“To each his own,” as the expression goes. The same holds true for business structures—there’s no universally “right” structure for all businesses. Choosing the best one depends on the specific needs you and your business have. Before setting up your company, it’s important to understand all the options available to you—in particular, you’ll want to evaluate the advantages and disadvantages of each business formation, paying special attention to the tax implications and government formalities.
We will look at four forms of business ownership in this step:
- Sole Proprietorships
- Limited Liability Companies
Forms of Ownership
For starters, it’s important to take the time to review your life plan and business plan. What should emerge are answers to questions like:
- Do you want investors as shareholders in your company?
- Do you want to maintain control of the company if you have investors involved?
- Do you anticipate losses in the early stages that can be taken as tax benefits by shareholders?
- Do you want to avoid double taxation?
- Is there a great risk of liability associated with your specific business?
To help you determine the best structure for your business, we’ve put together an overview of several options. And remember, it’s always best to work closely with an attorney and/or accountant to ensure you make the right choice.
Sole proprietorships are a popular choice for many new business owners because so little is needed to set them up. Apart from local business licenses, there are minimal government fees and paperwork.
On the other hand, there are also considerable risks to consider—for example, your personal assets are vulnerable to creditors and other liabilities such as lawsuits. You also don’t get to take advantage of certain tax breaks that are reserved for more formal business structures such as Corporations or Limited Liability Companies.
Most importantly, as a sole proprietorship, your company name is not protected. In other words, there is nothing to prevent another company from incorporating under your business name.
Similar to sole proprietorships, partnerships are extremely easy to set up and maintain, requiring no government fees or annual state paperwork. On the downside, you and your partners are each held fully responsible for all of your company’s debts. This means if you or one of your partners defaults on a company loan, creditors can go after your personal bank accounts, property holdings and other assets to satisfy the entire loan.
As a partnership, you are also at a disadvantage when it comes to raising funds. For example, you cannot raise capital by selling stock, and private investors may be wary of investing in your company without personal liability protection. Finally, just as with sole proprietorships, your company name is not protected. This means any new or existing business could incorporate using your company name.
Corporations are the standard for many businesses in today’s market. The primary reason is that incorporating shields you and the members of your company from personal liability. In other words, if your business hits hard times, creditors cannot go after your personal assets to make up for any company shortfalls.
But protection from personal liability is not the only benefit that comes with incorporating. The corporate business structure also offers significant tax savings, greater business flexibility, company name protection and increased opportunities for raising capital. You can also choose to set up your corporation as either a C-Corp or an S-Corp in order to take advantage of different tax options.
One thing to keep in mind - corporations do require some initial set up fees and a certain amount of regular maintenance. For example, you’ll have to keep up-to-date corporate records as well as file an annual report with the state.
If you’re ready for the big time and want to sell shares of stock in your business, consider a C Corporation. All publicly-traded companies are C Corporations which are considered a separate legal entity from the owners (also called the shareholders or stockholders) of the business. Because of this, the shareholders are not responsible for fees, liabilities and losses associated with the business.
The stock money and assets earned by the corporation belong to the corporation. Dividends are distributed to shareholders under the direction of the corporation’s shareholder-elected Board of Directors. Stockholders then pay taxes on the earned dividends, and the corporation also pays taxes on all profits (known as “double taxation”). To become incorporated, you basically fill out the appropriate documents for the state and have all shareholders vote on overall corporate management, stock shares, the name of the company, business industry and other key guidelines.
As a C Corporation you will need to hold annual stockholder meetings and keep meticulous records to avoid legal and accounting problems. In addition, forming a corporation is an intricate process, so we highly recommend that you find a good attorney or consultant to assist you.
It is possible to avoid the double taxation of a C Corporation by forming an S Corporation. Here, the corporation’s income is divided among all of the shareholders who report the earnings on their individual tax returns. This is a tax-efficient way to structure your business if you expect losses in the short term because the individual shareholders can report the losses on their tax returns rather than paying the double taxation of the C Corporation.
The downside is that to become an S Corporation, you must run the company according to a fiscal calendar year, have less than 35 individual stockholders who are all U.S. residents, and have only one class of stock, in addition to other guidelines.
Limited Liability Companies
For many new entrepreneurs, choosing a business structure comes down to liability protection, tax savings and convenience. LLCs require fewer formalities and less on-going paperwork than corporations while offering the same personal liability protection and tax flexibility. Just as with a corporation, your company name is protected, and you and the other members of your company are shielded from creditors and other company liabilities such as lawsuits. But with an LLC, you only have to keep minimal company records, and there is no limit to the number of members your LLC can maintain.
If you’re looking for more information than provided here, we discuss this subject in detail in StartupNation: Open for Business to ensure that you pick the perfect structure to fit your business.