These last few chapters were placed here with purpose. Now that you have an understanding of liabilities, contracts, intellectual property, and business regulations, you are prepared to end the study of business law with instruction on how to actually choose a business entity form and register it appropriately. Understanding different business entities and choosing the appropriate one is complicated and worthy of substantial consideration.
Many students wonder if they will ever have an opportunity to use this information in a practical way. My experience is that almost all, if not all, will. For example, the following common scenarios are ones in which former students have put this information to use:
- An employee starting an online side-business,
- An accountant or lawyer leaving a large firm to "go solo",
- A new farmer setting out to purchase land and raise bushels of...whatever, or
- A recent graduate joining a new small business.
The scope of this last unit is such that I cannot possibly review all aspects of business entity law. Nonetheless, we will review the basics ranging from how different business entities are taxed, operate, and limit the liability of owners. We will also discuss how to choose an appropriate name for the business and the mechanics of actually registering that business with the state (note, there is no federal registry for businesses).
Some students worry that when selecting a business entity, there is one correct and true business entity for their small business, and that by choosing the "wrong" entity type, the business will not prosper. To me, this sounds like the common misconception that each individual has only one soulmate. It's simply not true. Most businesses can operate as either an LLC or S-corporation, a partnership or C-corp. There are some rules where certain business entity types are not appropriate for a specific business model, but in the absence of those rules, business owners have much latitude to select their preferred business vehicle. You may know, for example, that many accounting firms operate as LLPs, but others are corporations or even LLCs.
As a result of this latitude, professionals may differ when recommending a business entity. For example, an attorney may recommend that a business operate as an LLC because of its enhanced liability protections. On the other hand, an accountant may recommend that the same business operate as an S-corporation for tax reasons. As usual, the attorney is probably correct, but the dispute between the two demonstrates how reasonable minds may differ.
The principal forms of business are 1) sole proprietorships, 2) general partnerships, 3) limited liability partnerships, 4) limited partnerships, 5) limited liability limited partnerships, 6) limited liability companies, 7) subchapter c corporations, and 8) subchapter s corporations.
Over the next several chapters, we will discuss tax, liability, and management rules for these different business entities. However, I'd like to dispense now with one of these types - the sole proprietorship.
A sole proprietorship is the simplest organizational form by which businesses can operate. As you can discern from its name, a sole proprietorship has only one business owner, regardless of the number of employees. If there is more than one owner, then it is not a sole proprietorship.
A sole proprietorship is started when a person starts operating a business. Perhaps you have started a sole proprietorship when you started selling lemonade on the side of the road or when you began selling knitted hats out of your dorm room. The business is not a taxable entity. All income derived from the business is taxable and paid by the owner directly.
A sole proprietor assumes a great deal of risk. She is personally liable for all obligations of the business. All debts of the business, including debts incurred by the business only, are her debts. Should she be unable to pay those debts, the creditors will require her to pay those debts from her personal, non-business assets. As such, a sole proprietor may lose everything if the business becomes insolvent.
Almost every text book I have reviewed indicates that despite these risks, a business person may choose to operate as a sole proprietor because it is simple and requires no formalities. I find this argument to be idiotic. As you will see, registering a business takes very little time and expense. That small investment can pay great dividends in terms of personal liability protection; hence, I feel there is no good reason to operate as a sole proprietorship. Unfortunately, because this text is not yet the most popular book on starting a business, around 70% of all businesses in the U.S. operate as sole proprietorships. We can do better.