A common question in the very early stages of any business is what business structure to choose.
There is no one-size-fits-all answer to this question. Different business structures have different advantages and disadvantages. The following is a short overview of the main categories of businesses in the District of Columbia (and many states).
Sole proprietorship
This is the easiest choice for beginning your own business without partners or other stakeholders. It costs nothing to form a sole proprietorship. Essentially, you are the business, and the only real paperwork is on your personal income taxes. (Of course, all businesses must get any necessary licenses and permits to operate, but this article is about forming a business, not running one!) This is also one of the advantages of a sole proprietorship: you are taxed at the individual level — there is no corporation, so you do not have to pay federal corporate income tax. (This is known as “pass-through taxation” — taxes are paid by the owners, not the business entity itself.)
The tax advantage of a sole proprietorship is less substantial in DC, which has an unincorporated business franchise tax that applies to many businesses. This puts unincorporated and incorporated business on roughly equal terms, at least at the DC income tax level. But it may still save you on the federal level.
A significant downside of an unincorporated business, however, is that you are the business, and are personally on the hook for debts or other legal claims arising from your business. This is why a more popular choice is…
LLC
LLC stands for “limited liability company.” A single-member LLC in DC has all the benefits of a sole proprietorship, but as the name implies, your liability as the business owner is mainly limited to your investment in the business. If the business fails or gets sued, your personal assets generally won’t be at stake.
The main disadvantage of this structure (relative to a sole proprietorship) is that it takes more work, time, and money to set up. In DC, you have to file paperwork to set one up (and pay a fee), and you have to file a report every two years (more fees).
Partnerships and multi-member LLCs
If you’re going into business with someone else (one or more partners), there are several ways to do this:
- You can form a general partnership, which is sort of equivalent to a sole proprietorship — you share the profits and risks with your partner(s). Little paperwork required, pass-through taxation, but you and your partners are personally at risk for the business’s liabilities. Also, any partner can dissolve the partnership, unless there’s an agreement to the contrary.
- Limited partnerships and limited liability partnerships (LPs and LLPs) are more work to set up (including a partnership agreement and registering in DC), but have clearly defined terms and, in the latter case, limited liability. They also allow some partners to be treated differently than others.
- LLCs can also be multi-member LLCs. They are kind of like general partnerships, but with the benefit of limited liability. An operating agreement organizing the LLC is highly recommended.
Corporations
All of the businesses above are mainly for people who own and operate their businesses, with money they put in themselves or get through loans. But sometimes you want other people to invest in your business, and own some share (or stock) in the company (even if they do not participate in operating the business). This is when you need a corporate structure, which lets you raise funds by selling shares to investors. A corporation also takes on a life of its own — shareholders can simply sell their shares and walk away, and the corporation keeps going.
One disadvantage of corporations, besides being more complicated to set up and operate, is that most corporations have to pay corporate income taxes of their own. Federal law also allows for a special kind of corporation known as an “S” corporation that benefits from pass-through taxation to its owners, but qualifying as an S corp is complicated and has a lot of requirements.
Not One-Size-Fits-All
Even within these categories, there are countless ways for companies to be structured or operated, based on the operating agreement, articles of incorporation, or similar governing documents. Above are just the main categories we group businesses into, for legal and tax purposes. Even within these categories, there’s a lot of diversity.
If you’re starting a business in DC and are not sure which entity to choose, contact Nigel for a free consultation. He can help you get started with an assessment of your business’s needs and goals.
