The Lowdown on Business Legal Structures
When you’re making money — even just scraps — from your creative work on your own, not as an employee of some other company, guess what: You’re running a business. It may not feel like it but in the eyes of the law you’re a business owner. As part of this, one thing you should think about is what legal structure to choose for your business.
In all states, the basic types of business structures are:
- sole proprietorships
- partnerships (general and limited)
- limited liability companies (LLCs), and
Sole proprietorships are one-owner businesses. Any business with two or more owners cannot, by definition, be a sole proprietorship. Technically, a sole proprietorship is simply a business that is owned by one person and that hasn’t filed papers to become a corporation or an LLC. Sole proprietorships are easy to set up and to maintain — so easy that many people own sole proprietorships and don’t even know it!
For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor. This is true whether or not you’ve registered your business with your city or obtained any licenses or permits. And it makes no difference whether you also have a regular day job (or three side jobs). As long as you earn money on your own (or sometimes with your spouse) and have not filed papers to become a corporation or a limited liability company, you are a sole proprietor.
There are two important aspects of sole proprietorships to understand:
- You and the business are one and the same in the eyes of the law, so any lawsuits or debts against the business will also bind you personally. In other words, you are personally liable for all debts of the business.
- Any profits earned by the business simply “pass through” to you, the owner, and are taxed as your personal income, similar to wages earned as an employee.
Bring two or more people together into a business venture, stir gently and — poof! — you’ve got a partnership. By definition, a partnership is a business that has more than one owner and that has not filed papers with the state to become a corporation or an LLC (or a limited partnership or limited liability partnership).
Similar to sole proprietorships, partnerships are not considered a separate legal entity from the owners, so the owners are personally liable for any business debts and obligations. Also, similar to sole proprietorships, profits earned by the partnership pass through to the owners and are taxed as their personal income. The business itself does not owe its own income taxes.
General vs. Limited Partnerships
Usually, when you hear the term “partnership,” it means a general partnership. General partners are personally liable for all business debts, and each individual partner can be sued for the full amount of any business debt. Another very important aspect of general partnerships is that any individual partner can bind the whole business to a contract or business deal — in other words, each partner has “agency authority” for the partnership. There are also a couple of special kinds of partnerships, called limited partnerships and limited liability partnerships. They operate under very different rules and are relatively uncommon.
Limited Liability Companies (LLCs)
Like many folks just starting out with their own ventures, you might find yourself in this common quandary: On one hand, having to cope with the risk of personal liability for business misfortunes scares you; on the other, you would rather not deal with the red tape of starting and operating a corporation (discussed below). Fortunately you can now resolve this issue by taking advantage of a relatively new form of business called the limited liability company, commonly known as an LLC. LLCs combine the pass-through taxation of a sole proprietorship or partnership (taxes on business income are paid on each owner’s individual income tax returns) with the same protection against personal liability that corporations offer.
For many, the term “corporation” conjures up the image of a massive industrial empire more akin to a nation-state than a small business. In fact, a corporation doesn’t have to be huge, and most aren’t. Stripped to its essentials, a corporation is simply a specific legal structure that imposes certain legal and tax rules on its owners (also called shareholders). A corporation can be as large as IBM or, in many cases, as small as one person.
One fundamental legal characteristic of a corporation is that it’s a separate legal entity from its owners. If you’re familiar with sole proprietorships and partnerships, you’ll recognize that this is a major difference between those unincorporated business types and corporations. Another important corporate feature is that shareholders are normally protected from personal liability for business debts. Finally, the corporation itself — not just the shareholders — is subject to income tax.
Choosing the Best Structure for Your Creative Business
Although there are many differences among the various types of business organizations, most business owners choose an operating structure based on one legal issue: the personal liability of owners for business debts. While the issue of personal liability can have a huge impact on successful small businesses a few years down the road, business owners who are just starting out on a shoestring often care most about spending as little money as possible on the legal structure of their business. Keeping things simple and inexpensive with your business structure makes good sense: Far more new businesses fail because they don’t control costs, not because they lose costly lawsuits.
That said, if your creative business will engage in a high-risk activity, rack up large business debts or have a significant number of investors, you should make sure to choose a structure that will limit your personal liability, either with an LLC or a corporation.