Business Planning 101 – Entity Formation
If you are starting or have started a business, then you know creating a business plan is one of the most important steps you will take. A business plan serves as a road map to help navigate the first years of a new venture. There are many elements that go into a business plan including an executive summary, business description, market analysis, SWOT analysis, sales strategies, and financial projections. BUT, what if I told you that one of the most fundamental and important elements of a business plan is often overlooked. That element is Entity Formation.
Forming the correct business entity for your venture is an important way to protect yourself from liability and create potential tax savings. In today’s economy there are typically five types of business entities the Sole Proprietorship, General and Limited Partnership, Limited Liability Company, S Corporations and C Corporation. According to the Tax Foundation (one of the nation’s top tax policy research organizations) there are 1.7 million traditional C Corporations, 7.4 million partnerships, LLCs and S corporations, and 23 million sole proprietorships in the United States.
Over the next couple of weeks we will discuss the positive and negative consequences of starting your business as one of these types of entities. This week we will briefly focus on the most popular business entity selection in the USA, Sole Proprietorships.
What is a sole proprietorship? A sole proprietorship is a business organization that is owned by a single individual, and is not classed or protected as a special legal entity, such as a corporation or LLC., which can only be established by filing a document with the state pursuant to the organizing states authority. An example of a sole proprietorship may be for example the factitious company LandEscape below:
John Doe started LandEscape, a landscaping company, as the single owner and did not register as a corporation, partnership or limited liability company. John Doe may work alone or even hire a small team of employees to maintain lawns, plants and trees of homeowners and businesses. While John Doe has given LandEscape a separate name, has employees, and both himself and his customers may see the business as a psychologically separate entity from John Doe. John Doe and LandEscape are still considered the same legal person in the eyes of the law because John Doe failed to register with the state as a corporation, partnership or LLC.
There are a few positives to creating a business as a sole proprietorship. First, there are no requirements to file forms or pay filing fees with the state agency that handles business filings (in the case of Massachusetts, the Secretary of State). Second, a sole proprietor does not need to file separate tax returns for their business because income is counted as personal income and owners pay taxes according to their individual tax rates. A sole proprietor reports the income and business expenses from the sole proprietorship on Schedule C of the sole proprietor’s Form 1040. Another benefit is that sole proprietors have total autonomy because they are the sole owners of their businesses and do not split profits or decision making with others.
There is a plethora of negative aspects to a sole proprietorship, all of which stem from one key issue: As a matter of law, a sole proprietorship has no separate identity from its owner. Meaning when a business owner takes no special legal steps like incorporating the enterprise the individual who owns a sole proprietorship has unlimited personal liability for debts and obligation incurred in the conduct of business. This risk extends to any liabilities incurred as a result of acts committed by employees of the sole proprietorship.
Additional negative aspects to a sole proprietorship include a limited lifespan often unable to survive the loss of the owner through illness or death.A sole proprietorship routinely has difficulty raising and difficulty funds because investors are unwilling to invest in an entity which they are unable to purchase equity ownership. While the net income earned by a sole proprietor is taxed on the proprietor’s Form 1040, the net income is subject both to federal/state income tax and federal self-employment tax.
With unlimited personal liability you can see why Attorneys, like myself, discourage sole proprietorship and highly recommend considering another entity formation such as a Limited Liability Company, Limited Liability Partnership or even inorporation.
Next week we will discuss the positive and negative aspects to forming either a general or limited partnership.
If you would like further guidance on starting your next venture please contact Lake Shore Legal at email@example.com