This month we continue our series on 10 Common Mistakes Business Owners Make.

In the last two months, we discussed the importance of using written NOT oral contracts, the value of defining rules for employees, and the importance of having a support network of professionals.

This month we’ll discuss how to choose the right legal entity.

While these are general tips, it is important to consult with an attorney individually if you have specific questions or concerns. The following is not intended to be legal advice.

Starting a new business is like designing a new car.

In the past few months, we’ve reviewed some of the components—surrounding yourself with a network of professionals are the safety features, your passion is the fuel, and your employees and the relationship you have with them are your passengers.

But one of the most important design features of that car is the shape it takes, and that is the type of legal entity you choose for your organization.

That structure will determine the number of drivers (required or optional) your car is equipped to handle, the registration steps you’ll have to take, and what credits, fees and tolls you may face along the way.

Mistake # 4 – Choosing the Right Legal Entity

Generally, there are three basic types of legal entities: sole proprietorship, partnership, and corporation.

We’ll walk through some of the pros and cons of each type of entity, but this may be a time you want to consult an attorney or other expert to have him or her weigh in on which entity is the best strategy for your unique circumstances.

Sole Proprietorship.

A sole proprietorship is simple to set-up because it is without formal structure or government regulation. A tax benefit of this type of entity is that any losses or business expenses may be able to offset your personal income, and therefore, lower your personal taxes.

With a sole proprietorship, however, you have total personal liability.

That means if something goes wrong in your business and a customer or supplier tries to hold you liable, all of your personal assets may be at stake, including your family home! With a sole proprietorship, you also have more limited financial resources because you are the sole owner of the company.

Partnership.

A partnership may be a good choice of legal entity when there are two or more people going into business together. There are different types of partnership: general or limited.

• A general partnership is an arrangement to share in the ownership (and the profits and losses) and management of the company, and is also relatively easy to set up because it requires no special registration. Like a sole proprietorship, all partners have unlimited personal liability. It is important in a partnership to have a written agreement about the duties and responsibilities of the partners, or default rules will control even if that was not your intent!
• A limited partnership is a formal structure that requires filing documentation with the State. All decision making and liability rests with the general partner. The limited partners are shielded from liability, but have no decision making authority.

Corporation.

There are many different types of corporations that you can choose to set up for your company. In general, a corporation is a separate legal entity and is considered a “legal person”—therefore, the corporation itself can contract and be liable (instead of a sole proprietor or partner being liable). Forming a corporation requires a state filing and more formalized documents and regulated record keeping.

• LLC. One of the most common entities currently is a hybrid formation, a limited liability company, or “LLC.” An LLC combines the benefits of a corporation with more of the structure of a partnership. There are still state filing requirements and limited liability for partners, but the tax benefits are not the same as with a corporation.

As you continue to design your business vehicle, remember the key design factors of liability, taxation, and record keeping that will help shape what type of legal entity is best for your adventure!

 Photo by Flickr (Jez.Atkinson)

Next Month: “Mistake #5 – Not Keeping Proper Records”

About Leah Barteld Clague, Esq.

Leah Barteld Clague is an attorney with McLaughlin Law Group, a boutique law firm focused on corporate (small business), estate planning, and estate and trust administration, and tax law. McLaughlin Law Group, started by L. Content McLaughlin, serves clients throughout Maryland. Leah started with the firm in August 2012 after graduating from the University of Maryland, School of Law. Prior to law school, Leah completed her MBA and worked as a financial analyst in both the private and public sector.

In addition to estate planning, Leah has a passion for working with small businesses. As a student, she helped grow a program called “The York Business Academy” that provided brief classes on marketing, management, financing, and legal issues for small businesses and aspiring entrepreneurs. More recently, she consulted for a number of for-profit and non-profit clients and developed business plans, financial models, and marketing strategies that were presented to venture capitalists.  

Feel free to contact Leah at leah@mclaughlinfirm.com or 410-660-2095.