In Alabama, a new business owner or entrepreneur needs to establish a business type (or the legislature chooses one for you.) As discussed in this Forbes article, How to Fearlessly Choose An Incorporation Type for your Startup:
Every business, from a mom-and-pop flower shop to the next billion-dollar tech giant, first has to legally establish itself as a company. But, just as there are many kinds of businesses, there are also many ways of establishing a company—and as you can imagine, a flower shop and a would-be Uber are probably not going to be best-served by the same one. There are four basic types of business structures available in Alabama: Sole Proprietorship, Partnership, Corporation, and Limited Liability Company.
When I first opened my law practice, it was myself and Kelly, my wife, as my secretary/receptionist. I didn’t organize; I merely started doing business. Many, if not most small businesses, operate as sole practitioners. My dad was a painter and he too just worked as a sole practitioner; he worked as a painter, hired hands as needed, and paid the bills. This form gives great power to the owner, but it also exposes them to great liability. If the business is sued, not only can the plaintiff get business assets, they can also get personal assets of the owner: house, car, retirement. As Forbes notes:
If your company will be entering into contracts, such as hiring employees, making purchases, or taking orders for which you may not immediately be able to deliver the product, you’ll probably want to create an entity that can sign these contracts. This concept, limited liability, means that you will not be personally liable for debts and claims.
However, this model is not the most dangerous. In my opinion, the most dangerous is a general partnership. A general partnership does not require any paper work or formality. I can be as simple as two friends striking out on a business venture together. Why is this more dangerous? Imagine all the exposure a person has to personal liability in a sole proprietorship, but double it. You are obligated and liable for any actions, contractual or tortious, which your partner does acting for the partnership. Sign a partnership loan? You’re own the hook. Do shoddy workmanship? You’re liable.
So anytime you go into business, I recommend one of the following: a limited liability partnership, a corporation, or a limited liability company. The Forbes piece’s author points out several considerations before deciding:
Are you worried about taxing your short-term profits?
Several kinds of company structure are perfect for an entrepreneur who expects to turn profits in the short term and does not want to be liable for paying corporate tax on top of personal income tax. These options, notably the LLC and S-Corporation, make use of a concept called “pass-through taxation” to pass income and losses directly to the entrepreneur, rather than taxing these profits at the company level.
Do you expect (or hope for) substantial growth in the long term?
There are certain tax benefits which are only available to companies that are structured for long-term growth—specifically, the Qualified Small Business Stock rule, which allows holders of C-Corporation stock to exempt huge portions of their value increase from taxation after a certain period.
Will you be seeking outside investment?
This is a big question. Many entrepreneurs founding high-growth startups miss out on the potential benefits of a C-Corporation because of common wisdom that pushes pass-through taxation as a major decision-making factor. Unfortunately for these founders, professional investors almost never enter into investment deals with entity types other than C-Corps, meaning that these companies will need to go through a potentially very costly restructuring at their first round. Because lawyers often bill at high hourly rates, this can rapidly erase any savings achieved in the initial phase of the startup.
However, you must also keep in mind the new changes to the tax code which may alter some planning between pass-through entities and a C-corp.
