Introduction
“Should I incorporate?” It’s a question most entrepreneurs ask themselves at some point, in the belief that it’s necessary to form a corporation in order to limit personal liability or establish a true “business,” often based on a vague appreciation of the advantages of the corporate form, perhaps informed by an vendor’s online recommendation (typically accompanied by an offer to do the formation work!). While each individual’s situation is different and a general reference source cannot comprehensively address this question, this article illustrates the primary differences between the basic “corporate” forms, to help a small business person analyze this fundamental decision.
As a starting point, the proper question typically isn’t “Should Iincorporate?” but rather “Should I form a business organization through which to conduct my business enterprise?” closely followed by the question “If so, what type of business ‘entity’ should I choose?” Digging down another level, several additional questions must be posed to properly inform the decision:
- How concerned am I that my business operations will expose me to liability? Sources of liability can include personal injury lawsuits, product or manufacturing defect lawsuits, intellectual property infringement, and vendor or lender debt claims.
- Will I take on a partner?
- Will I seek to attract outside funding, and if so, what type and on what terms?
- Do I expect to hire employees?
- What are my growth prospects or ambitions?
The following discussion addresses these operational considerations in the context of the choice of entity decision.
Choice of Entity
Sole proprietorship. Sole proprietorships are by far the most common form of small business. The “formation” costs are minimal – one simply conducts a business activity, typically using his or her personal bank account and name (or potentially a different name: if you see a moniker like “Harry Dunne, d/b/a Mutt Cuts,” that’s a sole proprietorship). This is adequate for many individuals who do not want to bring on a partner or investor, do not have a budget or tolerance for the administrative responsibilities of managing a more formal entity, and have limited concern that their business activities will expose them to personal liability. From a liability standpoint, the individual owns all of the assets and liabilities of the business, liabilities are not limited to the amount of capital set aside for the business, and existing liabilities are not extinguished upon the sale or dissolution of the sole proprietorship. From a tax standpoint, one simply files a Schedule C to one’s personal tax return, and any net profit or loss from the business is treated as either additional income or a tax deduction, respectively (though note that Federal self-employment tax must be paid on any profit). Despite the general lack of formalities, it is worth noting that Massachusetts law requires any person engaged in business under an assumed name to file a Business Certificate in the office of the clerk of the town or city in which the business is located.
Partnership. A partnership is the most basic multiple-owner form of business. Like a sole proprietorship, it is an unincorporated form of business organization and no written agreement or state filing is necessary to establish a general partnership (a state filing is, however, required to form a limited partnership). It is so basic that two individuals who split the costs and profits of a business venture, even in the absence of a formal agreement or legal filing, will be considered by law to be a partnership, and will be subject to the general provisions of the applicable state’s partnership statutes. A more deliberately formed partnership will typically entail a partnership agreement outlining the economic and other rights and responsibilities of each partner, which can be structured as simply (two friends tending a worm farm in their living room, agreeing to split their economic results 60/40) or as complexly (hedge funds, private equity funds, and venture capital funds are nearly always structured as partnerships, and their partnership agreements can be more than 100 pages long) as the owners require to achieve their goals. For tax purposes, a partnership is disregarded – it does not pay taxes at the entity level – rather, any profit or loss “flows-through” the partnership and is recognized by the partners on their individual tax returns, similarly to the way that a sole proprietor recognizes profit or loss. Nonetheless, a partnership must file an annual profit and loss statement with the IRS, and provide another form to each partner indicating that partner’s share of the profit or loss. With respect to liability, general partnerships assign undivided and unlimited liability to each partner for the debts and other liabilities incurred by the partnership (a concept referred to as “joint and several liability”). A limited partnership, typically used to raise money from passive investors (e.g., real estate or private equity investors) vests one or more general partners with all management responsibility and unlimited liability, while limited partners have no decision-making authority and are only liable for their contributions.
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