When starting a business, you want to give special attention to your business structure.
Many new entrepreneurs get caught up in the excitement of starting their business activities and thus end up rushing through this step.
The way you choose to structure your business, however, may have a significant impact on your later business activities, financial practices, and potential for liability.
Take some time to analyze how you want your business to operate. Focus not just on what you want to do right away but also on how you envision your business developing over time.
Once you have an idea of what you want your business to look like from an operational perspective, then it is time to decide how you want it to function legally and financially.
Ask yourself these key questions:
- If the business does something wrong, do I want to be sued personally, or is the business its own entity? Do I have complete and total control over business activities?
- If the business gets into debt, will I be paying off that debt from my personal accounts, or will the business assets be completely separate? Am I keeping the business income separate from my personal assets?
- Am I incurring any expenses that I hope to deduct when I do my tax returns each year? Which business structure allows me to make the most of those potential deductions?
Once you have answered these questions, then it is time to find a business structure that meets your needs and expectations.
We highly suggest you consult with a small business attorney and a certified public accountant (CPA) when making this decision. These professionals can make sure you are getting all the details relevant to your specific industry and type of business.
For your general knowledge, here are the most common business structures:
1. Sole Proprietorship
Sole proprietorships are the easiest types of businesses to start. You come up with an idea, put all the operational necessities in place, and start doing business. Your business name is the same as your actual name (ie: “John Smith” or “Jane Doe”).
If you want to operate under a separate business name, you can generally do this with a quick fictitious name registration through your local Secretary of State. For a sole proprietorship, you do not need to incorporate a formal business entity.
Legally speaking, sole proprietors are 100% responsible for their business activities. This means that you can be sued for the wrongdoing in any business activity just like you could be sued for any personal wrongdoing. Your business is, in essence, no different from yourself. This means that your personal assets would be the subject of any lawsuits resulting from business activity as well.
When it comes to finances, your money is no different from the business assets. You report all business earnings on your tax returns just as you would report a paycheck from an employer.
You are also personally responsible for any and all business debts. It is especially important with this setup that you are savvy at managing your finances and determining the profitability of your business on a regular basis.
Sole proprietorships generally work best for very small businesses that engage in low-risk activities.
If you expect to engage in high-ticket transactions or even moderately risky business activities, then you will likely want to choose a different business structure to keep your personal assets protected.
If you expect your business to always be run by only you and your business activities are relatively simple, then you may be the perfect sole proprietor.
A lot of representatives and agents for multi-level marketing (MLM) and network marketing companies choose to structure as sole proprietors because they have other protections in place for lawsuits related to their products and services. Entrepreneurs who have a business that allows them to work from home also make good candidates for this type of business structure.[video_embed url=”https://www.youtube.com/watch?v=aKkcggE7SRw” embed_style=”default” border=”yes”] [row]
2. General Partnership
A general partnership is, for all intents and purposes, the same as a sole proprietorship with just one important exception: the business is started and owned by more than just one person.
While this structure is relatively simple, it creates a lot more room for disputes and potential trouble due simply to the fact that no one person is completely in control.
When a general partnership gets into a legal situation, all partners are equally responsible. This does not mean that partners split the liability equally, but rather that any and all partners can be held 100% responsible for the actions of other partners.
Many partners go into business assuming that they will contribute equally to developing and implementing rules and policies. With a general partnership, however, if one partner fails to uphold their end of the bargain, the remaining partner(s) may be held responsible for their actions.
If one proprietor does not deliver then another proprietor can be targeted instead, even if their actions had nothing to do with the legal issue at hand.
The same is true with financial situations. Partners generally assume that they will divide all income and debt equally within the business.
If one person does not do their part in paying toward a debt, though, then the other partner(s) may be liable for their share. If the partners jointly do not report an accurate business income when doing their taxes then that may be grounds for financial trouble down the line as well.
General partnerships, like sole proprietorships, work best for small businesses that engage in relatively low-risk activities. To get around the uncertainty of how partners may act and what they expect, we suggest you work with a small business attorney to develop a strong operating agreement between the partners. This makes all roles, responsibilities, and expectations clear from the outset so that there are no surprises later on down the line.
3. Limited Liability Company (LLC)
An LLC is the most common structure for entrepreneurs who want to separate their business affairs from their personal affairs. To form an LLC, you must formally incorporate a business.
This means that you develop your articles of incorporation and make decisions from the outset about how your business will function.
From then on, your personal assets and affairs are completely separate from business assets and affairs, and you are responsible for making sure that divide is clear at all times.
Many business owners choose to incorporate as an LLC for the legal protection. If there is any misconduct within the business then you cannot be sued personally.
