Choosing Your Business Structure
Starting a new business is exciting. Looking to the future and dreaming of what your business can accomplish is enough to keep you awake well past your bedtime. So, during those sleepless nights you can read through your legal structure documents so you can get a good night's sleep!
One of the first steps you need to take when opening your business is deciding what type of entity you will be forming. In other words, how do you choose your business structure?
But first…
Disclaimer: We are not attorneys, and no information gleaned from our books, articles, productions, and websites or resources should be considered legal advice. We do our best to make sure that information is accurate but if you are unsure or still have questions, we do suggest you always consult with your legal counsel or tax professional before making business decisions.
Now that we have that out of the way, let’s look at all of the different options you have when forming your new business.
Sole Proprietorship
A sole proprietorship is the most common form of business structure and also the easiest to set up. If you are a single owner of a business and have not registered to become another entity structure you will automatically become a sole proprietor. You have total control over the business with this structure and the paperwork is very minimal. Many times, all you need is to register your trade name and acquire the needed permits or insurance to do business. You file your business taxes within your personal taxes which provide a level of ease that other structures do not offer.
The downside of the sole proprietorship is your personal exposure and level of personal liability. You are solely responsible for every mishap of the business and are personally on the hook for every liability. A bad debt in the business has access to your personal assets including your car or home. The sole proprietorship is also a poor structure for raising capital. If you intend to reach out to investors or to obtain a bank loan for the business, this is probably not the right structure for you.
Partnership
The partnership is very similar to the sole proprietorship aside from having more than one owner. Like a sole proprietorship, the partnership is the default structure assigned to a business with more than one owner without filing to become another type of entity. A partnership only needs to register its trade name and acquire business permits and insurance just as a sole proprietor. The partners can split ownership however they’d like and will share control over the business. When filing taxes, the partners will file their portion of the business taxes along with their personal taxes.
The liability of a partnership is also like that of a sole proprietor. Liability falls in full on each partner and not just based on the percentage of ownership putting each partner’s personal assets at risk of business liability. The partnership is also a poor vehicle for raising capital just as with a sole proprietorship. In addition, a partnership must take into account conflicts between partners. With so much personal liability in a partnership structure major conflicts can be detrimental to all owners of a partnership.
When forming a partnership, a Partnership Agreement and a Buy-Sell Agreement should be formulated so everyone is clear on their responsibilities and what would happen in the event that one or more partners decide to leave the business.
Limited Partnership
A limited partnership is very similar to a general partnership except that a Certificate of Limited Partnership must be filed with the state. The limited partners of the business do not have management control over the business as the general partners do. Instead, they are seen more like investors in the business. Limited partners are taxed in the same way as general partners with the details laid out in the Partnership Agreement.
With slightly more structure than a general partnership, it is easier to raise capital with a limited partner structure but it is still not the ideal structure if raising capital is your initial goal.
Limited Liability Company
A Limited Liability Company (or LLC) falls right between sole proprietorship/partnership and corporation. In an LLC the owners are called members or managers - you can be a single-member LLC or have multiple members or managers. The benefit of the LLC is stated right in the name: limited liability. The personal liability of the members is protected and the business is treated as its own entity. There’s also the benefit of pass-through taxes for the members, meaning that the business itself is not taxed but instead each of the members is taxed on their percentage of the business. However, you can choose to be treated like a corporation with the same taxation options and formalities. When forming an LLC, you will need to file the needed forms with the state and pay a nominal fee. Depending on how the structure will be treated you will need to file certain tax forms with the IRS. Additionally, you should have an Operating Agreement in place for your LLC to define the interests and rights of the members.
An LLC may be sounding pretty good so far, but it is not the right structure for raising venture capital or seeking investors. Also, every member of the LLC is subject to self-employment tax with this structure unless you decide to be treated as a corporation when it comes to taxes. The LLC may be the right structure for you if you are a small business not seeking investor funding but are looking for protection of personal liability.
Corporation
C Corp
A C corporation is seen as an established entity. With this structure, the founders are safe from liability and even have the opportunity to raise capital either through investors or venture capital. When forming a startup, the C Corp is a decent structure to consider as most startups will be looking to raise capital early on in the company’s life.
The big difference between a C Corp and some of the other structures we have talked about is that the shareholders of a C Corp own the business rather than the founders. Which brings us to one of the downsides of the C Corp: the possibility of double taxation. Since C Corps are entirely their own entity, they are taxed on profits earned. Those already taxed profits are then split between shareholders where they can be taxed again as income.
Another less than fun part of the C Corp is all of the paperwork. Whereas a sole proprietor registers their trade name and files their taxes with their personal taxes, C Corp has a whole stack of paperwork needed just to open the company and it files its own taxes. Some of the things needed upon the creation of a C Corp include:
Articles of Incorporation
Bylaws and Resolutions
Board of Directors
Stock Certificates for Shareholders
Registered Agent
And even after formation, keeping up with the required paperwork of a C Corp is much more time consuming than the other structures we have talked about so far.
S Corp
S corporations are similar to C corporations in the way they are formed. The business is its own entity and controlled by shareholders. The paperwork is the same and so is the ability to raise capital.
The major difference is that you must have under 100 shareholders to be eligible to be an S Corp and the business itself is not taxed. The S Corp avoids the double taxation of the C Corp by not taxing the company and instead passes all profits directly to shareholders to be taxed. Not all businesses are eligible to be S Corps, so we recommend you talk to your legal counsel to find out if you are eligible.
Keep in mind there are many other forms and combinations of forms of businesses. All of them have their advantages and disadvantages. A few examples are the LLP (Limited Liability Partnership), LLLP (Limited Liability Limited Partnership), and the Nonprofit Corporation. Make sure to do your research which kind of structure best suits your business. And remember, your business may start as one structure and grow into another so you can make changes as necessary.
We hope you are on your way to determining which business structure is right for you. If you have made your decision, Rosnik Consulting, LLC can help get the proper formation and originating documents drafted and filed. If you are still not quite certain, you can schedule a free consultation with us to talk to one of our business consultants about your options.
