Who Is This Article For?
First, let's
identify for whom this article is written. This article is for new
entrepreneurs thinking about starting an online business which operates
in the United States.
The information contained here is "entry
level" for people just starting out in online business. It is not
written for people in more sophisticated situations. That being said,
let's get going.
Most new online business owners seem to "jump off
the deep end" without giving much thought or doing much planning as to
how they will operate their businesses.
That is a poor approach to
starting a business. In reality, there are a number of considerations
that need to be taken into account at the outset if you want to succeed
with your online business and not expose yourself to problems down the
line.
Forms of Business Entities
One of the
first matters to consider is whether to form an entity to operate your
business. Let's begin at the very basic level and quickly identify your
options with respect to operating your business.
For most new businesses, your options are:
-
Sole proprietorship
-
Partnership
-
Corporation (S-corporation or C-corporation)
-
Limited Liability Company
There are other forms of doing business, but they are
usually for more sophisticated enterprises, so we'll confine our
discussion to the ones listed above.
Sole Proprietorship
This is the default option, one that many new entrepreneurs wind up using because they never really think about the issue.
Basically,
a sole proprietorship is just you doing your thing. You and your
business are not separated legally. That can be quite significant, as
we'll see below.
Advantages of a Sole Proprietorship
Here are the advantages for choosing to do business as a sole proprietor:
-
Ease of Formation. A sole proprietorship is the
simplest business format to form, because there is no formation. It's
just you doing business as you. There is no separate legal entity within
which you are operating your business. You may still require business
licenses, tax id numbers, etc., but there is no separate entity to be
formed and operated.
-
Low Cost of Formation. Since it is not necessary to
form a separate entity to operate as a sole proprietorship, it is less
expensive to get started because you don't have to pay an attorney or
company to form a special entity for you and you don't have to pay any
of the fees to you state that are required to form a corporation or LLC.
-
No Separate Income Tax Returns. Because there is no
separate entity involved in the operation of a sole proprietorship, the
IRS doesn't require you to file any separate income tax returns. You
will normally just add a schedule (Schedule C) to your good old Form
1040 and file away.
Disadvantages of a Sole Proprietorship
Here are the disadvantages of operating as a sole proprietorship:
-
Personal Liability. This is the overriding disadvantage
of doing business as a sole proprietor. Because there is no separation
between you and your business, if you get sued all of your personal
assets (house, car, investments, etc.) are at risk. Given the fact that
we live in a litigious society where people are suing other people over
ridiculous claims, and sadly prevailing sometimes, this is a major
concern. If you end up with a judgment against you, you risk losing most
of your personal assets.
-
Less "Professional" Image. Doing business as "John
Smith" doesn't present the professional image in the business world
that, for example, "World-Wide Multimedia, LLC" would. This may not be a
major concern for you, but it is something to consider, especially if
you are trying to get other businesses to recognize you as a joint
venturer, affiliate, or member of their CPA network.
Partnerships
We won't spend much
time on this one, because it is relatively rare in the online world. A
partnership is an association of two or more people or entities for the
purpose of engaging in business.
So, for example, if you and your
brother-in-law want to start a business, a partnership could work. It is
not something that is normally recommended, though, for reasons
explained below.
Advantages of a Partnership
Frankly, in most situations there are none.
Disadvantages of a Partnership
Here are the primary disadvantages of a partnership:
-
Separate Tax Returns. Partnerships are required to file
their own, separate income tax returns, so paperwork is increased
without commensurate advantages being offered.
-
More Complicated to Form. Partnerships normally require
paid assistance in the formation process, so costs are increased, again
without offsetting advantages in most circumstances.
-
Increased Liability. This is the big one. A partnership
does not protect your personal assets. Even worse, since you have one
or more partners involved, you potentially become liable for their
activities too, whether or not you actually participated in a given
transaction. In addition, your partners can normally obligate the
partnership to financial obligations and contractual agreements,
sometimes without your knowledge. So, there is definitely increased
personal risk to you financially in a partnership.
And, you must be cautious when pursuing business
objectives with other people. You can end up in a partnership without
meaning to.
