Finding The Right Formation
Starting a business has numerous legal implications, including liability, taxation, filing requirements and paperwork. Before you hang an “Open for Business” sign out front, you need to figure out what structure is best suited for your business. Each has its own advantages and disadvantages and you may want to consult with an attorney, business mentor or a CPA to determine which structure best meets your needs.
Following are the different structures with a brief summary for each. They are covered in greater depth in Lesson 5 in the Entrepreneur Academy.
A sole proprietorship is owned by a single person or a married couple. This type of business is inexpensive to form and there are no special reporting requirements. There are fewer legal controls than other structures, but the owners may be liable for all debts incurred by the business as well as all federal taxes and judgments from lawsuits. In essence, the business and its owners are one in the same.
A general partnership is formed by two or more persons who agree to contribute money, labor and/or skill to the business. Partners share managerial duties as well as the profits or losses and each one is personally liable for their share of any business debts. Formal terms of the partnership are usually contained in a written agreement and the business has to file a partnership return with the federal government, dividing the profit or loss of the company as a percentage according to how much each partner owns in tax filings.
Limited Liability Company
Also known as an LLC, this form of business is very popular. The business has limited legal liability like a corporation but doesn’t have as many governance requirements. For federal tax purposes, an LLC is treated like a corporation. Creating an LLC requires that you file with Washington’s Secretary of State office and the organization must also file an Entity Classification Election (Form 8832) with the IRS. While not necessary, you may want to consider seeking legal assistance to form an LLC to ensure that everything is covered completely in an operating agreement.
This is a more complex structure, but one that affords additional protections. There are two major types of corporations – C and S. A C-corp pays tax on its income plus a tax on whatever income you receive as an owner or employee. An S-corp doesn’t pay taxes in this manner as the profits from your operations are reported instead on your personal income. You’ll want to work with an attorney or CPA to discuss which is best. To form a corporation, you must file with the Secretary of State’s office and create a governance document, i.e., bylaws. There are other filing and management issues, including how stocks are handled and how directors are elected. Corporations must also keep minutes and records and file federal corporate tax returns with the IRS. The owner of a corporation is treated like an employee, which may offer additional tax and financial benefits as well as legal protections.
Social Purpose Corporation
Washington State is one of only 10 states that allow the formation of a social purpose corporation (SPC). This is a corporation that is organized to support a social purpose that involves:
• The corporation’s employees, suppliers or customers
• A local, state, national or world community
• The environment
It allows the organization’s directors to weigh and consider social purposes before making decisions, even if it results in a lower shareholder return. Directors are legally protected if they decide to choose environmental or social impact over economic gain. The Secretary of State handles SPC applications. We cover this business structure in greater detail in Lesson 2: Starting a Responsible Business in the Entrepreneur Academy.
A nonprofit corporation is a legal entity that is usually tied to some larger ideal or goal rather than the interests of making a profit. If the nonprofit is formed to raise funds from the public, it may need to be registered as a charity with Washington’s Secretary of State office. The state has a great guide that covers everything you need to know about starting a nonprofit in Washington State.
Following is a quick cheat sheet to guide you through the various pluses and minuses of each structure:
|File With Secretary of State||No||No||Yes||Yes|
|Liability||Unlimited liability for debts and taxes.||Unlimited liability for debt and taxes.||Members are not typically liable for debts other than taxes.||Board of directors, annual meetings, annual reporting required.|
|Operational||Relatively few.||Relatively few.||Some formal requirements such as operating agreements and annual reporting.||Board of directors, annual meetings, annual reporting required.|
|Management||Sole proprietor has full control of management and operations.||Typically each partner has an equal voice, unless otherwise arranged.||Members have an operating agreement that outlines management structure/ responsibilities.||Managed by the directors who are elected by the shareholders.|
|Federal Taxation||Not a tax entity. Sole proprietor reports and pays all taxes.||Not a taxable entity. Each partner pays on his/her share of income and can deduct losses against sources of income.||Depending on the structure there is no tax at the entity level.||Taxed at entity level. Any dividends are taxed at the individual level.|
|Washington Taxation||Taxes based on business entity gross income.||Taxes based on entity income. General partners have limited liability.||Taxes based on business entity income. Responsible parties may have liability for trust funds.||Taxes based on business entity income. Responsible parties may have liability for trust funds.|
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