Home Business Start-Up: Choosing the Form of Business Entity

Selecting a business entity is one of the most important thing to do when starting a home-based business.

Which form of business should you choose depends entirely on your specific situation and your objectives. Among the factors considered are how much control of the business, taxes on the earnings, ability to raise capital, liability concerns, continuity of the business, ease of formation, dealing with government regulations, and potential for growth.

There are various forms of business that you can choose from to apply for your home-based business. The most common ones are:

• Sole Proprietorship
• General Partnership
• Limited Liability Companies (LLC)
• Corporation

The Sole Proprietorship

Sole proprietorship is the simplest form of business because it is very easy and cheap to start and it only involves one owner. If you start your business now, you are considered as a sole proprietorship by default since there are no legal business entity paperworks to file to the state other than the licenses and permits required for all types of businesses.

One distinct feature for operating as sole proprietorship is that in the eyes of the law, you and the business  are treated as one and the same entity. There is really no separation at all and this can both be good and bad.

For most home-based business start-ups, a sole proprietorship may be the right choice because of the simplicity that it offers. You don’t have to file legal paperworks to the state and taxation is also very favorable. The earnings passes through the owners so there is no double taxation. In addition, there is no minimum tax liability imposed by some states on sole proprietorship that are usually imposed on LLCs and corporations. So this could be a big detriment especially if you are just starting out.

However, the biggest disadvantage is that you have UNLIMITED LIABILITY, which means that if your business fail or get sued, creditors and plaintiffs can go after your personal assets as well.

As good as a sole proprietorship may look, the unlimited liability factor almost trumps all the advantages. So does that mean you should not operate as a sole proprietor?

Well, it depends.

In my opinion, you should only operate as a sole proprietor if the following situations apply:

• You do not have a lot of personal assets - if you do not have a lot of personal assets such as a house, car, stock investments, IRA retirement accounts or any assets that business creditors can come after, then the amount of personal loss is very limited.
• You do not have any employees – potential lawsuits are usually present once you have employees. You can be sued by your customer, vendors or other parties for your employees tort actions. In addition, you can be sued by your own employees for discriminations, wrongful firing, injuries at work (worker’s compensation), and other human resource related wrongful actions.
• Your business liability exposure is low - business models such as affiliate marketing, content-based based websites or blogs, independent website writers, drop shippers, or direct sales (network marketing) may have low risk of incurring liabilities compared to other business operations.

If you are thinking of operating as a sole proprietor on your start-up phase, you should try to protect yourself by purchasing sufficient insurance coverage for your business and probably a personal umbrella insurance so at least you can limit the amount of personal loss. Although umbrella insurance may protect you from a few lawsuit judgments, it will not protect you if your business defaults on loans and other debts or if the judgments exceeds your insurance coverage.

Lastly, once your business becomes successful, you should try to convert to an LLC and corporations.

The General Partnership

A general partnership is similar to operating a sole proprietorship but with two or more owners. It boasts the same advantages when it comes to savings in taxes and disadvantages when it comes to unlimited liability. You usually go into partnership because you can obtain additional funding from potential partners and you can take advantage of your partner’s expertise you do not possess but critically needed to operate the business.

However, I do not recommend going into a general partnership due to a variety of reasons. Just like what my business professor said, general partnership is like a marriage but without the sex. There have been so many partnerships that have dissolved because of disagreement of the partners regarding decisions and controls. In addition, there is also a problem of continuity such as when your partner dies or decides to call it quits, your business may dissolve immediately. Another disadvantage of partnership is the unlimited liability similar to the sole proprietorship but with a greater twist: You are not only responsible for your own actions but you are also responsible for your partners’ actions and creditors can come after your personal assets even if it’s your partners’ fault.

If you think that you can handle the many disadvantages of the general partnership, then go for it but just don’t forget that you have been forewarned!!