This means that your personal assets (house, car, personal bank accounts, etc.) are protected from being seized and/or liquidated in legal proceedings.
Only the business assets are within reach. It also means that you are not personally liable for any wrongdoing. The business essentially takes on a life of its own and is treated as a separate entity.
When it comes to finances, running an LLC more closely mimics the employer-employee relationship. You will issue yourself regular paychecks from the business which may not reflect the business’s actual income.
The business has its own separate bank accounts and investment holdings to cover operating expenses. This means that you only pay taxes on the income you bring home. Your business will file its own tax return for the income it brings in overall.
This is where things can get a bit complicated. An LLC is generally a state-designated structure. When incorporating at the federal level, you may choose to incorporate an LLC as a C-Corporation or an S-Corporation as well.
A c-corporation is a business with stock options and a board of directors. Like an LLC, the legal and financial protections are in place for all proprietors and partners. The decision-making power, however, is spread out among the investors.
Legally speaking, there is no difference between an LLC and a c-corporation. The business is its own entity that is kept separate from you and the rest of your staff. If there is any wrongdoing then your personal assets, as long as they are kept separate from business assets, are protected and out of reach.
Financially, c-corporations have much more power and, generally, access to more money. Because this is a public designation, stock prices and other investment opportunities allow for more income for the business, allowing it to operate at a higher level.
The down side is that this structure commonly results in money being taxed twice. The business pays taxes on its gross income, then employees pay taxes on their salaries.
When choosing to form a c-corporation over or in addition to an LLC, you are giving up the power of making important business decisions on your own or among your partners.
This is where it becomes particularly important to have strong contracts and operating agreements between key staff members and the board of directors. In the event of an internal dispute on how the business should run, those contracts and agreements will control.
5. S Corporation
The difference between an LLC and a c-corporation is pretty substantial. If you are looking for something in between, that is where the s-corporation comes in.
An s-corporation is, quite frankly, a baby version of a c-corporation with the benefits of an LLC. The business may still have investors and a board of directors, but these are limited in size to keep the business operating at a relatively small level.
Business with a few key investors, but not open for trade on the stock market, are generally structured as s-corporations.
The same divide exists in an s-corporation as it does for c-corporations and LLCs when it comes to legal issues. As long as the people in charge of a business keep their business and personal assets separate then no one’s personal assets can be targeted in a lawsuit against the business.
Financially, s-corporations have the ability to deduct certain things from their taxes to avoid paying twice on the same money. The business generally shares the tax responsibility with employees so that salaries and wages are taxed only once instead of being taxed twice at the full rates.
This allows more money to stay within the business and more money to stay in the pockets of your employees, both of which contribute to overall business success.
S-corporations are good intermediaries if you want your business to have more options than a simple LLC but do not intend to take the company public. Remember, we cannot emphasize the importance of solid contracts and operating agreements enough.
Whenever you have more than one leader in a business then it is crucial to make sure that everyone’s needs and expectations are clear from the outset. If external legal and financial issues are handled, the next biggest thing to kill a business is an internal dispute about key aspects of management.
6. Non-Profit Organization
The final business designation is a non-profit or not-for-profit organization. Keep in mind that these terms are actually slang. The actual term for this type of business structure is a tax-exempt corporation.
A non-profit organization is treated the same way as an LLC when it comes to legal issues. The business and the founder are completely separate as long as business and personal assets do not get mingled in the process. The organization is its own entity for the purpose of legal proceedings.
Financially, non-profits have a huge advantage in that they are not required to pay income taxes on any of their business earnings or income. This means that the business keeps almost all of its income and pays very little to the government and other entities.
Don’t get too excited, though, because you cannot simply choose to become a non-profit organization for the tax benefits. To form a non-profit organization, you need to meet certain criteria that show your business is meeting a need so great in society that the IRS voluntarily exempts your business from paying taxes.
As you can probably imagine, that is not easy to do unless your motive for starting a business really is to serve a strong public need.
If you are starting a business that involves a significant amount of charitable work and giving back to the community then a non-profit organization may be right for you.
To determine if your business qualifies for tax exemption, you should consult with a small business attorney who specializes in non-profit organizations and reference section 501 of the federal tax code.
Remember, the structure of your business will determine its overall ability to function and make important decisions for the life of the business.
It will also determine how you structure your legal and financial policies and what kind of insurance you need to keep your business protected. You should choose a structure carefully from the outset so that you are able to engage in all of your desired business activities over time.
Consult the necessary professionals, like small business attorneys and accountants, to make sure you are choosing a business structure that serves the best interests of your business.