The most common forms of business entities in the U.S. is the sole proprietorship, the corporation (of various flavors), general and limited partnerships, and the limited liability company ("LLC"). The primary difference between the various business entities generally fall into two major categories: 1) whether they provide limited liability to owners; and 2) how the IRS treats the entity from a tax perspective.
What is limited liability? Limited liability is a business concept wherein a partner, investor, or shareholder cannot lose more than the amount invested in the business. Thus, the investor, partner, or shareholder is not personally responsible for the debts and obligations of the business in the event that these are not fulfilled, provided that certain basic rules of the road are followed. Limited liability applies to certain business organizations (e.g. a corporation or LLC) and not to others (e.g. a sole proprietorship).
In general, and for obvious reasons, limited liability is the kind of protection that an online entrepreneur wants, and therefore, most online businesses choose either a corporation or an LLC as a business entity type. For example, assume your net worth is $250,000 and you decide to invest $25,000 in an online business. Further assume that you get sued for copyright infringement and get a judgment against your business. The most you could lose (assuming you have followed the rules of the road) is $25,000. Your entire net worth would not be exposed and subject to the judgment. In short, limited liability is a legal doctrine that encourages investment without compelling the entrepreneur to put at risk their entire life's savings.
What are the rules of the road that must be followed? At the risk of gross oversimplification, the principle rules of the road are as follows: 1) you must appropriately create the entity in a state of your choosing; 2) you must follow certain annual processes and procedures in said state to maintain the entity active; 3) you must pay taxes to the IRS in a manner consistent with the type of entity selected; and 4) you must maintain the books and records of your business completely separate from your personal financial records. Although these formalities are not overly burdensome, they must still be followed according to applicable law or you risk losing the designated business entity status.
Formation of a corporation or LLC in most (if not all) states is relatively straightforward. However, the tax implications of these entities should be discussed with your attorney and/or CPA. Further, if the corporation or LLC is made up of multiple shareholders (for a corporation) or members (for an LLC) then things can get complex rather quickly. Why? Because once you have more than one individual involved issues regarding business entity governance become important to resolve at the onset. These issues include, but are not limited to, who owns controlling interest in the entity, who will manage the entity, how will the sale of shares or units of membership be handled, what happens if one of the owner dies, etc. These types of issues are dealt with in shareholders agreements for corporations and in operating agreements for LLCs.
Despite the low barrier to entry there are still pitfalls that the uninitiated should be aware of. For example, most online entrepreneurs will choose to form an LLC or corporation in their home state, and generally this is a good idea because it simplifies the annual reporting process. However, for historical reasons and/or for reasons that are more germane to large corporations, some may choose to form an entity in a differnt state (e.g. Delaware). If you are fairly certain that you are sitting on the next "Facebook" then a different state may be the way to go, but you may stilll need to file paperwork in your home state as a "foreighn entity" if you maintain an office in there.
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