Select a Legal Entity

Cautionary notice: this article makes mention of employer identification numbers (EIN). There are several websites that appear legit and provide an EIN in exchange for a payment. NEVER utilize these websites. They are fraudulent. You must obtain your EIN from the IRS directly, and EINs are ALWAYS FREE!

One of the most important steps in the planning process for your small business is deciding which business structure your business will adopt. Although this article contains both planning (non-binding) and launching (binding) procedures, I have included it in the planning section because your business structure significantly influences which products and industries you can engage in, as well as how you operate your business. Please note that there is a significant difference between a legal entity and a tax entity. Technically, sole proprietorships and partnerships are tax entities, not legal entities. LLCs and Inc’s are strictly legal entities, and the tax entity election must be a separate decision.

Sole Proprietorship

The sole proprietorship form of business is the simplest form of business. If you begin conducting business activities, you are a sole prop by default. Some common types of sole proprietorships include salons, mom-and-pop shops, street vendors, independent contractors, and utility services (electrician, plumber, and so forth). In 2023, the Small Business Administration reported that over 33.3 million businesses in the United States operated as sole proprietorships, employing over 61.6 million Americans. Sole proprietorships are owned by one person, who receives all the profits of the business and is responsible for all the debts and liabilities of the business. If you are unsure about what a liability is, think of it as a promise to pay someone back.  This idea of being responsible for ALL the debts and liabilities of a business is what we call unlimited liability. This is often viewed as a downside of operating a sole proprietorship. Why? If your business falls into debt that cannot be repaid, your creditors (the people you owe money to) may be legally allowed to take your personal assets (things you own) as payment to settle the debt. This is because, under the law, the sole proprietor (you) and the sole proprietorship (the business) are the same thing. On the flip side, it also means you get to keep and spend the profits of the business as you please. You have unlimited freedom to operate the business within the bounds of the law and face very little restriction. It is also the easiest to establish, requiring very little paperwork. The process usually looks something like this:

1. Choose a business name (can be your own name or a professional name).
2. File for a DBA (doing business as) name with the state government.
3. Obtain an employer identification number (EIN). If you do not have any employees, you may not be required to obtain an EIN and can use your social security number (SSN) for activities where an EIN is usually used. However, many sole proprietors obtain one regardless to reduce the risk of identity theft, which is a great idea! Also note that many banks require an EIN to open a business account, which is useful for keeping your personal and business affairs separate. You can obtain an EIN on the IRS website: Get an employer identification number | Internal Revenue Service.
4. Make sure you understand which taxes you are responsible for. Your state and local government have departments of revenue that spell out these taxes for you.
5. Obtain a business license. Many states do not require general business licenses, but even in these states it is a good idea to ensure that the nature of your business does not create a need to get additional permits, licenses, or zone clearance. An example of this is filing with your state tax authority if you sell taxable products or services. Also note that in some states, if your taxable income is above a certain threshold, you may be required to obtain a standard business license.

Visit your state and local department of revenue websites to explore requirements specific to you. The following website also gives valuable information: Form a Sole Proprietorship: How to Become a Sole Proprietor (in 50 States) – MoneyAisle.

I would like to add some additional general pieces of information regarding owning a sole proprietorship. First, while unlimited decision-making power may sound appealing, it forces small business owners to be experts in all facets of the business, from product development to marketing to accounting and tax. Naturally, this creates difficulties for owners seeking to create a sensible work-life balance. Second, it is very difficult to obtain financing (money to fuel your business). There are two reasons for this. The first is that banks are generally hesitant to issue loans to small proprietors as they are deemed to be high-risk. Banks prefer long operating histories, consistent cash flow, and low debt-to-income ratios, all of which are very difficult for new sole proprietors to achieve. The other reason is sole proprietors cannot issue stock (a topic discussed later in this article) to raise funds. They must fund the business through their personal (or investors’) funds, which can tighten cash significantly (see my article on “funding” for some tips). The last thing I would like to say is sole proprietorships are what we call “pass-through” organizations. Remember I said that the law deems the sole proprietor and the sole proprietorship as one and the same? Although bad for liability purposes, it offers an attractive tax advantage. Only you pay taxes on the profits of the business, as opposed to other forms of business where the business AND you pay taxes on profits. We will discuss in further detail later, but it is valuable to recognize in this section.

Small proprietorships are a great way to test a business idea involving a relatively small amount of funding, especially if you do not plan on creating heavy liabilities for your business.

Let’s summarize the basic advantages and disadvantages of the sole proprietorship form of business.