Since there are normally no formal organizational
requirements for a partnership, a handshake may be all that is required.
Just the act of doing business and sharing profits and losses with one
or more other people can result in the courts declaring you to be in a
general partnership, whether that was your intent or not.
Corporations
A
corporation is a separate legal entity that is formed to operate your
business. It is that separation between you and your business that can
be a major advantage.
You will hear two broad types of
corporations discussed: C-corporations and S-corporations. Those
distinctions are a topic for another article, but they will be mentioned
briefly.
In a nutshell, a corporation is a corporation, the
S-corporation/C-corporation distinction is merely an election made by a
corporation as to how it wants to be treated for income tax purposes by
the IRS.
Advantages of a Corporation
Here are the principal advantages of using a corporation to operate your business:
-
No Personal Liability. The main advantage has already
been hinted at. A corporation is a separate legal entity from you
personally. Assuming you set things up properly and adhere to the
operational requirements of a corporation, if your incorporated business
gets sued only the assets owned by the corporation are potentially
exposed to the business's liabilities. Your personal assets are shielded from liability.
-
More Professional Image. As discussed above, a corporation presents a more professional image to the world than a sole proprietorship.
-
One or More Owners. The owners of a corporation are
called "stockholders." The law allows a corporation to have one or more
than one stockholder. S-corporations may not have more than 100
stockholders (at the time of this writing). C-corporations may have an
unlimited number of stockholders.
Disadvantages of a Corporation
Here are the main disadvantages of a corporation:
-
More Complicated to Form. Articles of Incorporation and
other formation documents must be prepared and filed with the state in
which you incorporate. Normally, you will need paid assistance and there
will be certain filing fees paid to your state, so there is expense
involved. At least with a corporation you are getting the offsetting
benefit of limiting your personal liability.
-
Requires Separate Bookkeeping. Since a corporation is
regarded as a separate enterprise from you personally, you will be
required to keep separate books and records for business and tax
purposes. This may require an accountant or CPA to assist you in setting
them up properly.
-
Separate Income Tax Returns. Generally, a corporation
will be required to file its own separate income tax returns. You do not
report the corporation's income and expenses directly on your personal
tax return.
-
Annual Filing Requirements. You state of incorporation
will require at least one annual report to be filed for your
corporation, and there will be a small fee charged by the state in
connection with that filing.
Limited Liability Companies (LLCs)
Limited
liability companies are probably the most popular entities these days.
They are gradually replacing corporations and the "go-to" business
entity.
So as to not over-extend the length of this article, I'll
just list the advantages and disadvantages without more discussion,
since they are almost identical with the remarks about corporations.
Where there's a difference, it will be pointed out.
Advantages of an LLC
-
No Personal Liability (See discussion under corporations)
-
More Professional Image (see discussion under corporations)
-
One or More Owners. An LLC's owners are called "members." The law allows an LLC to have one or more members.
Disadvantages of an LLC
-
More Complicated to Form (See discussion under corporations)
-
Requires Separate Bookkeeping (See discussion under corporations)
-
Separate Income Tax Returns. A multi-member LLC will be required to file
its own income tax returns. For single member LLCs, there are some
special opportunities with respect to how they are taxed for income tax
purposes. Often, the single member can choose to have the LLC
disregarded for income tax purposes. That does not, however, jeopardize
your liability protection from lawsuits.
-
Annual Filing Requirements. (See discussion under corporations)
Summary
I think it's fair to say
that limited liability companies are the most recommended entities,
especially for online businesses. As a general proposition, they offer
the same protection of your personal wealth from business liabilities
that a corporation does, and LLCs are usually considerably more flexible
as far as what the law allows in their management structure.
There
are a lot of subtle nuances that professionals can debate when
considering the pros and cons of the various forms of doing business.
In reality, though, the main concern for most smaller businesses is liability protection for the owner's personal assets.
Liability
protection can be gained by using a corporation (S or C) or an LLC as
the entity for operating your business. Liability protection is
not gained by operating as a sole proprietor or in a partnership (formal or unintended).
