Choosing the right business structure is an important first step when starting a company. It affects your taxes, your exposure to liability, and your relationship with partners. In the case of corporations, it also affects the amount of paperwork you are required to fill out.
Business structures fall into four basic categories: Sole Proprietorship; Partnership; Limited Liability Company (LLC); and Corporation.
Both Sole Proprietorships and Partnerships are designated as informal business structures. Both are “pass-through entities,” which means that the profits pass through the business to the individuals. Rather than taxing the business for their profits and then taxing the individuals on their wages from the business, Sole Proprietors and Partners only pay taxes once on their personal tax returns.
LLCs and Corporations, on the other hand, are classified as formal business structures. That means that these structures exist legally separately from their owners. It also means that these businesses are subject to state and federal regulations in order to preserve their legal status.
Formal business structures, such as an LLC or Corporation, protect your personal assets in the event that you are sued or default on a loan. A formal structure also imbues your company with an aura of credibility.
Is a Lawyer Necessary?
You don’t need a lawyer to set up an LLC or a Corporation. If you have all the time in the world, you can research the particulars involved in setting up your business and filing. Filing can easily be done online.
The reason that you should have a lawyer is that they are professionals. It’s what they do for a living. They have the experience to do things the right way and to do the job quickly. If you don’t do things the right way, you may need a lawyer at some time in the future if you mess things up. It’s your decision—pay the lawyer now or pay later.
One important area where an attorney can help you is in deciding on LLC taxation. Do you want to be taxed as:
Sole Proprietorship or Partnership;
An S-Corporation; or
Generally taxation as a C-Corp for a small business is unrealistic. Large organizations may select this option if you intend to reinvest a significant portion of your profits in equipment or property or you have many investors.
The disadvantage of a C-Corp is double taxation. The Corporation is taxed and then you, as an owner, and your employees are taxed.
If you are starting a new company, first consult your attorney and CPA before deciding on your business structure (i.e., Sole Proprietorship, LLC, Corporation). The legal structure that you select will impact your personal liability and affect how you will be taxed.
An attorney can help you avoid potential liability exposure and also help in obtaining any necessary business permits. What’s more, by reviewing and analyzing all of the different types of contracts you are involved in (such as leases and contracts with your business partners), an attorney can protect your interests.
As a sole proprietor, you are “the king of me.” You and your business are one and the same. It is the easiest way to start a business.
That can be a good thing and, at other times, not so good. You rake in all of the profits, but you are on the hook for all of the debts. What’s worse, you are personally liable if you default on a loan or are sued.
The good news is that, if you open your shop as the only owner, you are a sole proprietor. You will, however, need to obtain any applicable state and local licenses and permits. You may also be required to file for a DBA (Doing Business As) with your County recorder if you operate your shop under any name other than yours.
Starting a Sole Proprietorship is easy and inexpensive. Compared to other business entities, taxes are lower. What’s more, you are your own boss with no one to answer to.
There are some downsides. You are personally responsible for all of your business liabilities. As a sole proprietor, you may also have more difficulty getting a commercial loan.
Running your shop as a Sole Proprietorship provides you with many advantages that other business structures do not have. You have fewer government regulations. Your tax obligations may also be lower (because you are only taxed at the personal level).
However, as a Sole Proprietorship, you are self-employed and incur the self-employment tax of 15.3 percent, along with applicable federal and state income taxes.
You are personally liable for all of your shop’s debt. What’s more, if your business is sued and a judgment goes against your company, you are personally liable and could lose your home or other assets.
General rule of thumb: If you are starting out in business or your shop is earning less than $40,000, you should operate your business as a Sole Proprietorship.
If you have significant personal assets, you should form an LLC before you start your business to protect these assets. A single-member LLC is taxed as a Sole Proprietorship and incurs the full 15.3 percent self-employment tax.
More than half of the businesses in the United States are Sole Proprietorships. You don’t need much more to get started than the tools of your trade. If you don’t employ anyone, you don’t need an Employer Identification Number (EIN). You don’t even need a separate business bank account. In fact, you will unlikely get a business account without an EIN. You simply file taxes using a Schedule C tax form.
The problem that Sole Proprietorships face is that, because the line between personal expenses and business expenses is often blurred, the IRS is more likely to audit you versus operating as a more formal business structure. When you face an audit, there is a high probability that you will lose and end up paying more in taxes and penalties.
If that isn’t bad enough, as a Sole Proprietorship, it is easy for someone to sue you. That puts all of your personal assets at risk. That may not bother you in the first place, if you are dirt poor and have nothing to lose. However a tenacious and vindictive litigant can pursue you to the ends of the earth to your dying day. Even after you lose everything you own, he can garnish your wages.
In the event that you pass away, as a Sole Proprietorship your business dies with you. That can be a problem for your family if they want to sell the business.
It is also more difficult for a Sole Proprietorship to obtain a business loan than operating your business using a more formal business structure, such as an LLC.
When forming a Partnership, you should, at the very least, have a written Partnership agreement. Never ever form a Partnership on a handshake, even when the partner is a friend or a family member.
