As a small business owner (or a future one), determining how to structure your company is an important decision. You are faced with several different options; but which is right for you? How do you know which structure is best for your situation, preferences or personality? From sole proprietorship to partnership through Limited Liability Companies (LLCs), S-Corporations (S-corps) and full corporations (and sometimes combinations thereof), there are different aspects to consider before you can choose the best form for you and your business. We will explore the considerations which need to be taken into account before you choose your business structure. Factors such as risk aversiveness / personal liability concerns, flexibility of management, tax concerns, transferability of ownership interest, future plans for the enterprise and formation and continuation costs are all considerations one must take into account before choosing the right business structure.
A major issue to consider when thinking about how to form your business is liability. When you operate your business as a sole proprietorship, you are essentially one and the same as your business. This opens you up to unlimited personal liability, which means that all of your personal assets, as well as your business assets, are at risk. This is true whether or not your personal assets were involved in any business dealings. Because you and your business are the same, creditors and courts can look to your home, savings, and other assets in litigation. If you own a restaurant and someone slips on your sidewalk, you may not want your personal property (such as your house) to be at risk in the case of a lawsuit.
Forming a partnership is much the same in regards to liability. While a partnership brings the benefit of involving another person’s ideas, skills, money, and time in the business, forming as a partnership still leaves both parties’ personal assets open to business litigation. In addition, you will be liable for acts of your partner, regardless of whether you agreed to the act at all!
If you want to reduce your liability, you should look into forming a Limited Liability Company (LLC), an S-Corporation (S-corp) or a C-corporation (C-corp). While different, each of these formations can put a wall between your business assets and your personal assets. Legally separating your business and personal assets ensures that even if there is litigation against your business, your personal finances and property will be protected. You need to consider how much risk is involved in your business and how open you are to litigation, before you make a formation decision. Usually, if there is any significant risk involved that can’t reasonably be covered by insurance, it is best to organize your business as an LLC, S-corp, or C-corp. If you feel that personal liability is low or can be covered by insurance, a sole proprietorship or partnership may be right for you.
Paperwork and Cost
When you start your own business it can feel as though you have a never-ending list of things to get done. Another consideration when it comes to business formation is how much time you can commit to paperwork, and how much you are willing to spend up front. A sole proprietorship will incur the least amount of extra paperwork to worry about, only requiring you to file a Doing Business As (DBA) filing, no or few yearly registration fees, quarterly tax payments and your own personal tax return. An S-corp or C-corp will be at the other end of the spectrum, with extensive paperwork, hefty upfront costs, and additional tax filings. An LLC will fall in the middle, with some additional paperwork and costs, but possibly with the same tax paperwork as a sole proprietorship if you are a sole-member LLC.
If you are just starting out, a sole proprietorship will be the easiest to jump into without having to learn about shares, dividends, or having annual meetings. In addition, yearly fees are not required of a sole proprietorship at the state level. Tax reporting is generally done on the sole proprietors own tax return filed with a Schedule C Profit and Loss Statement.
Forming an LLC would be slightly more complicated, but not overly burdensome. You must file Articles of Organization with the state of organization and pay yearly fees (More than sole proprietorship, but less than a corporation), but yearly stockholder meetings can be avoided and less paperwork and formality is required of an LLC than a corporation. Tax paperwork can be simple or more complicated depending on how which tax treatment you elect.
In organizing as a corporation, requirements will include filing Articles of Incorporation with your secretary of state and keeping detailed records of meetings, business decisions, and other formalities. This involves much more time and paperwork. In addition, yearly corporate fees can be substantial as well as the paperwork requirements for tax reporting. However, a bit of research and time committed upfront can reap rewards down the line, and if you think that your business will become large and have employees, you should consider the time commitment of incorporating potentially well worth it.
If you will be your businesses’ sole operator, you may not want any additional paperwork.
The cost of the different business formations is also an issue to consider. While there are no additional fees for a sole proprietorship or a partnership, an LLC will require some filing fees, and S-Corps and C-Corps will require even more. The fees for incorporating are ongoing, so be ready to commit to paying for your incorporated structure. There will also be closer IRS scrutiny on your business if you are a corporation, to ensure that you are following the hard and fast rules and staying compliant.
