10 Things You Need to Know About Choosing Your Business Structure
If you’ve just decided to start a business, you have many, many decisions to make about your product, your service, your location, your branding, marketing, and many more things. One of the most important is how you are going to structure your business.
In fact, it may be the most important of all the decisions you will make. If you’re not sure what a “business structure” is, or what your choices are read on.
Definition: “Business structure is the organization framework legally recognized in a particular jurisdiction for conducting commercial activities.”
- Why is this decision is so important?
- What are the different business structures?
- What are the advantages to each one?
- What are the disadvantages to each one?
- How can making this decision affect your life?
- How does each affect your taxes?
- How does each affect your time commitments?
- How difficult is each one to set up?
- Do you need a lawyer to set them up?
- What is the worst that can happen if you choose incorrectly?
- Why is this decision is so important?
You may have a great product or service. You may think you can run your company out of your garage forever. But eventually, you’re going to need to declare yourself. Once you decide to “be” a business, you must act like one. Half-hearted businesses are a sign of a weak commitment to the business and set you up to fail. Choosing the right structure for the type of business you’re running will help make all your other decisions, depending on your industry, the number of employees you want (see my blog on employee law), and your goals (How big do you want to be? Who are your customers? Other businesses? (B2B) Individual consumers? (B2C).
- What are the main different business structures? (There are variations from these, but these are the basic structures.)
- Sole Proprietorship — A single person owns the business
- Partnership —Two or more people are equal owners
- S Corporation — ‘S’ stands for small. The firm's income is passed through its stockholders (shareholders) in proportion to their investment and taxed at personal income tax rates. Also called Subchapter S Corporation.
- Corporation — An association of individuals created by law or under the authority of law, having a continuous existence independent of the existences of its members, and powers and liability distinct from those of its members.
- LLC (Limited Liability Corporation) — Combines the limited personal liability feature of a corporation with the single taxation feature of a partnership or sole-proprietorship firm
- What are the advantages to each business structure?
Advantages of a Sole Proprietorship
Easiest and least expensive form of ownership to organize.
Profits from the business flow directly to the owner's personal tax return.
Advantages of a Partnership
Partnerships are relatively easy to establish; however, time should be invested in developing the partnership agreement.
The business usually will benefit from partners who have complementary skills.
Advantages of a Corporation
Shareholders have limited liability for the corporation's debts or judgments against the corporations.
Corporations can raise additional funds through the sale of stock.
Advantages of the S Corporation
- With an S Corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.
- Owners of S corporations who don't have inventory can use the cash method of accounting, which is simpler than the accrual method.
Advantages of the LLC
- Limited liability for debts is similar to that of a corporation,
- Management is handled by members or managers, and
- Pass-through taxation is similar to that of a partnership.
- Disadvantages to each type of business structure.
Disadvantages of a Sole Proprietorship
Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
Disadvantages of a Partnership
Partners are jointly and individually liable for the actions of the other partners. Since decisions are shared, disagreements can occur.
Profits must be shared with others
Disadvantages of a Corporation
The process of incorporation requires more time and money than other forms of organization.
]Corporations are monitored by federal, state and some local agencies, and as a result, may have more paperwork to comply with regulations.
Disadvantages of the S Corp
- S corporations can only issue common stock. Experts say this can hamper the company's ability to raise capital.
- They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions.
Disadvantages of the LLC
No stock. LLCs are tough if you have several investors or raise public money since you don't have shares or stock certificates to offer.
Fewer incentives. LLCs aren't ideal if you want to give fringe benefits to yourself or employees. Unlike with a C corporation, you can't deduct the cost of benefits with an LLC.
Paperwork. LLCs file articles of organization with the State Corporation Commission or Secretary of State and must draft an operating agreement listing members' rights and responsibilities. There's more paperwork than if you're a sole proprietor.
Taxes. LLC members pay self-employment taxes, the Medicare/Social Security tax paid by entrepreneurs
- How can making this decision affect your life?
If you start out with one structure and change to another, it could affect your taxes. There’s a hassle factor in having to change all the documents for your business (contracts, bank accounts, etc.) The best way is to start out with the future in mind, so you have the best tax position for your finances, and have the best liability protection for your self and your family.
- How does each affect your liability?
As shown, the best liability protection you have is with the corporation. You may have some protection with the S Corporation and the LLC. The hassle of reporting and tax forms for the C Corporation may or may not offset what you gain in liability protection. Best to check with your attorney and understand the types of lawsuits you might face in your chosen industry/profession/product and service.
- How does each affect your time commitments?
The more complicated the structure, the more time is required. Corporations require annual meetings, tax forms to fill out, accounting knowledge. But it may be worth it. Ask your advisors.
- How difficult is each one to set up?
The sole proprietorship is the easiest. Don’t forget to get a business license, though, if your city requires it. Business cards, invoices. A Profit and loss statement you fill out yourself and your profits accrue to your own personal income tax. Corporations are the hardest. Definitely have your accountant and attorney help with corporations.
- Do you need a lawyer to set them up?
It is always still a good idea to run the business past an attorney to make sure you haven’t forgotten anything. You can do your own research on some state websites. For instance, for the LLC in California, you can find preliminary information at https://www.ftb.ca.gov/businesses/Structures/Limited-Liability-Company.shtml
- What is the worst that can happen if you choose incorrectly?
You can lose everything you own if you are a sole proprietor and someone successfully sues you. You can lose your business and all its assets (inventory, equipment, buildings, etc.), your home, your car, your savings. It’s not pretty. We have seen some of these happen over the years. It is devastating.
Call me to let me help you decide which business structure is best for you.