Two Step Process to Choose a Legal Entity to Conduct Your Online Business

Two Step Process to Choose a Legal Entity to Conduct Your Online Business 

Are you just getting started in your online service business?  Maybe you are a coach, course creator, a done-for-you service provider or you run a membership, and are considering forming a legal entity to run your business. Or maybe you have been operating your business for a while, but haven’t yet formed a legal entity to run the business. 

There’s a two-step process to undertake when deciding how you should conduct your online business. First, you’ll want to understand the differences among the different choices.  Second, you’ll want to consider how the differences among the choices relate to your specific circumstances. Getting your online business launched is an exciting process. With all the tasks on your to-do list, make sure you’re considering how you and your business will be legally protected based on the business structure you choose for your online business. 

There are four basic ways that most online businesses operate: sole proprietorship, partnership, limited liability company and corporation. Each of these choices has different characteristics, advantages and disadvantages. Before you select the mode of doing business that is right for you and your online business, you’ll want to understand what each of these choices means and then the pluses and minuses of each one. 

Sole Proprietorship

This is the most basic way to operate a business. It’s as easy as waking up one morning and deciding you want to offer a product or service to generate income. In this case you are the business.  You are conducting business as yourself, and there is no separation between you and your business. You may select a trade name, also called a dba (doing business as) or a fictitious name, but you are still the one conducting the business. Conducting business as a sole proprietorship has a low barrier to entry. It’s very easy to start. Although some states require sole proprietorships to register with the state, not all states require registration. 

One element of a sole proprietorship that is especially important to remember, is that a sole proprietorship is not a legal entity. A sole proprietorship is an unincorporated business that is operated by a single person. Because sole proprietorships are usually compared and contrasted with limited liability companies and corporations, it’s easy to assume that sole proprietorships are legal entities, but they are not. This is an important distinction for one very important reason. When you operate your business as a sole proprietorship, you are personally liable for all of the obligations of the business. This means that if your business breaches a contract or gets sued by a customer, your personal assets are at risk to satisfy any judgment against the business. There is no separation between you as an individual and your business when you operate as a sole proprietor. This means that assets such as your bank accounts, home and car can be used to satisfy legal judgments against you that arise from operating your business as a sole proprietor. 

Advantages of sole proprietorships include complete control over business decisions and operations, the simplicity of forming the business and maintaining it over the time you operate the business, and pass-through tax treatment. As its name implies, a sole proprietorship means that only one person can operate the business. This means that sole proprietors get to make all business decisions without consulting with anyone else. Sole proprietorships are easy to form, often requiring minimal or no paperwork at the outset and minimal to no paperwork to maintain them going forward. Pass-through tax treatment means that the income and losses from the business are reported on Schedule C of your personal federal income tax return. As a sole proprietor, you do not need to file a separate tax return for your business. The net income from your business, after deducting expenses, is taxed at your personal income tax rates. 

Limited Liability Company

Limited liability companies are a popular choice for online business owners looking to set up a legal entity to run their businesses. A limited liability company can have one owner or more than one owner. If the limited liability company, or LLC, has one owner, it operates similarly to a sole proprietorship. There is only one owner who is able to make all decisions regarding the business. If there is more than one owner, the LLC operates similarly to a partnership. With multiple owners of an LLC, they each have the rights and obligations determined among the partners and written in the LLC operating agreement. Unlike a sole proprietorship, which is a person conducting business as themself, an LLC is a separate legal entity. As a separate legal entity, an LLC offers limited liability protection for its owners that are conducting the business. If the LLC breaches a contract or is sued in the course of operating the business, then the assets of the LLC, and not the assets of the LLC’s owners, are at risk to satisfy these liabilities. 

LLCs are generally not difficult to set up, but are slightly more complicated to establish and maintain than sole proprietorships. LLCs are separate legal entities, and LLCs can only be created by filing the appropriate paperwork with the state where the LLC is formed. LLCs are permitted as a way to operate a business because each state has enacted a law that allows it.  Each state has its own statutes and regulations regarding the formation and registration of LLCs. Each state requires different information from the owners of an LLC filing for registration with the state and each state sets its own filing fees and ongoing reporting requirements and fees. In addition to the initial filing fee and registration paperwork, nearly every state requires LLCs to file an annual or bi-annual report and pay a fee along with the filing. LLCs that fail to file these reports can have their LLC charters revoked by the state. 

Operating as an LLC provides a few other advantages. There is a great deal of flexibility available to structure the LLC.  The LLC can be member-managed, meaning that the owner or owners make the decisions for the LLC. LLCs can also be manager-managed, meaning that one or more individuals is appointed as a manager of the LLC and decisions for the LLC are made by these managers instead of by the member or members. Someone can be a manager without being a member of the LLC. An LLC also gets to select its tax classification. When an LLC is formed, the default tax classification is pass-through tax classification. This means that if there is one owner of the LLC, income and expenses are reported on Schedule C of the individual owner’s federal income tax return as if the LLC was a sole proprietorship. If there are multiple owners of the LLC, then the LLC is taxed as a partnership and the income and expenses are also reported on Schedule C. The limited liability protection of the LLC doesn’t change as a result of the tax classification. 

