When starting a company, the business structure you pick can be vitally important. Choosing among the different business types will affect your day-to-day workings and how you pay taxes. Your choice can positively or negatively affect how you are protected as an owner and even your business’ future sellability. While I will provide you with an overview of the 5 different business types, lean on your “Dream Team” of attorneys, CFP’s®, and CPA’s to know which entity is the best fit for your company.
Before you pick a business type, you can decide whether you even want to make your company a structured, legally-recognized entity of the state. Your first choice as the company owner, then, is to decide how you want to operate your business. Would you rather become an individually run establishment or a legally recognized entity?
Usually, when someone starts selling a product or a service without establishing entity status with the state, your business will automatically be a Sole Proprietorship or General Partnership. Keeping this designation can potentially save money, time, and inconvenience. However, only you can decide if the initial cost-savings and flexibility are worth the absence of personal liability protection.
However, I recommend that you look to the distant future and determine whether a potential business buyer would want to assume the same liability risks you are willing to incur. If you don’t believe a future buyer wants to be held personally liable for business risks and taxes, you may want to bypass the Sole Proprietorship or General Partnership and look at forming a state-recognized business entity.
Running your company as a legally-recognized entity rather than as an individual separates your business dealings from your personal affairs. Ultimately, operating your business as an entity offers you personal liability protection from any lawsuits, debt, bankruptcy, tax claims, or negligence issues your business could face. A metaphorical “corporate veil” keeps your personal interests, liabilities, and assets separate from your business interests, liabilities, and assets. Furthermore, depending on the type of business entity you choose, you have the option to enjoy the pass-through tax benefits of an individually run company while enjoying the liability protection of a legal entity. The tradeoff is there is paperwork to be filled out, payments to be made, and documentation required.
Which of the business types do you choose, then? Which one provides you with the most benefits through all phases of your business’s life cycles?
While I briefly examine 5 types of business, please remember to consult your professional advisors for a more in-depth analysis of each so that you can choose the entity best-suited for your individual needs.
The Internal Revenue Service defines a Sole Proprietor as “someone who owns an unincorporated business by himself or herself.” Essentially, this means that you can begin working for yourself at any time without filing state forms or regional tax documents that require dues and fees.
As a Sole Proprietor, you can take contracts and accept bids under your own name, or you can informally “Do Business As” a company inseparable from you, the owner. Granted, you want to have correct licensing and certification to work in your industry or field. However, you can begin a company without wading through paperwork, documents, or state filing fees.
If you begin business as a sole proprietor, you don’t have to elect a board of directors to oversee company operations, nor do you have to hold annual meetings or record meeting minutes. You are in complete control of your business. You don’t have to answer to anyone for your decisions or your purchases. Because you operate the company alone, you receive all business profits, but of course, you will report and claim all business losses as well.
In addition to its many advantages, the sole proprietorship has several disadvantages. As a sole proprietor, your personal financial and legal situation and your business financial and legal situations are one and the same. Thus, you are liable for your company’s actions and interactions. If your business must declare bankruptcy, it will affect you and your family personally, most likely leaving you in personal bankruptcy. Likewise, any lawsuits filed against your business leave you personally liable for any fault found within the company.
Another disadvantage to operating your business as a sole proprietor is that you must pay income taxes and self-employment taxes (Social Security and Medicare) on the entire revenue of the business. If your business is profitable, you could have a significant bill to pay.
If you want to go into business with a family member, friend, or colleague, but you want the same ease of maintenance and freedom from fees the sole proprietorship gives you, you can operate the company as a General Partnership. Basically, a general partnership is the same type of structural operation as a sole proprietorship. It just allows more than one owner to run the company, and all assets and liabilities are strategically divided between the owners. In fact, the IRS calls this type of business a “relationship,” rather than an entity.
With more than one company owner in a general partnership, you can portion the start-up costs, the responsibilities, and the workload. Additionally, you can share the burden of business risks and expenses. Your skills can complement each other, and your individual contacts can lead to greater financial achievement together than would be possible apart. As each partner goes through personal highs and lows and as the business itself experiences gains or losses, general partners can mutually support, encourage, and motivate each other.
Because more than one person operates this type of business, though, partners must share profits, losses, and decisions. Neither has complete control over the company. Each must act and react with the other owner in mind and usually with the other owner’s approval. Some partnerships cannot survive that shared control. Recognizing the risk of lost friendships because of a business partnership, John D. Rockefeller once said, “A friendship founded on business is a good deal better than a business founded on friendship.”
Realize, too, that while this individual relationship structure is easy to begin and maintain, both of your personal income and expenses, your assets and liabilities, and your tax deductions and ramifications are inextricably linked to your business and your business to you. Like a Sole Proprietor, you General Partners cannot protect yourselves from liabilities, lawsuits, or taxes your business incurs because you are your business. Those liabilities, lawsuits, and taxes flow-through your company or your DBA directly to you, the partners.
Generally recognized by their technical term, C Corporations are legal entities that can shield the owners, or shareholders, from personal liability and company debt. Upon formation, 100 or more shareholders exchange money and/or property for the corporation’s capital stock. The shareholders then elect a Board of Directors to oversee company procedures and to appoint officers. The officers – the CEO, the CFO, the President, etc. – typically run the day-to-day operations of the business.
