Legal entities: Understanding the four key ones

Vehicles come in several types, from cars to SUVs to trucks. So when a person says that they own a vehicle, you need to ask follow-up questions to figure out exactly what they own. The same is true for businesses. Four of the main forms are sole proprietorships, partnerships, corporations, and limited liability companies.

Why does it matter? Because each type has advantages and disadvantages. Make the right choice and you’ll minimize taxes, administrative hassles, and legal liability. Pick wrong and you’ll pay unnecessary tax, jump through extra administrative hoops, and risk your home and assets.

Given those stakes, which legal entity should you pick? It depends. Let’s discuss each in a little more detail to help you start the thinking process.

Option one is a sole proprietorship, which is a business owned and operated by a single person. In a sole proprietorship, the owner and the company are treated as being one and the same for tax and legal purposes.

The main benefit of a sole proprietorship is simplicity. Sole proprietorships are easy to set up—so easy, in fact, that many people own sole proprietorships without even knowing it. That’s because it is the default form. Every business with a single owner is automatically a sole proprietorship unless they take steps to select a different structure. This is true even if the business has never obtained licenses and permits or been registered with the appropriate authorities.

Consider an example. Amy has a job but also moonlights as a photographer. But since photography gigs are sporadic, she’s never created a business name, formed a company, or obtained a business license. So, what is her business? You guessed it—a sole proprietorship.

Unfortunately, that simplicity comes with a major downside—unlimited personal liability for anything bad that happens to the business. If the business cannot pay its debts, the owner is on the hook for them. If the business is sued, the owner is ultimately responsible. Because of this unlimited personal liability, if something bad enough happens, the owner could lose virtually all of their personal possessions—their car, their savings, and perhaps even their home.

Scary, right? Absolutely. But not always. It depends on the type of business you are running. To figure out whether you should worry, imagine your business. Now think about what would happen if everything went wrong with a client. Do they go to the hospital? Do they lose millions of dollars? Or do they just lose the money that they paid for your service? If a really bad day at the office includes clients getting sick, hurt, or losing heaps of cash, then unlimited liability can be a nightmare. But if you’re the previously mentioned photographer who would merely need to refund some money, then unlimited liability is hardly cause for losing sleep.

Now let’s take a peek at option two: a partnership. At its simplest, it looks almost the same as a sole proprietorship, except that instead of one owner there are two or more owners. In other words, like a sole proprietorship, if a business has two or more owners but has yet to register and get licenses and permits, then the business is a partnership. Also, like a sole proprietorship, the business and each owner are treated as one and the same for tax and legal-liability purposes. Thus, a big enough lawsuit would risk almost all of the owners’ collective personal assets.

Option three is a corporation. In a corporation, shareholders own the business while officers and directors, respectively, operate and supervise the business.

Corporations enjoy two major strengths. First, unlike partnerships and sole proprietorships, corporations enjoy limited liability, meaning that an owner can only lose what they invested in the company, nothing more. So, their personal assets are not at risk. Second is easy fundraising. If your company needs to raise money, it’s relatively simple to sell stock in the company. The same is not true for partnerships, sole proprietorships, or limited liability companies.

But corporations have some drawbacks. For one, a corporation is taxed twice—once on the income that the company generates and then again on the dividends that it transfers to the company’s shareholders. For another, corporations tend to be more complicated to set up and maintain than a sole proprietorship or a partnership. You will need to create corporate documents, appoint a board of directors, and follow various corporate formalities such as holding annual meetings and executing corporate resolutions.

Now for limited liability companies, the most popular type of legal entity. The reason for that is LLCs merge the best of sole proprietorships, partnerships, and corporations. They are simple to form and require fewer corporate formalities, all while enjoying limited liability (like corporations) and being taxed just once (like sole proprietorships and partnerships). Plus, they have other tax benefits for serial entrepreneurs who own several LLCs.

But, as noted earlier, LLCs are generally less effective than corporations if the company needs to raise money for reasons we’ll get into during a future article.

To sum up: Chances are that an LLC is the right choice for a new business. But as with all things legal, the specifics of your situation matter a great deal. So, you may want to consult with your attorney and accountant before you decide what type of entity to use.

This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.

Jordan Sundell (Special to the Saipan Tribune)
Jordan Sundell is a lawyer primarily practicing business, real estate, estate-planning, and asset-protection law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including JZ Group. His columns—focused mainly on real estate, small business, and estate planning—are published every other Tuesday. Be sure to like the Fine Print on Facebook!