How to Choose A Business Entity Type – Part 1

This article is original content written by Thomas Scanlon, CPA, CFP® of Manchester, CT.

photo: train track

 

Choice of Business Entity

We are frequently asked by clients starting a business, what type of entity they should be.  Here we will address Sole Proprietorships and Limited Liability Companies.

 

Sole Proprietorship

Some (very) small businesses operate as a Sole Proprietorship. This is a one man (or women) band.  In their business, they merely use their own name or get a Trade Name, Doing Business As (D/B/A).

The beauty of the Sole Proprietorship is its simplicity.  Hang out your shingle and you are (mostly) in business.  Sure there might be some local registration / fees / license requirements, but once these are met, you are good to go.

With this simplicity however there is a very big cost associated with it. It’s the concept of Unlimited Liability. That doesn’t sound very good, does it? It’s not. Unlimited Liability is just like it sounds, Unlimited Liability.

This means if something goes wrong, (think Murphy’s Law here) any claims / damages that are not covered by insurance, the Sole Proprietor is personally responsible for them.

 

YIKES!

Why would anyone want to take on these risks?

 

Limited Liability Company

One alternative to a Sole Proprietorship would be a Limited Liability Company (LLC). In this case, as there is only one owner, this would be called a Single Member LLC (SMLLC).

If handled appropriately, a Single Member LLC should limit some of the potential exposures.

For the LLC to be effective, you’ve got to hold yourself out as an LLC. Here’s what you would need to do:

  • Register your LLC with the Secretary of State. Here is how to get to the Connecticut Secretary of State.
  • Obtain a Federal Tax Identification Number. This is done by completing IRS Form SS-4.

The IRS only requires you to have a Tax ID# when you have employees or maintain a Qualified Retirement Plan.   However, it is likely to be required by the bank where you maintain your accounts.

  • Adopt and maintain an Operating Agreement. In Partnerships, these documents are called Partnership Agreements. In LLC’s they are called Operating Agreements.  An Operating Agreement outlines the rules and regulations of the LLC.

I know it sounds silly to recommend having an Operating Agreement when there is only one member. It’s following the formalities that should help you minimize your liability, which is the reason for forming the LLC in the first place.

  • Maintain a separate LLC checking account. Other than the owners draw, do not run any personal expenses through this account.   This will indicate that the LLC is separate.
  • Take active steps to hold yourself out and an LLC. This can be accomplished by having the LLC name on:
    • Letterhead / Stationary
    • Checks
    • Invoices
    • Contracts
    • Website and Email

Keep in mind the purpose of the LLC is to limit your personal liability. There is no tax benefit to having a Single Member LLC.  This LLC is taxed the same as a Sole Proprietorship.

 

ACTION ITEM: If you are considering starting a business by yourself, or if you already have a Sole Proprietorship, consider an LLC.  For relatively modest legal fee to form the entity and some state registration fees, it should provide you with limiting your liability.

Tom Scanlon, CPA, CFP® has over thirty-five years experience in public accounting with an extensive background in the areas of financial, tax and estate planning.

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