The type of legal structure you choose for your company is one of the most crucial decisions you’ll make when starting a business. Not only will this selection affect the amount of tax you pay, but it will also affect the amount of paperwork your firm must complete, your personal liability, and your ability to acquire funds.
Mark Kalish is the co-owner and vice president of EnviroTech Coating Systems Inc. in Eau Claire, Wisconsin, which uses an electrostatic method to apply powdered paint to goods like motorbikes and musical instruments.
Kalish has also worked as an owner and in other managerial positions for a number of other start-up companies.
According to him, the answer to the question “What structure makes the most sense?” is determined by the unique circumstances of each business owner. “Every situation I’ve been a part of has been unique,” he says. “You can’t simply assume that one shape is superior to another.”
It’s also not a decision to be taken lightly, nor should it be made without strong advice from business professionals. When weighing the advantages and disadvantages of various business formations, Kalish advises that business owners seek expert guidance from business specialists.
“I’ve heard terrible stories from folks who, in retrospect, wish they had invested the time and money to seek expert guidance earlier,” Kalish says.
That guidance can come from a variety of places, ranging from free/low-cost organisations like the SBA or the Service Corps of Retired Executives (SCORE) to more expensive lawyers and consultants.
Types of Business Entities
The type of business entity you choose will depend on three primary factors: liability, taxation and record-keeping. Here’s a quick look at the differences between the most common forms of business entities:
The most frequent type of business structure is a sole proprietorship. It’s simple to set up and gives the owner complete managerial control. The owner, on the other hand, is personally liable for the company’s financial responsibilities.
- A partnership is formed when two or more people agree to split a company’s profits and losses. The partnership does not carry the tax burden of earnings or the benefit of losses; instead, gains and losses are “passed through” to partners for reporting on their individual income tax returns. One major disadvantage is that each partner is solely liable for the company’s financial responsibilities.
- A corporation is a legal entity formed for the purpose of conducting business. The corporation becomes a different entity from individuals who formed it, with its own set of duties. The corporation, like a person, can be taxed and held legally liable for its acts. Profits might be made by the corporation as well. The main advantage of company status is that it protects you from personal liability. The most significant disadvantage is the high cost of forming a corporation, as well as the substantial record-keeping that is required.
- While double taxation is occasionally stated as a disadvantage of incorporation, the S corporation (or Subchapter corporation, a popular version of the standard C corporation) avoids this by enabling income and losses to be passed through on individual tax returns, much like a partnership.
- The limited liability company (LLC), a hybrid type of partnership, is gaining popularity since it allows owners to benefit from both the corporation and partnership forms of business. Profits and losses can be passed through to owners without the business being taxed, and owners are protected from personal liability as a result of this corporate structure.
Selecting a Business Entity
When making a decision about the type of business to form, there are several criteria you need to evaluate. Kalish and EnviroTech co-owner John Berthold focused on the following areas when they chose the business format for their company:
1. Legal liability.
To what extent does the owner’s legal liability need to be limited? EnviroTech took this into account, according to Kalish. He and Berthold put a lot of money into their equipment, and the contracts they work on are huge.
They didn’t want to bear personal responsibility for the company’s possible losses. “You should think about if your firm lends itself to possible liability and, if so, whether you can personally afford the risk,” Kalish says. “A solo proprietorship or partnership may not be the best option if you can’t.”
Carol Baker is the founder of The Company Corporation, a Delaware-based organisation that provides incorporation services.
“The number-one reason our clients incorporate,” she says, is to protect their personal assets. No one can seize your personal assets in the event of a lawsuit or judgement against your company. It’s the only option.
2. Tax implications.
What are the options for minimising taxation based on the unique situation and aspirations of the business owner?
Baker points out that corporations have far more tax alternatives than sole proprietorships or partnerships. As previously stated, S company status allows you to avoid double taxes, which is a major disadvantage of incorporation.
According to Baker, a S corporation is open to businesses with fewer than 70 shareholders; business losses can help lower personal tax liabilities, especially in the early years of a business’s existence.
3. Cost of formation and ongoing administration
Tax advantages, however, may not offer enough benefits to offset other costs of conducting business as a corporation.
One reason why business owners may choose another option—such as a sole proprietorship or partnership—is the high expense of record-keeping and paperwork, as well as the costs connected with incorporation, according to Kalish.
Taking care of administrative needs takes up a lot of the owner’s time, which adds to the business’s expenditures.
Kalish identified the sole proprietorship as a very popular form of business formation because of the record-keeping responsibilities and costs associated with them. It’s the same structure he uses at his other company, Nationwide Telemarketing.
“As a first option, I would definitely choose single proprietorship,” he says. “I would advocate a sole proprietorship if you’re the single proprietor and own 100 percent of the business, and you’re not in an industry where a decent umbrella insurance coverage wouldn’t cover potential liability issues.”
There’s no real reason to encumber yourself with all the reporting requirements of a corporation unless you’re benefiting from tax implications or protection from liability.”
