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Friday, September 21, 2018

Selecting the Appropriate Business Entity (Sole Proprietorship, Corporation, Limited Liability Company, Etc.)

The number one inquiry my office gets from people looking to start a business is what type of business entity they should form.  There are a myriad of options ranging from corporations, limited liability companies, limited partnerships, sole proprietorship, etc.  There are numerous factors you should consider when selecting the type of entity to form.  The least important of these factors, however, should be the cost to form them.  The biggest mistake people make when starting a business is selecting an entity based solely on how much it cost to form them.  Doing so typically results in clients selecting the wrong type of entity which can have negative tax and legal implications.  The cost to resolve the issues surrounding the formation of the wrong entity will far exceed any money you had saved during the formation process.  Accordingly, my next few blog posts will discuss this very important step in starting your new business.

Sole Proprietorship/Partnership v. Legal Entity

The first decision you need to make is whether you should do business under a legal entity or simply as a sole proprietor (if one owner)/partnership (if two or more owners).  The biggest advantage of doing business as a sole proprietorship or partnership is that it is extremely easy to form.  Forming a sole proprietorship/partnership is as easy as going to the county clerk’s office where the business will be located and filing a Business Certificate Registration (a/k/a DBA—“doing business as”—application).  Said form is very simple to fill out and the filing fee is nominal.  For example, in Westchester County the filing fee for a Business Certificate is only $35.00 and the form itself takes no more than five minutes to complete (a copy of the form can be found here).  Immediately upon the filing of the application you can start doing business under the new business name.  This easy startup process is in stark contrast to forming a legal entity such as a corporation or limited liability company.  Forming these types of entities require legal papers to be filed with the New York State Department of State (Division of Corporations) and have filing fees that cost hundreds of dollars as well as other hidden costs (a topic to be addressed in another blog post).

The second advantage to doing business as a sole proprietorship or partnership is that there are no major state laws governing the internal operations of the business.  Again, this is different from both corporations and limited liability companies both of which are governed by lengthy and comprehensive state statutes (New York Business Corporation Law and Limited Liability Company Law respectively). 

Notwithstanding the aforementioned simplicity of starting a sole proprietorship/partnership, rarely is it the appropriate choice.  That is because sole proprietorships/partnerships do not provide the business owner with limited liability should the business ever be sued.  That means that if the business is sued and the court awards a monetary judgment against the business, the plaintiff (the party who commenced the lawsuit) can try to enforce the judgment against the business owner’s personal assets.  This includes freezing any personal bank accounts that have your name on it or even putting a lien on your home.  Legal entities such as corporations or limited liability companies, however, shield their owners with limited liability so that if the company is ever sued their personal assets are protected.  Just as the shareholders of large public corporations are protected if the company is sued (if somebody sues Uber, Inc. they can’t go after the assets of its shareholders), the shareholders of your small private corporation are also protected.

Partnership Agreements

Throughout this blog I have been treating sole proprietorships and partnerships as one and the same.  Although that is true when it comes to formation and how they are treated legally if sued, there is one additional aspect with partnerships that you should keep in mind.  When you are going into business with a partner is it imperative that you enter into a partnership agreement which addresses important issues such as what happens when a partner no longer is actively participating in the business (i.e. only one partner is doing all the work) or if a partner wants to sell his/her interest to an outside party (who the other partners might not get along with).  Think of a partnership agreement as a pre-nup which spells out the rights and obligations of the partners should there be a major dispute or divorce in the business relationship.  When you first start your business, you and your business partner(s) are in the honeymoon phase meaning it seems like you are on the same page and could easily resolve any problems that might come up.  It may, therefore, be tempting to view a partnership agreement as an unneeded expense.  Inevitably, however, some relationship may deteriorate and you and your partner(s) will find that you cannot work together.  A well thought out partnership agreement will establish the rules before there is disagreement thereby allowing for a more organized settlement of the dispute or business divorce.  This will allow the business to survive even after a partner has left.  In my experience, the lack of a partnership agreement will ultimately result in the demise of the business after the first major disagreement between the partners.

 






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