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
- 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.
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.
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.
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)
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).