4. Flexibility
Your goal is to make the ownership structure as flexible as possible by taking into account the business’s unique needs as well as the personal needs of the owner or owners. Individual requirements must be taken into account.
There are no two businesses alike, especially when numerous owners are involved. Nobody’s goals, concerns, or personal financial condition are the same.
5. Future needs
It’s common to be “caught up in the moment” when you’re initially starting out in business. You’re focused on getting the business off the ground and aren’t normally thinking about what it will look like in five, 10, or even three years.
What will happen to the company if you pass away? What if you decide to sell your share of a company partnership after a few years?
For EnviroTech, the issue of ownership was crucial. “Our motive for creating EnviroTech as a company was because of ownership,” Kalish recalls. “We wanted to be able to bring in stockholders as we grew.”
“”A corporation’s capital can be extended at any moment by issuing and selling new shares of stock in a private offering,” Baker notes. This is especially beneficial when banks are short on cash.”
“What do I want to happen to the business when I’m no longer around to operate it?” is another essential topic to consider. A corporation, unlike a sole proprietorship or partnership, can easily be passed to family members upon the death of its owner or owners.
Keep in mind that the business structure you choose at the outset may not be adequate for your needs in the future. As the company grows and the owners’ needs change, many sole proprietorships transition into another type of business, such as a partnership or corporation.
What’s the bottom line? Don’t take this crucial decision lightly, and don’t base your decision on what others have done. Before deciding on a business format, carefully analyse the unique demands of your company and its owners and seek expert assistance.
Sole Proprietorship
The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. If you intend to work alone, this may be the way to go.
The tax benefits of a sole proprietorship are particularly enticing because the business’s income and costs are included on your personal tax return (Form 1040). Your gains and losses are first reported on Schedule C, a tax form that is filed with your 1040.
Then you move the “bottom-line amount” from Schedule C to your personal tax return. This feature is particularly appealing because any business losses you incur may be mitigated by income from other sources.
You must additionally file a Schedule SE with your Form 1040 if you are a sole proprietor. Schedule SE is used to figure out how much self-employment tax you owe.
You must make quarterly estimated tax payments on your income in addition to paying annual self-employment taxes. Self-employed people with net earnings of $400 or more are currently required to make anticipated tax payments to cover their tax liability.
If your adjusted gross income for the previous year was less than $150,000, your estimated tax payments must be at least 90% of your current year’s tax due or 100% of the previous year’s liability, whichever is smaller.
On the 15th of April, June, September, and January, the federal government allows you to pay estimated taxes in four equal instalments. Unlike other business models, your earnings from a sole proprietorship are only taxed once.
Another significant advantage is that you have complete control over your company and make all of the decisions.
However, there are a few drawbacks to consider. You are personally liable for your company’s liabilities if you choose the sole proprietorship business structure. As a result, you’re putting your personal assets at danger of being confiscated to satisfy a corporate obligation or a legal claim filed against you.
Raising money for a sole proprietorship can also be difficult. Banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases, you’ll have to depend on your own financing sources, such as savings, home equity or family loans.
Partnership
If your company will be owned and operated by numerous people, you should consider forming a partnership. There are two types of partnerships: general partnerships and limited partnerships. In a general partnership, the partners control the business and are responsible for the debts and other obligations of the partnership.
In a limited partnership, there are both general and limited partners. The general partners own and operate the firm and are responsible for the partnership’s responsibilities, whereas the limited partners are merely investors who have no influence over the company and are not liable in the same way as the general partners.
Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.
One of the most significant benefits of forming a partnership is the favourable tax status it receives. A partnership does not pay taxes on its earnings, but gains and losses are “passed through” to the individual partners.
Each partner files a Schedule K-1 form at tax time, detailing his or her portion of the partnership’s income, deductions, and credits. In addition, each partner must record the partnership’s profits on his or her individual tax return.
Despite the fact that the partnership does not pay income tax, it is required to calculate and report its income on a separate informative return, Form 1065. Personal responsibility is a huge problem if you form your organization as a general partnership. General partners, like sole owners, are personally liable for the partnership’s duties and debts.
In addition, each general partner can act on behalf of the partnership, take out loans, and make business decisions that will affect and be binding on all the partners (if the general partnership agreement permits).
Keep in mind that partnerships are more expensive to establish than sole proprietorships because they require more extensive legal and accounting services.
Corporation
Using the corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.
The most significant advantage for a small-business owner who chooses to incorporate is the liability protection it provides. The debt of a corporation is not considered the debt of its owners. Therefore, forming a corporation will not put your personal assets at risk.
A firm can also keep some of its profits without having to pay taxes on them. Another advantage is a corporation’s capacity to raise funds.
To raise funds, a corporation can sell common or preferred shares. Corporations can also survive permanently, even if a shareholder dies, sells his or her stock, or becomes handicapped.
The corporate structure, on the other hand, has a number of drawbacks. One of the most significant is the increase in costs. Corporations are founded according to the laws of each state, which have their own set of rules. You’ll almost certainly need the help of an attorney to navigate the minefield.
In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.
