How To Select A Business Structure That’s Right For You
The first step in forming your business is selecting a business structure (or, as we lawyers love to call it, a “business entity”). Which structure you select will depend on your risk tolerance, liability protection preferences, willingness to deal with legal formalities, your long- and short-term business objectives, and tax planning considerations. (Whether you’re a risk-averse lover of state filings with a home- based cat sweater knitting biz, the founder of the next tech unicorn already working on your exit strategy, or the future queen of life coaching plagued by nightmares of filing your first business tax return, don’t worry, there is a biz structure for you).
Here is a general overview of the most common business entities – take some time to familiarize yourself with each, and choose the entity that best fits your situation, priorities and goals:
As a sole proprietor, you are your business. Unlike an LLC or a corporation, which are treated as separate legal entities from their owners, a sole proprietorship does not have an independent existence or “legal personality.” The business and the person are one and the same.
This makes things very easy in terms of formalities – since the sole proprietorship is “just you,” there is no requirement to register the business by filing paperwork with the state; there are no fees to pay; and no annual reporting requirements. You can simply get an EIN (in some cases you can even get away with simply using your social security number, although this is not recommended), open a business bank account, and start bringing in that moolah. Even taxation is easy – any profits (or losses) from the biz are going to be reported on your personal tax return.
Sounds too good to be true? Well, that’s because it kind of is.
While the idea of not dealing with the state sounds like a business dream, there is a major drawback to the sole proprietorship: with this business structure, you get zero liability protection. (Your business = you. Your business’s debts = your debts.) So, if your biz ever gets sued, and ends up owing more than it’s worth, the difference can be taken out of your personal savings. (Ouch. There’s a reason we used to call it “sole proprietorshit” in law school.)
Although you can obtain some business protection insurance to deal with this situation, keep in mind that insurance policies have limits, and may not cover a large judgment against you.
Limited Liability Company (LLC)
A favorite among entrepreneurs, the LLC allows you to cover your ass by separating you and your business, thereby limiting your liability exposure to the amount of your investment.
In other words, no one can go after your personal savings or your home to satisfy a debt of the business.
Tax treatment is flexible – you can choose whether you want your business to be taxed as a partnership, sole proprietorship, or C-Corporation. Most LLCs choose to be taxed as a partnership or sole proprietorship, meaning that the LLC itself does not pay any taxes on its profits; rather, those profits are taxed on the owners’ individual tax returns.
An LLC may consist of only one member, but there is also no upper limit on the number of members. LLCs can be owned by other LLCs or corporations. There aren’t many federal or state-imposed formalities to deal with – members can set their own rules for how profits are shared and how the business operates. While annual reports and fees are required in most states, there is no requirement to hold annual meetings, keep minutes, or perform other mandatory administrative tasks that come with owning a corporation.
Forming an S-Corporation can be slightly (or, significantly, depending on your perspective) more complicated than forming an LLC, and there are quite a number of rules, requirements and formalities that apply to its continued operation. For example, you have to file annual reports and pay annual fees; hold annual meetings and keep minutes; file more complex tax forms; have a board of directors and officers (even though they can all be you); and so on.
Despite its complexities, it’s still an attractive option for many businesses, because owners of S-Corps do not have to pay self-employment taxes (a.k.a. “payroll taxes,” a.k.a. Social Security and Medicare taxes) on the share of the business’s profits.
But, before you get too excited, there is a catch: owners who also work as employees of the corporation, participate in its day-to-day operation or perform a key service, are required to pay themselves a “reasonable” salary, which is subject to self-employment taxes.
So, any tax savings don’t kick in until the S-Corp is making profits that exceed the mandatory “reasonable compensation” payable to its active shareholders. (In contrast, with an LLC, 100% of the business’ income would be taxed at the self-employment rate).
When you consider the startup costs and ongoing legal and accounting costs, an S-Corp may cost you more than it saves, particularly if you live in a state that charges S-Corporations additional fees and taxes.
