Choose a Legal Structure for Online Business

In many ways, formation of a commercial Internet venture is similar to the formation of any other kind of business, and requires that the founders consider conventional brick-and-mortar world issues. However, given the rapid, uncertain, and ultimately "borderless" development of global ecommerce law and taxation, online factors argue for the adoption of certain business structures over others.

Types of legal structures

There are four basic legal structures related to the creation of a business entity:

  1. Sole proprietorship is a business structure in which an individual and his or her company are considered a single entity for tax and liability purposes. In other words, the owner files only a personal tax return and is personally liable for all obligations of the business.
  2. Partnership is a type of business structure comprised of two or more owners who are personally, jointly and severally liable for all partnership obligations. A "Limited Partnership" is comprised of General partners and Limited partners. General partners are personally, jointly and severally liable for all partnership obligations. Limited partners invest in the partnership but have no management responsibilities and are liable for partnership debts only up to the amount they have invested. Like a Sole Proprietorship, a partnership is taxed as a "pass through" entity – income is taxed at the shareholder level only.
  3. Limited liability company (LLC) is a type of business structure in which the owners, called "members," enjoy limited liability from obligations of the business, up to the amount they have invested. The LLC provides many of the benefits of a corporation without some of the strict operational requirements.
  4. Corporation, the most common business structure, has many legal rights and is viewed as an entity separate from its owners. This separation limits owner liability for obligations of the business. Corporations also provide for the transfer of shares of stock and survive the death of their owners. All corporate income is taxed at the corporate level and again at the shareholder level when distributed as dividends.

    Note: S-Corps. Corporate income is determined at entity level passed through and taxed at shareholder level regardless of whether distributed. Some S corporations pay tax on built-in gains and excess net passive income however accumulated earnings tax is not an issue.

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Sole Proprietorships and Partnerships

Services keyboardIn the brick-and-mortar world, many people initially decide to form either a sole proprietorship or, if there are multiple owners, a partnership. Both business structures are relatively simple and inexpensive to establish and maintain. Conventional wisdom holds that either structure is appropriate for owners who can determine with relative precision the applicable tax laws and rates and who can predict and minimize their risks of litigation (one characteristic of both structures is that owners are personally liable for all company debts, including judgment debts).

However, conventional wisdom doesn't always prevail on the Internet. The principal reasons to avoid a sole proprietorship or partnership in an online business are that fundamental concepts of jurisdiction and taxation are changing too rapidly. An Internet entrepreneur engaged in global or international ecommerce should not assume that he or she can safely predict where in the world a Web site would be determined to transact business and, consequently, where liability for breach of contract, fraud, or taxes might arise. It is therefore prudent for a new online business to organize either as an LLC or a corporation, and for existing businesses that are moving online to seriously consider reorganizing as LLCs or corporations.

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LLCs and Corporations

Forming an LLC or corporation is somewhat more complicated and costly than creating a sole proprietorship or partnership, but it is worth it. As long as the entity adheres to basic rules of organization governance (easily accomplished with assistance from an attorney or accountant), the owners' personal liability for business debts and court judgments is limited. This limitation can be critically important for Internet entrepreneurs. On or off the Internet, tax considerations are another factor, because no one can predict tax rates will apply.

At least from an Internet perspective, entrepreneurs and businesses with multiple owners probably are better off forming an LLC rather than forming a corporation. The LLC allows different classes of ownership, whereas certain forms of corporation do not. This can be ideal for an Internet entrepreneur who projects different levels and stages of investor financing, because in such a situation stock transactions can have different and more onerous tax consequences (e.g. transfer of stock by an S-Corp. to anyone other than a natural person destroys "S" status). Also, an LLC can offer more flexibility than a corporation for allocation of profits and losses and delegation of management duties. On the other hand, a corporation may be able to offer certain forms of stock options for key employees that an LLC can't.

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Bottom line

Regardless of the individual nuances of your Internet venture, forming an LLC or corporation for your small business online is a routine matter for a lawyer or accountant with relevant experience.

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