An Overview of Legal Entity Forms for Small Business Owners - Part 1: A Brief History of Legal Entities and Their Benefits

When operating your own business or starting a new one, you are faced with a lot of choices. One of those choices is the legal structure of your business. Some business owners may think that it is too complicated to have a formal legal structure and may proceed to operate without a formal structure (which is known as a “sole proprietor” or “sole proprietorship”). However, there are many downsides to not taking the time to understand the various legal structures that may benefit your business.

This article is intended to provide Indiana small business owners (businesses with only one or a few owners) with some basic information about corporations and limited liability companies in Indiana. It is organized as a four-part series in November 2018, as follows: 

·      Part 1 explains what a legal entity is and discusses the benefits of choosing a formal legal entity versus operating as a sole proprietor.

·      Part 2 will provide an overview of the two most common entity structures that small businesses in Indiana chose. (Release date: 11/7/18).

·      Part 3 will outline some of the factors you should consider when trying to determine what structure is best for your business. (Release date: 11/9/18).

·      Part 4 will provide an overview checklist of what information to bring with you to your first meeting with your business attorney. (Release date: 11/14/18).

Of course, it is always important to meet with your own attorney to discuss what is best for your situation and for your business. The advice in this article is general information only, and is not a substitute for a business owner seeking personalized legal advice.  

Part 1. A Brief History of Legal Entities and Their Benefits

A legal entity is a formal structure that creates a legal distinction between an owner and her business.*

A full history of corporations is beyond the scope of this article. However, keep in mind that the concept of corporations existing as a separate legal entity from its owners has a long history. Even modern corporations have been available for over one hundred years. As a result, owners and companies have had many decades to mull over and fight about the operations and rules of corporations.

By comparison, limited liability companies (“LLCs”) are a relatively new concept that began in the 1980s, and the form has only been available to Indiana business owners since the early 1990s. LLCs are the hybrid vehicles of the business entity world. Just as a hybrid vehicle sometimes runs off of gasoline and other times off of batteries, LLCs sometimes function like corporations, and other times function like partnerships.

The practical result of these differences between corporations and LLCs, is a greater degree of certainty for owners of corporations when it comes to predicting the outcome of legal questions involving corporations. LLCs generally have the benefit of more flexibility in their operations, but a cost can be less certainty regarding how courts may resolve disputes if and when they arise.

Both a corporation and an LLC will provide the owner with some protection for her personal assets in addition to some possible tax advantages. The creation of an entity distinct from its owner is important to protecting the owner’s personal assets. One of the biggest advantages of organizing as an entity is that if something goes wrong, the risk to the owner’s personal assets is likely minimized. By comparison, if a sole proprietor is sued by a customer or client, the owner’s personal assets—her house, her own accounts—could be at risk of loss. 

In addition to liability considerations, business owners should consider the possible income tax advantages of organizing as an entity (particularly as a “pass-through entity,” which will be discussed in Part 2 of this article) versus a sole proprietor. As a sole proprietor, the owner may be obligated to pay both self employment tax and income taxes without as much flexibility for structuring her income as she would have had if she had formed a corporation or LLC. Additional income tax benefits may exist for the owner of a pass-through entity depending upon the type of business. Owners will want to consult with their personal and business accountants as part of their investigation into organizing as an entity.

It is understandable that businesses with only one or two owners often overlook the benefits of forming an entity. In fact, a sole proprietor who forms a single member or single shareholder entity can end up feeling like she has a split personality—herself and her business (which is also just herself). This can make the tasks of managing the entity feel repetitive, or even silly. But as explained earlier in this article, that split personality is beneficial for both asset protection and tax reasons. Therefore, the small business owner should give serious thought to the benefits of forming an entity for the business.

*Of course, there are many forms and types of legal entities. This article is aimed at only discussing two popular business-related ones, the corporation and the limited liability company.

Part 2 of this series, The Distinction Between Corporations and LLCs.