Advantageously, operating as a C Corporation can reduce company and shareholder tax liabilities because “fringe benefit” items like healthcare are tax deductible. C Corp shareholders can utilize and offer medical reimbursement plans. Those plans enable the company to deduct medical payments up to a fixed amount and allow the shareholders to receive personal tax deductions from those payments. C Corps can also take advantage of tax-free “fringe benefits” like travel and entertainment.
Additionally, operating a business under a legal C Corporation entity can attract venture capitalists. As a publicly traded company, shareholders can ask investors for millions of dollars at a time to grow their business into the next FaceBook or Amazon.
Operating as a C Corp entity may provide a company with many advantages, but C Corporations aren’t particularly designed for small businesses because of their complex reporting and potential stock trading requirements. All governing bodies – shareholders, directors, and officers – must abide by corporate by-laws and keep track of all stock-related transactions. Since C Corps can have 100 or more stockholders, imagine how many records the company must keep! From holding formal board meetings to keeping track of shareholder meeting minutes, the paperwork can get overwhelming. The complexity of the tax forms and stock distribution forms can also cause much confusion. Therefore, most small business owners do not choose to operate as a C Corporation.
Although C Corporations do experience some tax advantages, they are most known for their notorious double-taxation status. Basically, this means that the company owes taxes on any money it makes, AND the shareholders owe taxes on the money the company pays them. While this is an over-simplification of a complex accounting process, you get the idea that C Corp owners will be taxed twice. Therefore, many entrepreneurs choose not to operate as this type of business entity.
As a sub-chapter of the traditional C Corporation, the S Corp functions as its counterpart. Restricted to 100 U.S. citizen shareholders, this type of entity allows business owners to own stock and receive the same corporate veil of liability protection as the C Corp. Similarly, shareholders elect a managing board of directors who then appoint operations officers.
At first glance, the S Corporation looks almost exactly like the C Corp, but it avoids the double-taxation C Corporations face. Instead, the S Corporation passes down its profits and losses directly to the shareholders, preventing the company AND the owners from having to pay taxes on revenue. As Wikipedia explains it, “Income is taxed at the shareholder level and not at the corporate level. Payments to S Shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed.”
While S Corporations may not attract venture capitalists like the C Corps, they can attract investors and sell and transfer corporate stock. Investor buy-ins allow for growth that an individually run company cannot necessarily achieve.
Now, the S Corporation also has some disadvantages. As a corporate entity, owners are required to file or maintain many federal and state documents including Articles of Incorporation and corporate minutes. Like the C Corp, the rules and regulations that govern this type of business entity are extremely complex. They may even require a multi-faceted understanding of accounting that many lay-people do not possess.
S Corporations also have stock restrictions that C Corps don’t have. While C Corporations can buy and trade multiple types of stocks, S Corps can only use one class of stock; however the stock can have different voting rights: non-voting stock, voting stock, limited stock, general stock, etc. When it comes to planning, shareholders could run into problems if they are trying to do advanced estate planning. Therefore, they would need the help and assistance a good CPA and CFP® could provide.
Unseen in business structures up to this point in our descriptions, the S Corporation requires all shareholders and officers within the company to take a “reasonable” salary, even if the company is not making a profit. This could be very problematic for new business owners who may experience loss rather than profit during their first one to three years of operation.
For entrepreneurs who want the flexibility and control Sole Proprietorships or General Partnerships provide but desire the liability protection of a Corporation, a Limited Liability Company may be the answer for you. Quickly becoming one of the most popular types of business entities, the LLC is “simpler and more flexible than a corporation.” It offers the flow-through taxation that individually operated companies enjoy. Yet, it separates the individual owner from the business and its liabilities.
In an LLC, you can have one owner or an unlimited number of owners. Also known as members, owners are unlike stockholders or shareholders. You don’t have to elect board members or directors of operations, nor do you buy/trade stocks for ownership percentages. Because LLC’s are business entities, states often require members to hold annual meetings and record meeting minutes. However, you often don’t have to do the same amount of financial reporting and legal documentation that corporations must do.
Unique to the LLC, entity members can choose their method of taxation. You have the flexibility of being taxed as a sole proprietorship, as a partnership, as an S Corporation, or as a C Corporation. Whichever taxation structure you prefer or think a future buyer will prefer, you can apply it to the LLC.
Another advantage of the LLC entity is that members can receive write-offs that are larger than your individual ownership percentages. That means that members can own unequal company percentages but split profit or loss 50/50 if your financial planner believes it can help all parties involved.
While an LLC’s flexibility offers many benefits to business owners, this type of entity also has its disadvantages. State renewal and compliance fees for LLC’s can get expensive. Some counties even require payment of fees in addition to the state ones. Certain states also collect a Franchise and Excise Tax or a Capital Values Tax from LLC’s. While the paperwork required is simple, the fees demanded can get complicated and pricey.
Additionally, operating your business as an LLC makes it hard for investors to contribute capital. Your Operating Agreement could prohibit investor contributions, or investors may not want to put money into a company that will never be publicly traded.
FREE DOWNLOADABLE: Business Entities Pros & Cons Cheat Sheet
No matter which you pick, each of the different business types has pros and cons. Each has nuances that require research and thought before you choose the one best suited for you and the business you want to build. Every state-recognized entity offers personal liability protection and investor contributions, but the amount of protection and contribution available varies.
If you decide to run your company as an actual entity, and you choose the “wrong one” for your needs, you can always file to change your entity status. Therefore, while this is a vital decision at the start of your business, you can make changes down the road if necessary. Don’t let worry or indecision prevent you from starting. Jump in, friends. Begin!
Next article: Where to find financing for your new business.