Another drawback: owners of the corporation pay a double tax on the business’s earnings. Corporate income tax is collected at both the federal and state levels, and any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
To avoid double taxation, you could pay the money out as salaries to you and any other corporate shareholders. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. Keep in mind, however, that the IRS has limits on what it believes to be reasonable compensation.
How to Incorporate
To start the process of incorporating, contact the secretary of state or the state office that is responsible for registering corporations in your state. Ask for instructions, forms and fee schedules on business incorporation.
It is feasible to incorporate without the assistance of an attorney by following the instructions in books and software. The cost of these resources, filing fees, and any other charges related with incorporating in your state will be your expenses.
You’ll save money if you file for incorporation yourself rather than hiring a lawyer, which can cost anywhere from $500 to $1,000. The disadvantage of taking this option is that it may take some time to complete the process. There’s also a chance you’ll overlook a minor but crucial feature in your state’s legislation.
The preparation of a certificate or articles of incorporation is one of the initial steps in the incorporation process. Some states will give you a printed form to fill out, which you or your attorney can fill out.
The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the shareholders, directors, and officers, when stockholder meetings will be held, and other details important to running the company.
Once your articles of incorporation are accepted, the secretary of state’s office will send you a certificate of incorporation.
Once you’re incorporated, be sure to follow the rules of incorporation. If you don’t, a court can pierce the corporate veil and hold you and the other owners personally liable for the business’s debts.
It’s important to follow all the corporation rules required by state law. You should keep accurate financial records for the corporation, showing a separation between the corporation’s income and expenses and that of the owners’.
The corporation should also issue stock, file annual reports, and hold yearly meetings to elect officers and directors, even if they’re the same people as the shareholders. Be sure to keep minutes of these meetings.
On all references to your business, make certain to identify it as a corporation, using Inc. or Corp., whichever your state requires. You also want to make sure that whomever you deal with, such as your banker or clients, knows that you’re an officer of a corporation.
The S Corporation
The S corporation is more attractive to small-business owners than a standard (or C) corporation. That’s because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation.
With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay.
Furthermore, S corporation owners who do not have inventory can adopt the cash method of accounting, which is less complicated than the accrual approach. Income is taxable when it is received, and expenses are deductible when they are paid, according to this technique.
S companies have become even more appealing to small-business owners as a result of recent tax law reforms brought about by the Small Business Job Protection Act of 1996. S corporations used to be limited to 35 stockholders.
The number of stockholders was expanded to 75 by a law passed in 1996. According to tax experts, increasing the number of shareholders allows for more investors and hence more capital to be attracted.
S corporations do have some drawbacks. For example, they must comply with many of the same regulations as corporations, which entails higher legal and tax fees.
They must also file articles of formation, convene shareholder and director meetings, record corporate minutes, and allow shareholders to vote on significant business decisions. The costs of forming a S corporation are comparable to those of forming a regular corporation.
Another significant distinction between a S corporation and a regular corporation is that S firms can only issue common stock. This, according to experts, may limit the company’s capacity to raise financing. S corporation stock, unlike that of a regular corporation, can only be owned by people, estates, and certain types of trusts.
Starting in January 1998, the 1996 Small Business Job Protection Act law included tax-exempt entities such as eligible pension plans to this list. Because a lot of pension plans are ready to invest in closely held small-business stock, tax experts believe that this change will assist S businesses get even more access to cash.
Limited Liability Companies
Limited liability companies, often referred to as “LLCs,” have been around since 1977, but their popularity among small-business owners is a relatively recent phenomenon.
An LLC is a hybrid entity that combines the greatest aspects of both partnerships and corporations. According to Ralph Anderson, a CPA and small-business tax specialist at accounting firm M. R. Weiser, “An LLC is a far superior company for tax purposes than any other entity.” LLCs were formed to give business owners the same liability protection as corporations while avoiding double taxation. The owners’ profits and losses are passed through to them and are reported on their personal tax returns.
Sounds like a S corporation, doesn’t it? It is, except that an LLC has even more benefits for small business owners than a S corporation. In contrast to a S corporation, which has a limit of 75 shareholders, an LLC has no limit on the number of shareholders it can have.
Furthermore, every LLC member or owner has full participation in the running of the business; limited partners, on the other hand, have no say in the operation. You must file articles of incorporation with the secretary of state in the state where you plan to do business to form an LLC.
In some states, an operating agreement, which is comparable to a partnership agreement, is also required.
LLCs, like partnerships, have a finite lifespan. Some state statutes require the corporation to be dissolved after 30 or 40 years. When a member dies, quits, or retires, the company technically dissolves.
Despite the attractions, LLCs also have their disadvantages. Since an LLC is relatively new, its tax treatment varies by state. If you plan to operate in several states, you must determine how a state will treat an LLC formed in another state.
If you decide on an LLC structure, be sure to use the services of an experienced accountant who is familiar with the various rules and regulations of LLCs.
Even after you settle on a business structure, remember that the circumstances that make one type of business organization favorable are always subject to changes in the laws. It makes sense to reassess your form of business from time to time to make sure you’re using the one that provides the most benefits.