One often overlooked advantage of using an LLC to operate your online business is that having an LLC often lends a certain amount of credibility and professionalism to the online business. Having a legal entity conduct your business tells your customers you take business seriously and are taking the steps necessary to have a legitimate business. A legal entity such as an LLC can also make a business appear larger than it is, which sometimes can aid in securing certain contracts or business engagements. 

Corporations

With the increasing popularity of LLCs as a choice of legal entity for online business, corporations as a choice of entity have taken a back seat. Like an LLC, a corporation is a separate legal entity. Corporations also offer limited liability protection to their owners, called shareholders. Like an LLC, a corporation is a choice of legal entity for business because each state has enacted a statute that allows business owners to form a corporation to conduct business. A corporation can have a single shareholder or multiple shareholders. 

Corporations are much more structured and rigid in how they are set up than LLCs. Corporations are operated by three distinct layers: shareholders, directors and officers. Shareholders own the corporation and elect the board of directors. The board of directors sets policy and guidance for the business and elects the officers, and the officers carry out the day to day operations of the corporation. You might be thinking, if I’m the only owner of the corporation who fills all of these roles? When a corporation has only one shareholder, then that shareholder can elect herself as the sole director, and then as the sole director she can elect herself as the officers of the corporation. Each of these layers has different roles regarding the operation of the corporation, and when there is only one shareholder then that shareholder switches hats to carry out the tasks of each role. These layers make the operation of corporations much more complicated than LLCs or sole proprietorships. 

Like LLCs, corporations are required by most states to file annual or bi-annual reports and pay filing fees with these reports. Failure to file these reports may result in the state revoking the corporation’s charter. When a corporation is formed, the default rule is to tax the corporation as a separate legal entity, instead of passing income and expenses through to the owner. This means that the corporation has to file a separate tax return. Both corporations and LLCs are able to make tax elections to change their default method of taxation. A corporation can elect to be taxed as an S-corporation. The “S '' stands for Sub-chapter S of the Internal Revenue Code where the rules about this special tax election are located. Without an election to be taxed as an S-corp, a corporation would pay taxes on its earnings and then its shareholders would pay taxes on any shareholder distributions. This is known as “double taxation,” and so many corporations with a single owner elect to be taxed as an S-corp. LLCs can also elect to be taxed as corporations and then make an S-election so that they are also taxed as S-corporations. I'll discuss S-corporations in a future edition of the blog. For now, it's important to know that both LLCs and corporations can take advantage of the tax benefits of an s-corp election.

Partnerships

This blog wouldn’t be complete without at least a passing mention of partnerships. Partnerships operate similarly to multi-member LLCs, but without any limited liability protection. A partnership means that 2 or more persons are carrying on the business as co-owners for profit. Although a partnership is considered a legal entity and can engage in business in the name of the partnership, a partnership lacks the protections afforded to LLCs and corporations. All partners are liable for the actions of the other partners and each partner’s personal assets, like their accounts, home and car can be reached to satisfy a judgment against the partnership. In the 1990s, when LLCs started to become an option for businesses that used to operate as partnerships, people who wanted a partnership-style structure to operate their online business started to transition instead to the LLC structure for their business. The popularity of LLCs has continued to grow ever since. 

Making the Choice for Your Online Business

You’ll want to consider all of the above factors in deciding how to conduct your online business. Sole proprietorships, LLCs, and corporations each have their own advantages and disadvantages, and what one person considers a benefit for a particular choice of business structure another person may view as a burden. The four main categories of factors are: liability protection, tax treatment, cost and management/control. 

To obtain limited liability protection and keep your personal assets like your accounts and house safe from debts and liabilities of the business, LLCs and corporations may be the best option. Sole proprietorships and partnerships do not offer any limited liability protection to their owners. 

Each choice of business structure also offers different tax treatment and the ability to make different elections for tax treatment. Sole proprietorships and partnerships are pass-through entities and profits and losses are reported on Schedule C of the owner’s federal income tax return. LLCs by default are pass-through entities but can elect S-corp tax treatment. By default corporations are taxed as separate legal entities, but also can make an election for S-corp. tax treatment. 

Costs can also vary widely when setting up your business structure. Sole proprietorships are the least expensive to set up and maintain. LLCs, corporations and partnerships are all more complex and costly to establish and maintain, and these costs can vary widely from state to state. 

When considering management and control of your business, if you are operating the business by yourself then sole proprietorships, LLCs and corporations all offer you the ability to maintain full decision-making control over your business. A sole proprietorship is the least formal and corporations are the most formal, requiring layers of management even if you are wearing all the hats for the different roles in a corporation. If you are entering into business with one or more partners, then LLCs, corporations and partnerships each offer different advantages and disadvantages regarding the management structure. LLCs are less formal and can be operated by their owners (the members) or managers if a management structure is selected. Corporations will be more formal and the owners, in addition to being shareholders, will serve as directors and be appointed to the different officer roles in the corporation. 

Consulting with legal and tax professionals can aid you in deciding the best legal structure for your online business and making an informed decision about how these various factors will impact your personal situation. You’ll want to consider factors such as your overall tax situation, level of assets, expected risks in your online business, goals and plans for the business now and in the future and the funds you have available to start and run your online business. 

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