that states the terms and conditions of the relationship. That is, how the business will distribute ownership, profits, loss, and responsibilities. Business taxes are not paid by the partnership; the taxes of the business are paid by the individual partners themselves. 

Stockman & Poropat, PLLC Can Help With Legal Entity Formation 

Are you interested in legal entity formation or transitioning an existing one into a different type? Our stellar team can provide you with the appropriate counsel so that your business will thrive and succeed both immediately and over the long haul. Contact us for a free consultation today!

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