This question deserves significant consideration of the goals and preferences of your business. Although you don’t need to form a business entity to do business, there are several important reasons why you should consider forming one. At the outset, doing business in your personal capacity – in the form of a sole proprietorship or a partnership – is an unpredictable way to run your business.
Alternatively, forming a business entity by filing the required documentation with the New York State Department of State provides for greater predictability and continuity for your business. Some of the most common entities are corporations and limited liability companies (LLCs). Ultimately, the decision of whether or not to incorporate your entity involves consideration of the desired liability protection, as well as considerations relative to the management, permanence and taxation of your business.
First and foremost, liability is a vital consideration when forming a business entity. Different entities provide different levels of protection for those associated with the business. For example, LLCs, and Corporations, if properly established and operated, are distinct legal entities from their owners. This allows for the entity to provide a full liability shield to owners, members, officers, directors, and investors, who properly follow the requisite business formalities. On the other hand, a sole proprietorship, which is not considered a separate legal entity from the owner, provides no liability shield to its owner, and may result in the owner being personally liable for losses incurred by the business. Indeed, business entities were created by the states for this precise reason: promoting and encouraging businesses to form without the risk of being personally ruined by a potential lawsuit against the business.
Preferences regarding the control and management of a business can help facilitate your decision on which business entity to create. Sole proprietorships and general partnerships, which can be formed without any formal agreements or filings, are run according to the individual business owners. In a general partnership, management is described in a partnership agreement. If no partnership agreement has been formed between the business owners or the agreement leaves out some key management information, the New York State Partnership Law governs management of the business.
Corporations have legal structures created under New York law that provide formal guidelines as to the organization and management of the business. This includes the creation of different positions and roles for certain owners. In addition, business owners generally enter into a Shareholder Agreement that defines exactly how the corporation will operate in the future, addressing some critical issues like such as redeeming ownership interests upon retirement, death or incapacity of a shareholder, how loans and cash infusions will be dealt with, and how the day-to-day business decisions will be handled. LLCs are commonly referred to as a hybrid between corporations and partnerships. Owners can create operating agreements, similar to shareholder agreements, where important management and succession decisions are described. However, the statutes governing LLCs often allow for a more customizable framework than corporations based upon the type of business, the amount of owners, and the desired type of management.
When planning for the future, the life and transferability of your company depends on the chosen entity type. Corporate statutes allow for the business to continue indefinitely into the future. Turnover in management, employees, and owners have little to no consequence on the life of the business. On the other hand, sole proprietorships and some partnerships cannot withstand the loss of the founding business owner. Those businesses are controlled and run by the business owner and depend on their services for the business to continue to run.
Understanding the tax implications of each potential entity is critical. LLCs, S-Corps and unincorporated entities are eligible for what is known as “pass-through” taxation. This means that the entity calculates itsprofits and losses for the tax year and then allocates them to each owner. The business itself does not pay taxes on its income but rather the profits and losses are passed through to the owners and reported on their personal tax returns. For all other corporations, referred to as C-Corps, the entity is subject to “double taxation.” What this means is that the business itself pays a tax on its taxable income in the year it was earned and then the money is taxed again when it is distributed to the owners on their personal tax returns. The takeaway from double taxation is that the money is being taxed at both the corporate and personal level.
Each entity offers different advantages and disadvantages based on your specific business needs. When you form a business or seek to form an entity, legal advice from an experienced attorney can be invaluable.
If you have questions regarding this article or the benefits and limitations of the different entity choices, please feel free to contact The Wagoner Firm, PLLC for a free consultation on how to achieve your business goals.
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