When entrepreneurs develop a business idea, it’s natural for them to want to jump right in and begin conducting business as soon as possible. But like so many aspects of developing a business, the wisest among them also plan ahead, choosing the structure that best fits their business operations and objectives.
If you’re planning to start a business or own a growing one, it helps to understand the pros and cons of different structures. One size does not fit all, nor does one size always fit the same company over the years.
The simplest, easiest structure to form, sell or transfer is the sole proprietorship where one owner has full control of the company. Money passes freely between the business and the owner, so when the company loses money, the owner typically saves on taxes. When the company makes money, the owner makes more and pays more taxes.
The biggest downside to sole proprietorships is that they leave owners vulnerable to any problems incurred in the business. If someone were to sue a sole proprietorship, they’d essentially be suing the individual owner — and all the owner’s personal assets are on the line with the business.
Many companies begin as sole proprietorships by default — simply because the owner didn’t set up anything else.
General partnerships are similar in that regard. Two or more people start a business together, and because they don’t set up any other structure, they end up as general partners. But general partnerships potentially carry more risk than any other business structure. A major drawback to general partnerships is that any one partner can incur debt for the business and all partners can be held personally liable for it.
You can tweak general partnerships to become limited liability partnerships, preventing partners from being responsible for others’ debts, but another structure is probably a safer option.
Corporations are common structures. They are appealing because they have been around for hundreds of years, have a long string of case law clarifying the rules and are more uniform from state to state.
Corporations provide an automatic structure (consisting of shareholders, directors and officers), insulate owners from liability and offer different tax options. With C corporations, for example, the company is taxed on the profit; whereas with a subchapter S corporation, profits pass through to shareholders and only shareholders pay income taxes.
Corporations have a couple of notable disadvantages. One is cost (e.g., incorporation and annual report filing fees). Typically, those are fairly minimal for a business with few owners unless you are doing business in a number of states, there are different classes of ownership, there is a need for a buy-sell agreement or other situations exist necessitating other documents or planning.
Another disadvantage is that corporations must operate according to established rules. That means maintaining separate bank accounts exclusively for the business, annual meetings and minutes and annual report filings in every state applicable.
If you fail to treat the business as a completely separate, stand-alone entity, you run the risk of a creditor "piercing the corporate veil." If the veil is pierced, your personal assets may be at risk for a corporate liability.
An important part of maintaining the integrity of the corporate entity is to be sure third parties dealing with the business realize they are dealing with a separate entity. The corporate status should be listed in conjunction with the name of your business wherever it may appear publicly — on business cards, signage, letterhead, ads, Web sites, customer correspondence, invoices and checks.
The most common business structure is the limited liability company (LLC). A hybrid between partnerships and corporations, LLCs have the formalities of a corporation but greater flexibility in management and organization. They essentially combine the liability protection of a corporation with the pass-through taxation of a partnership or sole proprietorship.
Deciding on a structure may not be a one-time effort in your business. Any time a company experiences or anticipates considerable growth, a change in business models or any other significant development, it’s time to re-examine whether you have the correct structure.
As you consider your options, keep in mind that different structures can impact taxes and other operations in subtle ways, so it is critical to gather input from your key professional advisors, including your attorney, accountant, banker and insurance agent. They can help you determine the right structure for your business with all the opportunities you see today as well as those still to come.
Article by Johns, Flaherty & Collins, SC. For more information on choosing the structure that's right for your business, call us at 608-784-5678.