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If you don’t have time to do it right, when will you have time to do it over? John Wooden
Deciding to start a new business is exciting. Forging out on your own to sell a product you love, provide a service you are passionate about, becoming your own boss, is empowering. To start off in the right direction and make sure your business has a sound foundation it is important to consider and select the best business structure for your business at the time.
Business structures determine legal and tax responsibilities. Each structure has a pro and con; some are easier to implement and maintain; while others require more effort. When selecting a structure consider the legal and tax consequences first then the ease of maintaining the structure. If your initial structure doesn’t work well for your business it can be changed later. For example a sole proprietorship can transition to a LLC or corporation. However, a corporation cannot move down to a sole proprietorship — something to keep in mind.
Sole Proprietorship: A sole proprietorship (great SBA article here) is the basic business structure. Legally and tax wise there is no distinction between you and the business. It is very easy to implement and maintain as the law views the business as you; no meetings, resolutions, votes, etc. are necessary. The profits and loses of a sole proprietorship are passed onto the owner and taxed at the individual level rather than subject to corporate rates. Another consideration is the liability issues. As the law does not differentiate between you and the business you are personally liable for the actions of the business. A legal action can be taken against you personally and all of your personal assets. I’ve had two sole proprietorships and they were very easy to operate. Unfortunately, it was very difficult to raise funding — remember banks and lenders will review your personal finances because you and the business are ONE. Liability insurance was also more expensive because the business structure offers no protection so the insurance must do more.
Pros of a Sole Proprietorship: Cons of Sole Proprietorship:
* Easy to form * Liability risks for the owner
* Owner has complete control * Raising financing is difficult
* Little or no paperwork * Self-employment tax
* Easy tax filing
General Partnership: Similar to the sole proprietorship, a general partnership is between two or more people. The partners are legally responsible for all business liabilities and profits / losses are passed onto each partner as personal income. In a partnership you must confer and make decisions with one or more individuals limiting your control of the business. However, partners can pool assets to fund the business in ways a sole proprietor may not. Tax filing is more complicated in that a CPA will prepare K1’s (profit and loss statements) for each partner. A partnership agreement is highly recommended. The agreement spells out partnership percentages, responsibilities, and processes for dissolving the partnership in the event it ends. I can attest to the importance of a partnership agreement as my husband and I had to dissolve a partnership. We had no agreement with our partner and it was an expensive and contentious legal battle. Dissolving a partnership is akin to a divorce and just as a pre-nuptial agreement helps in the event of dissolution so does a partnership agreement. Here is a very basic agreement by Entrepeneur.com.
Pros of a General Partnership: Cons of a General Partnership:
* Easy to form and maintain * Share decision-making
* Funds raised between partners * Personal liability and legal risks
* Taxed on a personal income level * Partner discord
LLC (limited liability corporation): A LLC is a happy combination of a partnership and corporation. It takes the tax benefits of the partnership structure (passing profits and losses onto the “members” as income) while providing the liability benefits of a corporation. The owners are called members and have the ability to operate the business like a partnership. An LLC doesn’t require as much documentation or records (such as board minutes, shareholder votes, etc.) However, a LLC must be dissolved when a member leaves and members will pay self-employment taxes on profits. An Operating Agreement (similar to a partnership agreement) is highly recommended upon forming a LLC. It makes operating the company much easier. I have formed one LLC and it was a fairly simple process. I also developed the Operating Agreement and maintained all documentation. The tricky part was extracting myself and my husband from the LLC when we decided to leave. There were 2 other members so it did not dissolve but I had to research the correct, legal way to remove ourselves from the entity.
Pros of an LLC: Cons of an LLC:
* Liability protections of a corporation * Must dissolve if a member leaves
* Tax benefits of a partnership * Self-Employment taxes
* Shared responsibilities * Share profits and control
S-Corporation: Is a corporation called Subchapter S. Meaning it is a corporation but small enough for the profits or losses to pass onto the shareholders like a partnership. The corporation has the full benefits of a corporation i.e. liabilities but the is not taxed at corporation tax rates. The business is its own entity; separate from the owners. This separation makes securing funding less difficult as the corporation is judged and examined rather than the shareholders (depending upon the lender. Some lenders like to examine officers for solvency). Another difference is corporations are expected to pay officers a reasonable salary and the IRS strongly discourages excessive distributions. In a partnership and sole proprietorship does not have these restrictions. The corporation is initially formed as a C-Corporation with an application for Subchapter S classification. The requirements are fairly simple: domestic corporation, fewer than 100 shareholders, only eligible shareholders, and one class of stock. Subchapter S is an IRS classification rather than legal as the beneficial difference between an S-Corp and C-Corp are at the taxation level. I have one S-Corp. now and I really like it. I formed the C-Corp., applied for S-Corp. status, maintain records, and other administrative duties. For my business it is a perfect solution to my liability and taxation issues.
Pros of an S-Corporation: Cons of an S-Corporation:
* Liability protections of a corporation * Recordkeeping similar to a C-Corp.
* Taxed at partnership rates * Officer/Owners receive salary
* Easier to obtain funding * Distributions discouraged by IRS
C-Corporation: aka The Big Daddy. I’m being silly but a C-Corporation is the traditional, full corporation structure most companies use. This structure is the most complicated and time-intensive. The benefits to a C-Corp. are the legal protections. A corporation is its own entity to the law and IRS. It is operated by officers hired or chosen by a board of directors (for small companies they are typically the primary owners). The board of directors are chosen by the shareholders (again, for a small company typically the primary shareholders). C-Corporations follow the laws of the state in which they are formed and the states they operate. For example, my former C-Corp was formed and located in California so those were the laws it was bound. My new corporation is formed outside California but operates in California so it must follow the laws of the state it is filed and the state is operates. Most larger companies opt for a C-Corp because it offers legal protections, sells stock to secure funding, and can secure outside financing much easier than other structures. I have formed and operated a C-Corp and though it offered great protections it did require considerable maintenance.
Pros of a C-Corporation: Cons of a C-Corporation:
* Limited personal liability * Extensive recordkeeping
* Easier to obtain funding * Taxed at corporate rates
* Separate entity from the owner * Expensive to form & operate
Do your research, educate yourself, and learn the differences between each structure. The more you know the better your decision-making. Once you’ve narrowed your options discuss your choices with your CPA and lawyer. From here the direction is set for forming the company.
Next post I’ll discuss the different processes to actually form these structures.