State Regulated Legal Entity: Corporations and LLC’s

As discussed previously, the unlimited liabilities of a sole proprietorship and general partnership pretty much trumps all the advantages they provide. At this day of age, I’ve read about numerous lawsuits that may seem ridiculous yet very costly to the business owners. Some of the lawsuits can pretty much put you out of business and to make matters worse, you may end up losing your personal assets as well since you do not have the protection of having your business as a separate entity. In order to limit your liability, you should legally separate yourself from your business and this can be done by forming a corporation or limited liability company (LLC).

1. Corporation – A Corporation is a form of business that is regulated by the state. Corporations may be overkill if you are just running a home-based business. You usually go into corporation if you are planning on going public in the near future, or if you have already accumulated a lot of capital. For the most part, corporations are good if you have established yourself throughout the years and have been generating significant revenues.

The three biggest disadvantages of corporations are formality compliance with the state, double taxation of earnings and a very complex tax accounting and bookkeeping. You need to make sure that you are in compliance with the state regarding the annual reporting, board meetings, stockholder meetings, corporate minutes, etc. You may end up personally responsible for the corporate debts and obligations if you are non-compliant. Another big disadvantage of a corporation is that earnings are taxed twice. It is taxed initially on the corporate tax return and when dividends are distributed to the shareholders, it is taxed again at the shareholder’s personal tax return. Lastly, the tax rules are not as simple as those of the sole proprietorships.

One way to get around this double taxation is to file an S Corporation election. This is usually done by filing Form 2553 (Election by a Small Business Corporation) with the IRS within the first 75 days of the tax year.  There is no double taxation because all the income and losses passes through the shareholders which are quite similar to taxation of sole proprietorships and partnerships. However, S Corporation owners need to file using form 1120S instead of Schedule C.  Another key tax advantage of the S Corporation is that you may not have to pay self-employment taxes on some of the earnings that normally applies to sole proprietorship and general partnerships. However, S Corporations have very strict requirements for the shareholders and the tax accounting is much more complicated than that of sole proprietorships, partnerships and LLCs.

2. Limited Liability Companies (LLC) – Just like a corporation, LLC is also formed under state law. It is somewhat a hybrid between a corporation and a partnership. It is similar to a corporation because of the limited liability attribute; the losses are limited to the amount of your investments and creditors may not come after your personal assets if your businesses defaults, unless of course you personally guaranteed the debts. On the other hand, it is similar to sole proprietorship/partnership for tax purposes in avoiding the double taxation because earnings passes through directly to the owners and pay self-employment taxes on all the earnings. In general, single member LLCs are taxed automatically as sole proprietor while multiple members LLCs are taxed automatically as partnerships unless an election to be taxed as a corporation is exercised.

An LLC is an ideal form of business for most home-based business owner because it provides single taxation, limited liability to owners, less complicated tax accounting than corporations, and fewer formality requirements than S corporations.

Conclusion

Selecting a business entity is one of the most important thing to do when starting a home-based business. Which form of business should you choose depends entirely on your specific situation and your objectives.

The simplicity of the sole proprietorship in terms of formation and the pass-through/single taxation advantage makes it the popular choice for most home-based business start-ups. However, as good as the a sole proprietorship may look, the unlimited liability almost trumps all the advantages of it. If you still want to start as a sole proprietor, you need to make sure that you have enough insurance protection and try to convert to either one of these two legal entities as soon as you can.

You can achieve limited liability and still take advantages of single taxation of a sole proprietorship/partnership by forming an LLC or an S Corporation.

The choice between an LLC or an S-Corporation depends on your situation. An S Corporation has stricter criterias to qualify than an LLC but may provide you a better tax benefit since you may not have to pay self-employment taxes on some of the earnings depending on the level of your income. In addition, the formality requirement of an S Corporation is much more complex than the LLC. S Corporation has the same formalities as the regular or C Corporation where you would need to make sure that you conduct annual board meetings, stockholder meetings, and keep corporate minutes as otherwise you may lose the privileges of limited liability and you may end-up being responsible for the corporation’s liability and claims. Because of these strict requirements, an LLC may be  a better option  than an S Corporation for most home-based business owners.

On the final note, you may want to consider converting to a regular corporation once your business becomes really successful since it may offer more benefits than an LLC for larger companies.