Also keep in mind that S-Corps cannot have more than 100 shareholders; they cannot be owned by C-Corps or other S-Corps or LLCs; they can have only one class of stock; and all shareholders must be U.S. citizens or residents, and “natural persons” (not other businesses). Because of these limitations, they are not a favorite among investors.
Unlike LLCs and S-Corps, C-Corporations must file separate corporate tax returns in their own name and pay taxes on any profits reported. In addition, if any of those profits are distributed to business owners as dividends, then those shareholders also pay personal income taxes on that same money. (This is the infamous “double taxation” of C-Corps, a.k.a. just accept that with this business structure you have to pay “the Man” twice). C-Corporations also pay high corporate income tax rates on annual income in excess of $75,000.
On the other hand, some of the advantages to forming a C-Corporation include: low tax rates on the first $75,000 of annual income for non- professional service corporations; superior fringe benefits for owner- employees; a lower audit potential than pass-through entities; possible availability of reduced rate on capital gains taxation; and possible availability of high ordinary loss deductions in the event that the corporation fails.
Another advantage is that investors and venture capitalists (VCs) often prefer to work with C-Corporations for a variety of reasons: they are easy to transfer, can have unlimited shareholders (and can therefore be the subject of an IPO); and can issue preferred stock, which pays higher dividends and pays out first in a liquidity event – something that VCs want in exchange for the risk they take in investing in you. VCs also prefer C-Corp taxation, and a structure that allows foreign investors and domestic VC firms to become owners of the business.
A partnership is a business structure where two or more self-employed individuals come together as co-owners of a business. Each partner contributes capital, labor and skill, and each shares in the profits and losses of the business. As for taxation, partnerships, like sole proprietorships, LLCs and S-Corps, are “pass-through” entities, meaning that the business itself does not pay income tax on its profits. Instead, each partner simply reports their share of the profits or losses of the business on their individual tax return.
It is relatively easy to form and maintain, as there are no filing requirements, no annual fees or mandatory reporting, or any of the other formalities required by LLCs and corporations. Only a handful of states require that limited partnerships (see below) file annual reports.
One drawback of the partnership is that, like sole proprietors, the partners generally have unlimited liability for the debts, losses and financial obligations of the business. This means that the personal assets of all partners can be used to satisfy the partnership’s liabilities – all of it, not just that partner’s share. So the partners are not only liable for their own actions, but also the actions and decisions of the other partners.
In some instances, the above is partially remedied by setting up a limited partnership. A limited partnership has two classes of partners: “general partners,” who run the business and remain personally liable for its debts; and “limited partners,” who only invest capital in the business, but do not take part in its management, and whose liability is limited to the capital they invested. Note that there is no partnership structure in which it is possible to limit the liability of all partners. If covering every member’s ass is a priority, consider forming an LLC or Corporation.
I’m going to let you in on a little secret: a joint venture is just a partnership between two businesses or individuals who decide to pool their resources and expertise for a particular project. The difference is that, while partnerships can be formed for the general purpose of “doing some business together” and can last for an indefinite amount of time, joint ventures tend to be limited in scope and duration to the achievement of their specific objective.
A joint venture can be greatly profitable, as it gives the members access to each other’s resources, experience, established markets and distribution channels. But it’s not without its challenges – in addition to the legal and administrative complexities of partnering with another business, problems can arise if the parties are not familiar with each other’s management and leadership style, or have not clearly and specifically communicated their objectives and expectations to one another. So, to avoid major meltdowns later, make sure that you do your due diligence on the business and people that you want to collaborate with, and see to it that your Joint Venture Agreement is 100% clear about the objectives of the enterprise as well as the expertise, contribution and responsibilities of each member.
Disclaimer: The tax, legal, accounting and strategic considerations in choosing a C-Corp versus an S-Corp, LLC, or Partnership could (and does) fill many books. This short overview is only intended to provide you with an idea about the types of issues you need to consider in selecting a business structure, and not as in- depth legal and/or tax advice.
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