Several key factors should be taken into consideration when you are deciding on a structure for your startup.
There are many questions that should be answered before you can start a new company. The business structure you choose to operate under is a crucial decision with long-term implications. While there are several options available, it’s not always easy to determine which will be most advantageous for your company.
It’s important to understand that this can have a direct impact on several major areas, including taxation, liability, and costs. In addition, there are specific points to consider that are unique to each type of business structure.
For starters, most owners of for-profit businesses have three choices of entity structures: a sole proprietorship, corporation, or limited liability company. If the business has multiple owners, you can also consider a general or limited partnership.
Keep in mind that every business will have different needs, and it’s highly recommended that you consult with an attorney when making decisions about your company’s structure.
Sole Proprietorships: Becoming One with Your Business
Although a sole proprietorship is the easiest and most cost-effective business structure to establish, it comes with several risks worth noting. In a sole proprietorship, the law considers business and owner as one entity. That means the owner is personally liable for paying the company’s debts and judgements from lawsuits – even those brought on by another employee’s conduct. In addition, the owner’s personal assets (like his home or car) can be seized in the case of a corporate bankruptcy.
Sole proprietorships can also experience difficulty finding investors. Since your business cannot build credit on its own, lenders will look at your personal scores when considering making a loan. Financial institutions may be reluctant to work with someone who has limited assets to cover risks. In addition, sole proprietorships can be audited at a higher rate than corporations due to the marriage between owner and business.
Despite these concerns, sole proprietorships can be attractive because of their simplicity. All expenses and income from the business are included in one’s personal tax returns, which avoids double taxation. This structure may be a viable option for a business with a single owner who can handle the financial risks.
Forming a Corporation
When the risks of a sole proprietorship outweigh the benefits, or your business has more than one owner, forming a corporation offers an alternative path. A corporation is an independent legal entity that is completely separate from its owners. That means your personal assets cannot be seized in the case of bankruptcy, and are also shielded in most legal actions. The corporate structure offers tax advantages, as well. Many business expenses can be deducted and tax rates are usually lower than those paid by the self-employed.
There are two types of corporations, "S" and "C." Each offers its own set of advantages and drawbacks, but many small companies elect to be "S" corporations.
Although the expenses involved in bookkeeping and legal compliance can be far greater than with a sole proprietorship, the liability protection provided by the corporate structure is often helpful for a young business.
Limited Liability Companies
Many business owners have elected to form limited liability companies (LLCs). This structure is something of a hybrid between the previous two business structures. LLC status provides liability protection for the business owners and avoids the double taxation that can be levied on corporations. With this structure, company earnings and losses pass through to the owner and are included on his/her personal tax return.
LLCs have their downsides. First, they're dissolved upon the owner's death or bankruptcy. You'll also be considered self-employed, subjecting you to a higher tax rate.
There are additional options available to businesses with more than one owner: general and limited partnerships. A general partnership can be thought of as a sole proprietorship for more than one person. Simple to establish, partnerships offer no protection from your business's liabilities. For this reason, they're not recommended for companies that could face significant headwinds or legal trouble.
Limited partnerships consist of a general partner who runs the business and assumes liability, along with limited partners who contribute funds but are usually not on the hook for liabilities.
Each business structure has its own strengths and weaknesses. It's up to you to determine which offers the maximum benefit with the least risk. As always, business decisions require careful consideration.
Ready to go into business for yourself? Learn how to build business credit and find other helpful resources.