Income taxes for businesses will either fall into the category where business owners pay tax on profits, or the category where they do not pay tax on the business profits. The structures where you do pay tax on business profits include sole proprietorships, partnerships, and LLCs. These businesses are referred to as pass-through entities because the business owners still file personal tax returns, and business profits are passed through those returns. A business owner who operates a sole proprietorship, partnership, or LLC will pay taxes on any net profits from their business. This is different than the tax structure of an S-corp or C-corp. Under these formations, owners do not pay tax on profits, but rather on the profits they take from the business in the form of salaries, dividends, or bonuses. An S-corp will pay its employees a reasonable salary, and deduct all payroll expenses such as federal taxes. The remaining profits are distributed as dividends, and this is where the tax savings come in. These dividends are taxed at a much lower rate than personal income, so individuals can end up paying less tax and keeping more money in their pocket. An S-corp still passes through most of its income and losses to the shareholders, and there is no double taxation at both corporate and individual levels. Another advantage for a startup business, is that the corporation’s losses can offset other individual income, which can be very helpful when business money is tight. The difference between C- and S-corps lies in taxation. Income from a C-corp is taxed twice; once as a corporation and next as the shareholders pay tax on distributions. A C-corp usually does not make sense for a small business, but if you are not planning on distributing all of your businesses’ profits, it could be a good choice. You need to carefully consider which structure will suit your business best, and remember that with the tax benefits of a corporation comes increased paperwork and fees. In any case, YOU SHOULD ALWAYS CONSULT A TAX ATTORNEY OR ACCOUNTANT when deciding what form of business to adopt!
If your future business plans include having investors and selling stock, a corporation is going to be how you want to structure your company. Investors will look at an S- or C- corp with much more legitimacy than a sole proprietorship or an LLC. LLCs can sell interest in their companies, but only corporations can sell stock. An S-corp can have only one class of stock, and there can’t be more than 100 shareholders or foreign ownership. C-corps don’t restrict ownership, and you can have an unlimited amount of shareholders, foreign shareholders, and these shareholders can be entitled to different classes of stock. If you are intending to do business overseas, and want unlimited growth potential, a C-corp could be a good choice. If your business is going to be more simple and not involve selling stocks or needing investors, sole proprietorship’s and LLCs are fine choices for structuring your business.
Another area to think about is how much flexibility do you want in running the business. sole proprietorships, partnerships and some member-managed LLC’s allow for quite a bit of flexibility in running the business while manager-managed LLC’s and all corporate entities must adopt a rigid management approach in order to keep its liability protections for officers and members intact.
In addition, if you want to the interests in your company to be freely transferable, than LLC and corporate forms are best suited for such transfers. As a sole proprietorship, it is much harder to transfer an interest (Other than selling the whole business), especially upon the death or incapacity of the sole proprietor. The same holds true for partnerships, unless the partnership agreement covers these potential areas.
Think about issues such as what will happen to your business after you die, or if you want to sell your part of a business partnership. Sole proprietorships or partnerships will end when the business owners die, whereas incorporated businesses continue to exist even if ownership changes. If you want to have your business as an asset you transfer to your family or loved ones, a corporation is a better choice for you. Transferability with an LLC is also possible, although it can get complicated if there are multiple members involved. If one member of an LLC wants to sell their interest in the company, it would be up to a vote whether that could take place.
It is also important to think about the investment options mentioned above, even if you aren’t in a position to be selling company stock at the start. If you see your company growing larger in the future, you need to work that into your business structure. Taking the time to seriously weigh the different business formations at the start will help tremendously throughout the life of your business.
When you are starting a business, it is easy to get caught up in the chaos of the early stages and you may not want to devote much time to formation. However, the formation you choose at the start of your business will influence you liability, paperwork, taxes, investments and flexibility/transferability. Choosing the best way to structure your business from the start is important. Choosing an LLC, an S-corp, or a sole proprietorship forms the basis for how you conduct meetings, file paperwork and are taxed by the IRS. Because this decision impacts you legally and financially, it is best to have legal counsel when choosing how to incorporate. At INTELLEQUITY IP Legal Services, LLC, we can help you assess your personality and business and decide what formation will be best for you. If you are looking for a business lawyer in Portland, we would love to partner with you and help through the complex landscape of business formation. Call us today at 503-575-1939. It might just be the smartest decision you make!