When you are starting a business one of the most critical decisions you will make early on in the process is determining how you want to structure your business from a legal perspective. This decision has huge ramifications on a number of critical areas for your business. I can tell you from personal experience, having started a number of businesses, that this an area you will want to spend some time on before making a decision. In addition, I advise that you seek the counsel of an experienced business attorney to guide you through the myriad requirements and options that came with making this decision.
Today’s post will cover at a high level the types of business structures available and go into some detail as to the questions you should consider as you are analyzing your options.
Many thanks to Entrepreneur Magazine for publishing the article. You can read the full article by clicking on the following URL.
Of all the choices you make when starting a business, one of the most important is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.
Mark Kalish is co-owner and vice president of EnviroTech Coating Systems Inc. in Eau Claire, Wisconsin, a company that applies powdered paint through an electrostatic process to items ranging from motorcycles to musical instruments. Kalish has also been involved with a number of other start-up businesses, both as an owner and in various management positions. The answer to the question of “What structure makes the most sense?” depends, he says, on the individual circumstances of each business owner. “Each situation I’ve been involved with has been different,” he says. “You can’t just make an assumption that one form is better than another.”
It’s not a decision to be entered into lightly, either, or one that should be made without sound counsel from business experts. Kalish says it’s important for business owners to seek expert advice from business professionals when considering the pros and cons of various business entities.
“I’ve heard horror stories from people who, in hindsight, wish they had taken the time and spent the money to get expert advice upfront,” Kalish says. That advice can come from a variety of sources, ranging from the no cost/low cost, such as the SBA or the Service Corps of Retired Executives (SCORE), to pricier attorneys and accountants who can serve as valuable sources of information throughout the life of your business.
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:
- A sole proprietorship is the most common form of business organization. It’s easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.
- A partnership involves two or more people who agree to share in the profits or losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses are “passed through” to partners to report on their individual income tax returns. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.
- A corporation is a legal entity that is created to conduct business. The corporation becomes an entity-separate from those who founded it-that handles the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. The key benefit of corporate status is the avoidance of personal liability. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that’s required. While double taxation is sometimes mentioned as a drawback to incorporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income or losses to be passed through on individual tax returns, similar to a partnership.
- A hybrid form of partnership, the limited liability company (LLC) , is gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this business format are that profits and losses can be passed through to owners without taxation of the business itself while owners are shielded from personal liability.
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 need to be insulated from legal liability? This was a consideration for EnviroTech, says Kalish. He and Berthold had a hefty investment in equipment, and the contracts they work on are substantial. They didn’t want to take on personal liability for potential losses associated with the business. “You need to consider whether your business lends itself to potential liability and, if so, if you can personally afford the risk of that liability,” Kalish says. “If you can’t, a sole proprietorship or partnership may not be the best way to go.”
Carol Baker is the owner of The Company Corporation, a firm based in Wilmington, Delaware, that offers incorporation services. She points to the protection of personal assets as “the number-one reason our clients incorporate. In case of a lawsuit or judgment against your business, no one can seize your personal assets. It’s the only rock-solid protection for personal assets that you can get in business.”
2. Tax implications. Based on the individual situation and goals of the business owner, what are the opportunities to minimize taxation?
Baker points out that there are many more tax options available to corporations than to proprietorships or partnerships. As mentioned before, double taxation, a common disadvantage often associated with incorporation, can be avoided with S corporation status. An S corporation, according to Baker, is available to companies with less than 70 shareholder returns; business losses can help reduce personal tax liability, particularly in the early years of a company’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.
Kalish refers to the high cost of record-keeping and paperwork, as well as the costs associated with incorporation, as one reason that business owners may decide to choose another option–such as a sole proprietorship or partnership. Taking care of administrative requirements often eats up the owner’s time and therefore creates costs for the business.
It’s the record-keeping requirements and the costs associated with them that led Kalish to identify the sole proprietorship as a very popular form of business entity. It’s the type of entity in place at his other business, Nationwide Telemarketing.
“I would always take sole proprietorship as a first option,” he says. “If you’re the sole proprietor and you own 100 percent of the business, and you’re not in a business where a good umbrella insurance policy couldn’t take care of potential liability problems, I would recommend a sole proprietorship. 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 maximize the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners. Individual needs are a critical consideration. No two business situations will be the same, particularly when multiple owners are involved. No two people will have the same goals, concerns or personal financial situations.
5. Future needs. When you’re first starting out in business, it’s not uncommon to be “caught up in the moment.” You’re consumed with getting the business off the ground and usually aren’t thinking of what the business might look like five or ten-let alone three-years down the road. What will happen to the business after you die? What if, after a few years, you decide to sell your part of a business partnership?
The issue of ownership was a key one for EnviroTech. “When we started EnviroTech,” Kalish remembers, “our reasoning for forming it as a corporation was because of ownership; we wanted to be able to bring in stockholders as we grew.”
“A corporation’s capital,” Baker says, “can be expanded at any time in a private offering by issuing and selling additional shares of stock. This is especially helpful when banks are being tight with money.”
Another important question to ask yourself is, “What do I want to happen to the business when I’m no longer around to run it?” While a sole proprietorship or partnership may dissolve upon the death of its owner or owners, a corporation can be readily distributed to family members.
Keep in mind that the business structure you start out with may not meet your needs in years to come. Many sole proprietorships evolve into some other form of business-like a partnership or corporation-as the company grows and the needs of the owners change.
The bottom line? Don’t take this very important decision lightly, and don’t make a choice based on what somebody else has done. Carefully consider the unique needs of your business and its owners, and seek expert advice, before settling on a particular business format.
In my next post I’ll discuss in additional detail the types of business structure and some of the do’s and don’ts of each option. Until then this video also offers some great insight into this subject.