Short answer: you should probably just buy insurance instead.

Entity types to consider include the corporation (with S- or C- taxation), limited liability companies (LLCs), partnerships, sole proprietors, and a few other entities with specialized application (such as the limited liability partnership for law firms).

The reason these entities exist is for limited *liability.*

The decision path to entity formation and selection should start with risk analysis and risk management. The two significant questions that you have to answer to decide whether this is the right course for you are: “What is my potential liability? and “What do I have to protect?”

What is your potential liability?

For example, if you’re going to be writing articles or conducting information research for corporate clients, then your primary risk is going to be from a generic commercial litigation issue. Based on the types of problems you’re most likely to encounter, errors and omissions insurance is the general type you would want to consider. If you are doing work where it is difficult to have lots of liability, either because it’s non-dangerous (e.g., designing websites) or you can contractually exclude much liability, then you’re almost certainly better served spending $500-$1000 a year on errors and omissions-type insurance.

If you are doing work where you can cause damages (anything dealing with people’s bodies or repairs to dangerous items), you definitely need to start with insurance and then look at your remaining liability exposure.

What’s your loss exposure?

Finally, if you’re just not that well-off, then spending an extra $1000 of time and effort and money to protect miniscule net worth might just not be worth it. If you have a home with equity and savings and retirement accounts, then, after you get sufficient insurance you can re-address this sort of question.

Once you’re properly insured (since not being sufficiently insured is one route to evaporating the limited liability protection you’re trying to establish by forming an LLC or other entity in the first place), then you can start analyzing the right entity for your purposes. If you’re going to be a single person in the business, then an LLC is usually the right place to start and end.

If your situation is different than the plain-vanilla model I described, then you should contact a lawyer with specific corporate experience. Your CPA doesn’t regularly address these issues of entity selection and may likely focus too much on the tax aspects, which is the wrong way to approach the issue (particularly since it’s easy to get the tax treatment you want these days with various entity types). Tax issues get addressed before you finally decide on an entity type.

==========

Since I’m a New York lawyer, I happened to notice someone in NY asking about LLCs:

With specific respect to NY LLCs, there is a publishing requirement that is just a pain in the neck, and so I recommend using a service to do the actual filings and publications. That is different from having them draft the actual LLC operating agreement, and any decent services would allow you to provide them with your own operating agreement. If you choose to do that piece yourself (again, only really a good idea if it’s just you in this business), then Nolo provides well-written guides.

In the wake of the turmoil in the financial world, there have been a variety of articles discussing whether different governance structures (entirely different, not just better corporate governance) would have perhaps made a difference. Of course, it all comes back to incentives. In this Dealbook Deal Professor installment, Stephen Davidoff explores the tensions between private and public firms and sets out the issues. He references Prof. Ribstein’s timely response/reply (it seems almost like more of a conversation), which points the reader to Ribstein’s uncorporation concept.

Davidoff notes that the incentives for employees to stay with the large firms was dramatically decreased after they went public, which parallels my MLM analogy for law firms. Once you’re in, the only way to make money appears to be staying on the inside. Leaving doesn’t really get you anywhere.

Among the topics of most intense interest for associates at large law firms (and even more intense interest for second-year law students, which is funny considering how remote the issue really is) is the partnership track. True, most associates learn quickly that until they get to at least fifth-year status, the brass ring of partnership, which has moved about 4 months back a year, on average, since I was a law student (7 years then, 8 at the biggest NYC firms, to a solid 10 years now), is relatively meaningless from any reasonable day-to-day perspective.

But, several big things in the world of professional service firm partnerships have changed since 1997. Goldman Sachs went public, turning senior managing directors into hundies (that’s over $100m) and probably created the intense increase in compensation thereafter (although I would have to do some research to track down the numbers. With nothing saved up in terms of equity in the firm, bankers wanted to see their money, in cash. (Or, of course, in stock that could be sold for cash – it’s mostly the same.) Also, Andersen Consulting, now Accenture, did the same thing. While it wasn’t quite as profitable as Goldman (what is?), consulting partners extracted a substantial amount of wealth from the firm. What both these firms did, however, was take away the “vested” (not in the technical sense, of course) interest of associates of all ranks in staying to make partner/MD. Without the big pot of gold at the end of the rainbow, associates became mere employees, and they realized that they needed more short-term compensation to make up for the lack of the back-end opportunity and, more importantly, they realized that the partners didn’t really care about them and were willing to sell off the future that some of those associates had been working towards.

Now, this hasn’t happened in the law firm context, in the US, because of something known as fee-sharing. It is unethical, in terms of there being specific ethical rules in each state, that prohibit lawyers from sharing legal fees with non-lawyers. In simple terms, my friend Mike can’t be a partner in my law practice because he’s not a lawyer; the concern is that the non-lawyer, not bound by the ethical rules that constrain lawyers and protect clients and the courts, might exert inappropriate influence over the lawyer and cause the lawyer to do something wrong. (Of course, spouses, children, college bursars, vendors, the IRS, clients, opposing counsel, and the government all exert these influences too, but they’re not looking to a share of bigger legal fees as the justification for their behavior. Except maybe spouses.)

What I’ve often wondered is whether a law firm really works as an independent business, if it can stay up on its own feet without the constant influx of “free talent” at the bottom of the pyramid that is paid off at the partnership level years later. Indeed, every associate that leaves (partners call that attrition) has benefited the firm by not getting the implicit value of that extra work that wasn’t compensated on an annual basis. Firms without associates generally have much lower profits per partner. Some of that is from the leverage that is gained from having employees and charging three times their salary for legal work (historically, the rule of thumb is that of billings, 1/3 goes to salary, 1/3 to firm overhead, and 1/3 to firm profits).

If an investment firm needs new people at the bottom to keep coming in and investing, so that the people who came before can get paid, we put those people in jail. That’s what we call a Ponzi scheme, and it’s considered illegal because the real value is being extracted from the new investors, not created by the company. Now, law firms do indeed do work, but how much is really extracted from the new investors, the ones that hope their name will reach the top of the chain letter?

Or, in a slightly less cynical view, are law firms more like MLM companies, where each associate is brought in at the lowest level and slowly moves up, eventually getting to bring someone else in underneath, until the threshold is crossed and profits start to roll in just from what the folks downstream are doing? Law is sort of like this, but there are no profit shares until you cross the Partner line. However, some firms do have practice-group specific bonuses, and so in those circumstances, some mid-level associates might actually be gaining from the efforts of the juniors.

I write this post because I realize that I don’t have time to turn this into a humorous article or even sponsor an undergraduate senior project to perform the actual economic analysis and compare the various professional services models, pre- and post-partnership, to law firms, to pyramid schemes and MLM systems. If someone would like to take up the topic, please let me know, and I’ll be happy to publish it here.