Advantages	Disadvantages
Retain all profits and decision-making power	Responsible for all the debts and responsibilities of the business
Easy to form and understand	Difficulty raising funds
Unlimited decision-making power	Long hours and limited input from others

Partnership

While sole proprietors are the easiest business for one person to set up, partnerships are the easiest for two or more people to set up. This is a great choice for those wanting to form a business with multiple owners, especially professional and medical services (financial advising, legal, dental, family doctor etc.). There are two types of partnerships that are useful to discuss: general and limited. Let’s begin with general partnerships (GP). In a general partnership, there are two or more general partners. These general partners each own an equal portion of the assets of the business, share in the profits, and have unlimited liability for the liabilities of the business. A subtype of the general partnership is the limited liability partnership (LLP), which offers limited liability to the owners. Limited liability means that the owners cannot lose more than they invested. If you and your partner invested $40,000 in the business and had debts of $100,000 when you close, your collective loss will be limited to that initial investment of $40,000. Now, let’s discuss limited partnerships (LP). In a limited partnership, there is at least one general partner, who, as we discussed in general partnerships, has unlimited liability. Since this owner has unlimited liability, it stands to reason that they generally have much more control over the day-to-day operations and decision-making than the rest of the partners, called limited partners. Ultimately, general partners have more to lose. Limited partners have limited liability, but less decision-making power than their general counterparts.

LPs are generally more suitable for businesses where investors do not want to be involved in the management of a company. This is why LPs are common in real estate and film production. You can simply invest in the company and leave management to the general partner.

LLPs are common for professional groups where partners want to be involved in the decision-making process. This usually includes marketing, accounting, tax, and legal professionals who work with various types of businesses and individuals.

GPs are the only type of partnership (or business form for that matter) that are rarely utilized. Unlimited liability is a severe drawback, and there is little reason to assume this risk when the LLP form is available. The only situation where a GP may be appropriate is if multiple partners want to test a business idea without the small additional hassle introduced by the LP and LLP.

Now, you may be wondering: how do partners decide decision-making responsibilities, profit distributions, and asset ownership? This is where a partnership agreement is required! A partnership agreement outlines the details of how profits, decision-making, and assets are shared, as well as the expected contributions and ethical requirements for each partner. Experts highly recommend hiring a lawyer to draft a partnership agreement, as it saves partners from disputes and headaches down the line.

Here is the process for starting a partnership:

1. Select one or more business partners. Be careful! It is difficult to dissolve partnerships, and your partner represents the business, regardless of their liability.
2. Select the partnership type that best suits your needs.
3. Research the requirements and process for creating your business name. You may be able to combine steps 3 and 4. Ensure you have a name you are satisfied with. It is difficult and costly to change.
4. Register the partnership with your Secretary of State. If you are operating in more than one state, you are required to file with each state’s Secretary of State. Your main state of operation will be classified as a “domestic” partnership, and every other state will be classified as “foreign” partnerships.
5. Obtain an EIN from the IRS at the link provided earlier.
6. Create a partnership agreement with a lawyer that meets your Secretary of State’s partnership agreement requirements. This agreement should include but is not limited to the name of the partnership, the principal office (mailing address), length of the partnership (2 years, 10 years, indefinite, etc.), the purpose of the partnership, the types of partners and their roles, profit allocation, a process for adding new partners, rules for withdrawing profits, decision-making power, and dissociation processes (how can partners leave). Please note that partnerships are considered “at-will” unless otherwise outlined in the agreement, meaning a member can leave before the expiration of the partnership.
7. File permits, licenses, and other important documents. This includes your DBA, sales tax filing, and other registrations specific to the nature of your business. Consult with your state’s department of revenue for a complete list.

Advantages	Disadvantages
Combined expertise and labor	Potential disagreements or conflicts
Pass-through taxation	Difficult to leave or dissolve
Shared responsibilities and ability to expand	More difficult to create than sole proprietorships

Incorporated (Inc)

An incorporated entity is a type of business that is considered to be its own legal entity. In other words, the business is its own person, so it can sue, be sued, own property, pay taxes, enter into contracts, and obtain loans. Because it is separate from its owners, the owners can only lose whatever they have already invested into the company, which is called limited liability. Creditors cannot pursue owners’ personal property to settle debts. Because of its complexity, the incorporation process is usually not suitable for small businesses and have decreased in popularity since the widespread adoption of LLCs. That is why, generally speaking, the incorporated business form is not suitable for small business owners. Therefore, our time is better spent on limited liability companies (LLCs).

