One of the most common questions that I receive is, “Should I form a corporation or an LLC or do I even need one of these?” There is no one-size-fits all approach to this question. Rather, there are many factors to consider and there not always an obvious choice. Different advisors (attorneys, CPAs, financial advisors, real estate brokers) might be advising their clients to use one or another choice. Each advisor may have a preference or may be considering their own discipline which sometimes leads to variations in the answer. So, how do you make a choice? The key to this choice is to carefully evaluate the considerations based on the advice from all of your advisors and make the best choice for you which is, of course, easier said than done.
Definitions. First, let’s begin with a basic definition. Your default choice, if you start a business, is either a sole proprietorship (if you are by yourself) or a general partnership (if there is at least two persons carrying on a business for profit). In Washington, sole proprietorships and general partnerships do not need to register with the Secretary of State although they still need to register for a business license with the Department of Revenue. Corporations, limited liability companies (LLCs), limited partnerships (LPs) are, what are referred to as, “separate legal entities” which means that they exist separately from their owners. In the old days, corporations were even called “persons” under the law.
Considerations. There are many considerations that go into deciding whether a separate legal entity is necessary or valuable to your business and, then, deciding which entity fits best for you. The following is an example of some, but not all, of the possible considerations:
- Entity or No-Entity. The first question that you must ask yourself is whether you want or need an entity at all. Many advisors will suggest forming an entity in most cases for liability and tax purposes but many small businesses are just fine as sole proprietors or traditional partnerships. There are both hard costs and administrative costs with having a separate legal entity but do not forget that choosing not to incorporate is also a choice!
- Risk. One of the primary considerations is risk. Separate legal entities provide some level of protection against the collection actions of creditors seeking access to the owners’ personal assets for payment of business debts. However, this protection is not always what business owners think it is for a variety of practical reasons. Nonetheless, risk is a major consideration when selection a form of business.
- Cost. For many small businesses, the cost of forming and maintaining a corporation, LLC or other business form may be prohibitive in the very early days of the business. Many very small businesses choose to start as a sole proprietorship and incorporate later in order to save costs. As long as the businesses owners understand the impact on their risk taking and their taxes, this can be a perfectly valid choice.
- Taxes. The tax impact of the form of business is probably the most complicated consideration but it is also the consideration, next to risk, that is the most impactful. For this reason, it is extremely important to include a competent tax advisor as part of the team when planning a new business. Unlike some of the other considerations, tax structures can be more difficult to unwind later. And, the tax law is always changing so considerations made at the start of a business may no longer be valid later.
- Business Objectives. This consideration should probably be at the top of the list; however, the context of the other considerations is important. I typically advise clients not to obsess over the specific formation but, rather, to inform the advisors of the business objectives and allow the advisors to help craft a plan. All to often, clients come in focused on a corporation or LLC only to find out that the business objectives might be better suited to a partnership (for example).
I regularly consult with clients on this question and I am happy to confer with you to help you navigate the various considerations so that you can make the most informed choice possible.
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