There’s one crucial step in starting a small business that many entrepreneurs forget to consider. Before you can file paperwork and officially organize your company, you need to decide how to structure your new business.
When you choose how to structure your company, you’re essentially deciding how your small business entity will be recognized by the government. This decision will have a tremendous impact on various aspects of your business, so it’s important to take the time to seriously consider your options.
What’s a Business Entity?
A business entity is a kind of legal organization created to carry on a trade or business. To create a business entity, you have to file the proper paperwork at the state level. You, as the business owner, will need to file the proper paperwork for business entity formation with the Secretary of State or other proper agencies in your state.
The primary types of businesses are Sole Proprietorships, Partnerships, C-corporations, S-corporations, and Limited Liability Companies.
How do you decide which business entity is right for you? It all comes down to what you want from your business and what you want to put into it. Here are a few key things to consider as you make your choice.
Assess the Risks
One of the top concerns to keep in mind as you decide how to organize your company is liability. In the event of a lawsuit or a judgment against your business, your personal assets may be exposed to liability and can be taken away to satisfy the claims against you.
Different kinds of business structures leave you more or less liable for legal or financial problems that confront the company. How much liability are you willing to take on for this business, and how many other benefits are you willing to give up in order to avoid personal risk?
Look at the Costs
Different kinds of business structures also require paying various fees. Some business entities require that you pay the state for the right to organize. Costs are determined by state statutes, and they generally include formation fees and possibly annual fees to keep the entity active.
In many states there is a common annual fee known as a franchise tax, in which you have to pay the state every tax year for the right to continue operating with that business structure in their state.
Think About the Tax Structure
Different entity structures will impact your tax rate and how the taxes are assessed for your business structure.
C-Corps are taxed as separate entities, meaning you’ll need to file a separate tax return for the business. Then you will have to file again for personal income that you take out of the company. Most other business types avoid that double taxation with pass-through taxation. The income from the business is taxed as if it were personal income on your own return.
For Partnerships and Sole Proprietorships, however, you may be subject to self-employment tax.
Consider Your Goals
The type of business structure you choose will also depend on your long-term plans for the entity. Are you an entrepreneur planning to sell the company once it becomes profitable? Are you planning to pass it on to your children?
Different business structures give you different rights and responsibilities over the long-term operations and control of the business. Some structures are less flexible than others.
Types of Business Structures
There are six major types of entities for businesses. While it may not seem like there are very many options, nearly all for-profit businesses in the United States fit into one of these categories.
Corporations, whether they’re C-Corps or S-Corps, are separate business entities owned by stockholders. Corporation shareholders make decisions about the company depending on how much of the stock they own.
C-Corps allow for issuing a different class of stock to different individuals. Generally speaking, Class A stocks allow for a share in key decision making for the business, while other classes of stock offer more limited power over the business.
These corporations are very effective at shielding individual owners from liability, but owners’ income is taxed as a dividend when it’s withdrawn from the company.
S-Corps largely function in the same way as C-Corps, except that owners receive pass through income and do not have to file multiple tax returns. Owners can also only issue one class of stock.
The owners receive a salary, the same as their employees. The remaining revenue from the business goes back into running the business or expanding employees’ salaries.
Corporations in general are among the most expensive businesses to run in terms of fees. Starting one requires filing Articles of Incorporation with the proper state authority.
Limited Liability Companies
While corporations are run by a board of stockholders, Limited Liability Companies (LLCs) are run according to the LLC operating agreement established by the single or multiple business owners that created the business.
The owners of an LLC are called members, and they decide how the business is run. They can decide to have a member manager assigned from among them, or they can hire a manager to run the organization for them.
The pros of LLCs include their flexibility. They can be taxed as any other kind of organization, depending on what is preferable for the manager. Forming an LLC requires filing articles of organization with the state.
Like corporations, LLCs shield owners and their assets from liability. You will choose a registered agent to represent your company and receive tax and legal documents on behalf of the company.
Partnerships are more easily established than a corporation or an LLC, and the fees are proportionately less as well. Multiple business owners simply file paperwork and establish the ratio they will use to split up profits from the business.
Income for each owner is then taxed on their personal tax return. The owners share all decisions regarding the business according to their agreement, but they each share liability if something goes wrong.
A Sole Proprietorship is essentially the same kind of structure as a partnership but there’s only one owner. Forming a business is simpler and less expensive than establishing a more complicated business entity.
As the owner, you receive all profits and are free to make any decision you want about the company. However, your personal assets may be at risk if your business fails and you are left with the debts.
Now you’re informed about the basic options before you plan your business. Make sure you choose the business structure that best aligns with your vision for the future.
It’s important to properly research your options and consider your long-term plans before you make a final decision. Speak with a tax expert to ensure you choose the best entity for your business.