Limited Liability Company (LLC)

An LLC is a form of business that combines the tax benefits of partnerships and the limited liability feature of corporations. The profits are passed through to the owners, who are taxed once. The company is a separate legal entity from the owners, so the owners are protected in the case of a business failure. Your checking account, house, car, and any other assets you own are safe from repossession. This makes LLCs an attractive option for small business owners operating medium to high-risk businesses.

First, LLCs are pass-through entities by default but can elect to be treated by the Internal Revenue Service (IRS) as a C-Corp (conventional corporation) or an S corporation, which have additional requirements. When I discussed corporations earlier, I was referring specifically to conventional corporations, which are taxed twice, once at the company level and again at the owner level. S corporations elect to be treated under subchapter S of the IRS, which allows extra tax benefits but carries extra requirements than the traditional LLC structure. Since this gets quite complicated, I would recommend the following website to discover some additional types of LLCs: 8 Types of LLCs Explained & Compared – Forbes Advisor.

Second, even though LLCs (as well as sole proprietors and partnerships) are considered pass-through entities, self-employment taxes for Medicare and Social Security still apply in most cases. If you have ever been employed before, these taxes were automatically withheld from your paycheck. However, as a business owner, you are responsible for withholding and paying them yourself. Generally, you must pay self-employment tax if your net earnings exceed $400 (as of 2024). For single-member LLCs and multi-member LLCs (default taxation), all net earnings are subject to self-employment tax, which is 15.3% (12.4% for Social Security and 2.9% for Medicare), though only the first $168,600 of earnings is subject to the Social Security portion. Additionally, high earners making over $200,000 (single) or $250,000 (married filing jointly) may owe an extra 0.9% Medicare tax. Note that these numbers are as of 2024 and usually change each year.

However, if an LLC elects to be taxed as an S-corporation, the owner can receive a “reasonable salary” (which is subject to payroll taxes) while taking additional profits as distributions, which are not subject to self-employment tax. Likewise, an LLC taxed as a C-corporation pays employment taxes on wages, but any dividends paid to owners are taxed separately and are not considered self-employment income. It is also important to note that you can deduct the employer portion of your self-employment tax when calculating your adjusted gross income (AGI), helping to lower your overall tax burden.

Third, many states allow LLCs to have limited lives or indefinite lives. Make sure you have an agreement in place within your LLC for adding members or for members leaving. Otherwise, the law may require you to dissolve and re-organize your LLC to remain in operation.

Last, forming an LLC and paying taxes for the profits earned through a default LLC are much simpler than in the case of corporations. However, they are generally more complex than sole proprietorships or partnerships. There are also state and local restrictions and fees on LLCs that may not apply to sole proprietorships or partnerships.

Quick tip: if you want to go public one day (sell stock on a stock exchange), an LLC may not be the best choice for you. The transition is possible, but quite complex.

Here is the general process for creating an LLC:

1. Choose a business name. Your name may include some form of “LLC” such as “John Smith Advisory Services, LLC.” See your Secretary of State website for additional details.
2. Obtain an EIN.
3. Select a registered agent. A registered agent is anyone over the age of 18 who receives legal documents on behalf of your LLC. The person must reside in your state and be available for contact during regular business hours. There are registered agent companies that you can elect as your registered agent. You can also register yourself, another owner, or someone who works for you. Registered agents’ name and address are public record, and they must be able to handle complex legal documents.
4. File your state’s articles of incorporation. The document may have different names such as articles of organization, certificate of formation, etc. You will indicate, among other things, your name, business address, purpose of business, method of management, registered agent, and the life span of your LLC. Pay the filing fees and wait for approval. Once approved, obtain your tax ID number from the IRS.
5. Form an operating agreement. If you are the only owner, it may still be worth creating an operating agreement to detail processes for adding new members. Whether you are a single-member LLC or a multi-member LLC, hiring a lawyer to assist you is important, even if it just means that you create the initial draft and have the lawyer review it.
6. Obtain relevant business licenses and permits for your unique situation.

Summarizing the advantages and disadvantages looks like this:

Advantages	Disadvantages
Pass-through (default taxation)	Some states require LLCs to be dissolved in certain scenarios. C corps exist indefinitely.
Limited liability	A large determiner of success is the Operating Agreement created between the members. If it is not done correctly, there may be conflicts and misunderstandings that damage the business.
Smaller administrative burden than conventional corporations	Higher administrative burdens than sole proprietorship