Now that you’re aware of some of the questions to ask before starting your own company, it’s time to decide how to structure said company. There are multiple business entity types to choose from, each with its own advantages and disadvantages that should be carefully considered. Making the right choice can set your company on the path to success early on.
In addition to how your company’s basic operations will run, your choice of business entity type will also have legal and financial implications. How much tax will you have to pay? How easy will it be to get a small business loan? How much liability are you personally at risk for? All of this will depend on the structure you choose.
State governments recognize over a dozen types of business entities, but the average new business owner generally makes their choice from these options: sole proprietorship, partnership, limited liability company, C-Corporation and S-Corporation.
A sole proprietorship is the simplest and most popular type of business entity, despite many drawbacks. It has a single person as the owner and operator. A married couple may also own it jointly. Sole proprietorships are common for freelancers, consultants and small mom-and-pop businesses.
Sole proprietorships are easy to start and are not required to register with the state. There is no need for formal paperwork like bylaws. Filing taxes is a relatively simple process and you can deduct most business expenses on your personal tax return.
However, because of the lack of separation between you and your business, you are personally liable for all business debts and operating risks. That means that, in a lawsuit, you could be at risk of losing your personal assets, including savings, your home, or other assets. Since sole proprietorships are unregistered, it can be more challenging to be approved for loans, find investors, and build business credit, in addition to the significant risks related to personal liability.
A partnership is similar to a sole proprietorship, the main difference being that your company has two or more owners. There are two types of partnerships, general and limited.
General partnerships share many of the same pros and cons as sole proprietorships, but split gains and losses between partners. In some states, though, each partner may be liable for the actions of every other partner. With the right partner(s), general partnerships may lower the individual risk of starting a business, since the liability is split between more than one person, although that liability may be unlimited and jointly shared between the partners and so may be a significant risk.
Limited partnerships (LP) require more formalities but are generally safer for individual partners than a general partnership. They are registered with the state, meaning that you must file the proper paperwork. Another difference is that the partners have very different roles in the company when compared to a general partnership. The general partner (or partners) owns, operates and assumes liability for the company, while the other(s) act simply as investors. Generally, these other limited or “silent” partners own a stake, but have no day-to-day control over the company.
LPs have an easier time raising money, since investors can become limited partners while only taking on limited personal liability, and can generally leave without dissolving the business. The general partner(s) has the benefit of controlling the company, while getting money from investors to operate. Because of this, though, the general partner is generally personally liable for business debts and other business obligations, without help from limited partners. Limited partners must also avoid taking too active a role in the company.
Limited Liability Company (LLC)
Limited liability companies are very popular among small business owners because they are relatively easy to form and have more legal protections than sole proprietorships and partnerships. An LLC’s must be registered with the state, but are also required to separate personal and business assets of the owners and follow certain other formalities. Owners are generally not personally responsible for business debts as long as certain procedures are followed.
The freedom to choose how your company is taxed is another significant advantage of an LLC. You can elect for the company itself to be taxed directly or you can pass profits and losses through the personal tax returns of investors and who must then pay out of their own pocket. This flexibility can be very advantageous for many business types.
Like an LLC, a C-Corporation is a separate legal entity from its owners, or shareholders in this case. Shareholders share control over the company with a board of directors and officers, although one person can fulfill all of these roles if desired, depending on the state where the company is formed.
Shareholders are generally not responsible for business debts and liabilities. Tt is also easier for C-Corps to qualify for certain tax deductions than other entities. However, they face what’s often referred to as double taxation. The company pays corporate taxes and shareholders pay taxes on personal gains from dividends. However, shareholders generally cannot deduct business losses from their personal tax returns. However, this taxation risk can be somewhat mitigated through proper legal and tax planning.
Running a C-Corporation is generally more complex than sole proprietorships, partnerships and LLCs. There are additional formalities involved with C-Corps creation and maintenance, including board meetings, shareholder meetings, and bylaws. Experienced corporate counsel, well versed in this type of business, is absolutely necessary.
S-Corps share the limited liability and corporate formalities with C-Corps, but they differ in their tax treatment. S-Corps are pass-through entities, so business profits and losses generally get taxed through shareholders’ personal tax returns. The company itself does not get taxed. S-Corps combine corporate structure with tax flexibility. However, S-Corporation are subject to limitations in the types of people and entities that can own them as well as certain other limitations.
Updating Your Entity Type
Even if you have started a business in one arrangement, you may want to convert it to another. However, there are legal formalities required for conversion and several considerations to take into account. There are a variety of reasons why you may want to change how your business is set up. If you start out as a sole proprietor you may find yourself growing to a point where an LLC makes more sense. If you are merging your company, bringing on or removing a partner, taking on investors, or selling your business to another business, you will need to consider how your business is currently set up and how it will need to change to accommodate updates.
It’s important to consult a business lawyer to analyze your goals and weigh the pros and cons of each entity. A business lawyer can also help analyze if you’re at a point where you will need to change the entity type. Sole proprietorships and partnerships have less protection from liability, but taxation is simple and a have low level of government requirements. LLCs and corporations have stronger protection, but they are more complex to form.
Which set up makes the most sense for your business? Talk to a lawyer to discuss the best option. Any questions? Don’t hesitate to reach out! We’re here to help you and your startup.