When starting any new development project, it is important to decide on the proper business entity. A business entity can provide benefits, such as limited liability, and can provide a professional appearance for the project.
When starting any new development project, it is important to decide on the proper business entity. A business entity can provide benefits, such as limited liability, and can provide a professional appearance for the project when dealing with investors and publishers. However, there are a few different entity types, each with their strengths and weaknesses. Before choosing, it is best to consult with an attorney or accountant to ensure that the type of entity that you enter into is appropriate for your project.
The following four types of entities are the most common found in the business world:
The sole proprietorship is the default entity for a business run by a single person. That single person is in charge of everything, and doesn’t have to answer to a board of directors or any other officer or partner. However, the sole proprietor also has full responsibility for the debts and other liabilities of the business. Therefore, if something goes wrong and a judgment is entered against the sole proprietor, their personal assets are answerable for that judgment. While this is the easiest type of business to form (it happens automatically), the lack of protection usually makes it unsuitable for a project that involves raising money.
When two or more people get together in a venture for profit, the default business entity they form is a partnership. As with a sole proprietorship, they don’t have to do anything to make the partnership a legal entity; it just exists by default whether they intend to form one or not.
However, in the absence of some kind of partnership agreement, several things are generally true. First, the partnership is managed by the partners equally, with each partner getting an equal vote on all decisions. Decisions are made by majority vote. Second, without an agreement, all profits and losses are divided equally. This means that even if one partner puts 90% of the capital into the partnership, they are generally only due 50% of profits without some sort of agreement that says otherwise. Third, liability is also shared between partners. If one partner incurs some kind of legal liability or debt, all partners are responsible for it. Fourth, partnerships are generally taxed on the individual level, with what is called “pass-through” taxation. Last, when one partner leaves, the partnership automatically dissolves.
Because of these default aspects of partnerships, it is wise to get some sort of partnership agreement signed by all parties prior to doing business. This agreement can cover who makes what decisions, who is bringing what money or services into the partnership, who is liable for what, and who gets what percentage of profits and losses. No one starts a partnership with the intent to have disagreements, but they do (almost inevitably) happen. An agreement can be extremely valuable in pre-planning what happens in the event of a disagreement or if one partner wants to leave.
A corporation is a common entity formed by businesspeople, for good reason. While it has many more formalities than other entities, the benefits are great. The most obvious benefit of a corporation is limited liability for owners and directors. Owners, or shareholders, are generally only liable for the amount of money that they have put into the company. Their personal assets beyond that will not be in jeopardy to pay the debts of the corporation. In some cases this is not true, such as when the corporation is undercapitalized or is merely a sham. Generally, however, this limited liability is the true strength of the corporation. Additionally, unlike a partnership, the corporation can continue indefinitely regardless of changes in management or ownership.
Different states have their own particular rules on how they treat corporations, with Delaware generally being most friendly to the corporate form of business. One issue with corporations is taxation. Usually, corporate income is taxed on two levels. The corporation itself pays taxes, and then the individuals who receive income from the corporation are taxed again. This is different than other business entities, including one specialized form of corporation (the S Corporation), partnerships, and LLC’s, which we will see shortly.
The limited liability company, or LLC, is a relatively new form of business that combines the best of both worlds: The limited liability of the corporation and the “pass-through” taxation of the partnership. This means that, like corporations, liability for the debts of an LLC is limited to the amount that LLC members (similar to shareholders) have contributed.
Taxes, however, can be set up to work like a partnership, where the LLC itself is not taxed but earnings are taxed at the individual level. If the LLC wishes to be taxed like a corporation, however, this can also be chosen. An LLC can even be a single-member entity in some states, effectively replacing the sole proprietorship with a form that offers benefits for the sole entrepreneur. This flexibility in business formation makes and LLC a great choice for many small businesses, especially game developers.
There is no “one size fits all” approach to business formation. Situations are very fact-specific, and require an informed determination. For further advice and counsel regarding the type of business entity that is right for you, feel free to contact your local attorney. Additionally, a tax professional should be contacted in order to ensure that the tax implications are appropriate for your particular situation.
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