Out of all the decisions you can make for your business, choosing your legal entity is one of the most important.
The legal entity you choose for your business will have an impact on how much you pay in taxes, what kind of paperwork is required of your business, your ability to secure funding, and the personal liability you face.
Why Form a Legal Entity?
A legal entity is a commercial, corporate, or other institution that is legally formed to engage in business activities (like selling a product or service). Some examples of legal entities include:
- Sole Proprietorship
There are three main reasons to form a legal entity:
- To protect personal assets
- To establish credibility
- Increased tax flexibility
1. Protect Personal Assets
One of the main benefits of forming a legal entity is that, unlike with a sole proprietorship, as an LLC the law views you and your business as separate. That means your personal assets would be safe should something happen to your business.
With an LLC, in the event your business is sued, judgment against your business will not extend to your personal assets (except for those that are invested in the business). In addition, your business creditors can only come after company assets, with personal assets, such as your house and savings account, remaining safely out of their reach.
2. Establish Credibility
Forming a legal entity is also an effective way to strengthen your brand’s image. This is critical, because as a start-up business owner, you’re already starting out a step behind your more established competitors.
As a small, new business, you need to build up credibility with your target market, and forming a legal entity goes a long way towards accomplishing that. Customers will be more willing to trust your business if it is an established business entity.
3. Tax Flexibility
Finally, forming a legal entity like an LLC or S-corporation will eliminate the double taxation of a traditional corporation. Whereas a C-corporation is taxed on its earning as if it were a person, an S-corporation allows you to be taxed as a partnership, so you don’t pay taxes at the entity level. In this case, you would only fill out an information return for your business, and the profits and deductions pass through proportionally to your shareholders.
Types of Legal Entities
There are five main types of legal entities:
- Sole Proprietorship
LLC stands for “limited liability company” and refers to a flexible business entity that blends elements of a partnership and corporation. An LLC is not a corporation – it is a legal entity that provides limited liability to business owners. An LLC is more flexible than a corporation, and is a great option for businesses with a single owner.
With an LLC, the law views your personal assets and your business assets as fundamentally separate, meaning that if your business is sued your personal assets will remain safe. An LLC operates in most ways as a corporation, yet the distributions to its “members” (shareholders) are not subject to taxation at the corporate level. Instead, the distributions are “passed through” the corporate level and are taxed only at the individual level. Therefore, the LLC avoids double taxation.
A C-corporation is the most common kind of corporation. It refers to any corporation that is taxed separately from its owners under U.S. federal income tax law. A C-corp is different from an S-corp in that an S-corp is generally not taxed separately. For federal income tax purposes, most major companies in the United States are treated as C-corporations. A business may qualify as a C-corp without regard to any limit on the number of shareholders.
An S-corp is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. S-corporations do not pay federal income taxes. Rather, the corporation’s income or losses are divided among and passed through to the business’ shareholders. The shareholders then, in turn, report the income or loss on their own tax returns.
A partnership refers to an unincorporated company formed by two or more people, in which all partners are personally liable for any legal actions and debts the company may face. In a partnership, the partners all share both the responsibility and the liability equally.
5. Sole Proprietorship
A sole proprietorship is a type of legal entity that is owned and run by one person. There is no legal distinction between the business and the owner. This means the owner receives all profits from the business, but also has unlimited responsibility for any losses and debts. All of the business assets are owned by the proprietor, and all debts of the business belong to the proprietor as well.
What Legal Entity Is Best for You?
Choosing the right kind of legal entity is a critical step in establishing your start-up. In general, you want to reduce your own liability exposure, minimize your taxes, and ensure that your business can be financed and run efficiently.
Choosing a legal entity for your business also provides you with a mechanism to ensure that business operations continue, rather than being automatically terminated upon the death of an owner. Finally, forming a legal entity also clarifies the ownership of all participants in the venture.
When choosing a legal entity for your business, it is important to consider:
- The degree to which your personal assets are at risk from liabilities arising from your business.
- How to best pursue tax advantages and avoid multiple layers of taxation.
- The ability to attract potential investors.
- The ability to offer ownership interests to key employees.
- The costs of operation and maintaining the business entity.
The availability of a particular entity type initially depends on the number of owners. A single owner may operate as a sole proprietor, a corporation, or a limited liability company. If there are two or more owners of the business, by definition it cannot be a sole proprietorship, but it can be a corporation, limited liability company, general partnership, limited partnership, or, in certain situations, a limited liability partnership.
Federal EIN, Banking & Corporate Binder
1. Federal EIN
A Federal EIN (“Employer Identification Number”) is the business equivalent of a Social Security Number. A Federal EIN is issued to anyone, businesses and individuals, who have to pay withholding taxes on employees. Federal EINs can also be issued to other entities such as states, government agencies, corporations, LLCs, and any organizations that need an ID number for the purpose of reporting withholding tax.
A bank is a financial institution and a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly by loaning or indirectly through capital markets. A bank is the connection between customers that have capital deficits and customers with capital surpluses.
Most banks operate under a system known as “fractional reserve banking,” where the bank holds only a small reserve of the funds deposited and lend out the rest for profit. They are generally subject to minimum capital requirements which are based on an international set of capital standards, known as the Basel Accords.
3. Corporate Record Binder
A corporate record binder is where business owners keep all important corporate papers, including the Articles of Incorporation, bylaws, meeting minutes, stock certificate ledger, stock certificates, stock certificate stubs, and stock transfer documents. It is critically important that you maintain a corporate record binder at your business’s principal office.
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