A Partnership agreement is a contract between you and your business partners. The value of a Partnership agreement is that it avoids possible disputes. When it comes to money, disputes are common. What’s more, as the saying goes, there is no such thing as friends when it comes to money.
Some areas that a detailed written agreement should include are:
The nature of your business;
Capital contributions of each partner;
Distribution of profits and losses;
How members withdraw from the partnership; and
Dissolution of the partnership.
A lawyer can help you structure an agreement and address all of the possible pitfalls that you can encounter when going into business with someone else. The fact is that Partnerships rarely work for a variety of reasons.
A better alternative to a general Partnership is a multi-member LLC. This business structure not only delivers all of the benefits of a formal general Partnership agreement but also provides personal asset protection and flexibility in how your company is taxed.
Limited Liability Company (LLC)
Among small businesses, an LLC is the most popular business entity. Not only does it protect your personal assets, it also provides tax benefits (such as pass-through taxation).
When profits pass directly through to the owners, the owners, not the business, are taxed. By comparison, businesses that are set up as C-Corporations are taxed twice. First, the profits that the company makes are taxed. Then anything paid to the members is taxed again. Of course, an LLC can choose to be taxed as a C-Corporation, which makes no sense for most businesses.
You can realize tax benefits as the sole member of an LLC, if you select to be taxed as an S-Corp. If your shop makes a profit of $100,000, you can pay yourself half as wages and half as dividends. If all of the profits are passed through to your personal tax statement, the normal self-employment tax is about $15,000. The self-employment tax of 15.3 percent covers 12.4 percent for Social Security and 2.9 percent for Medicare. You must also pay federal and state income tax.
On the other hand, as an S-Corp, if you pay yourself a reasonable salary of $50,000, you can reduce the self-employment tax by 50 percent.
If this sounds like bookkeeping finagling, keep in mind that the IRS is more likely to audit you when filing as an S-Corp. For this reason, consult a lawyer or a CPA when selecting how your LLC should be taxed. If the IRS deems that $50,000 is not a reasonable salary and some of what you paid yourself as dividends should be reclassified as wages, you could face tax penalties.
LLCs with multiple shareholders are actually not that different from a single-owner LLC.
When an owner of an LLC filing as an S-Corp performs tasks within the business, he must be treated as an employee. He must receive reasonable compensation for his work. In addition to payroll deductions for Social Security and Medicare, federal and state taxes must also be withheld.
With respect to other employees, the owner must contribute half of their employment taxes and all of his own. In part tax savings are realized from the money paid to shareholders, which is not subject to employment taxes. Another tax benefit is that unlike a C-Corp, LLCs, and S-Corps do not incur corporate taxes, because they are pass-through entities.
If you are a one-man shop, set up as a single-member LLC, so you can segregate business finances from personal finances. This permits you to write off business-related expenses (office supplies. travel and entertainment costs, etc.).
For tax purposes, you may need to file any number of tax forms that were not required when filing as a sole proprietor. This can be complicated. For this reason, consult your CPA or tax professional.
Forming a Corporation.
The requirements for forming a corporation are governed by the rules in the state where the business is formed. Generally, you should incorporate in the state where your company operates.
You may have heard that some businesses incorporate in Delaware and Nevada because their laws are more business-friendly. While this is true, you must also register your company as a foreign corporation and pay taxes in the state where it is physically located and operating. In addition, you also must pay taxes in Delaware or Nevada.
Forming a corporation makes sense if your company has more than 100 employees and generates significant sales and profits. The C-Corporation establishes a business as a separate legal entity. In other words, the company exists independently or separately from its owners or shareholders.
For a larger corporation, this business structure has advantages. The biggest advantage is limited liability.
Another advantage is stability. Because a corporation is a separate legal entity, if one of the owners dies, the business continues. This is often the case with a sole proprietorship or partnership, which frequently dies when an owner dies.
For a smaller company, forming a corporation requires time-consuming paperwork and more expense. Double taxation is another disadvantage. Because a corporation is not a viable business structure for most small companies, this article will not devote much time to it.
One of the first tasks required in forming a corporation is to write Articles of Incorporation. These are similar to Articles of Organization required for LLCs. The requirements will vary from state to state. You will need to inquire about these requirements at the Secretary of State’s office for your state. Generally, they will have forms and guidelines covering the preparation of these articles.
The Articles of Incorporation provide the basic information and outline for the business including company name and location; names of the members on the board of directors and the numbers of shares that can be issued.
While the Articles of Incorporation provide a basic outline of the business, the Corporate Bylaws get into the specific rules governing the organization. These specifics might outline the company mission and objectives, responsibilities of each of the board members, how meetings are conducted, how the Board of Directors are elected, and how they in-turn select corporate officers.
While you can write your own Articles of Incorporation and Corporate Bylaws, the easiest way to prepare these is to consult with your attorney.
For most companies, forming your company as an LLC is your best option.
Whatever choice you make, make sure to take the following steps:
Do your homework. Read as much as you can about the advantages and disadvantages of the various business structures.
Contact your Secretary of State’s office. As part of your research, find out the regulations, forms, and procedures necessary to form a business in your state.
Discuss the different business structure options with your attorney and CPA or tax professional.
Do all of your planning before you open for business. Remember that proper prior planning prevents poor performance.