You’ve come up with a business idea and decided to start a company. Excellent! But what’s next? How do you do it? Do you hire an attorney to file the registrations? Do you pay a registered agent? What kind of business structure do you need?
There are several options on how to get started and registered as a business. Going with an attorney or other service generally costs more, but is often faster; however, there is still a chance that things may not go as expected and it’s very likely that the business owner will be the one who has to deal with the fallout. This is why we typically recommend that anyone starting a business be the one to file everything so that they are fully aware and informed of the process.
Another important factor is making sure that owners choose the right business structure as it affects their liability, taxes, ability to raise funds, and management of the business. There are also some business structures that are easier to change later should the situation of the company change. Here are several business structures with some benefits as well as detriments to choosing them.
Sole Proprietorship
The Sole Proprietorship is the simplest structure. A single individual owns and operates the business. This is useful when starting out as it’s cheap to start, cheap to maintain, requires limited paperwork, and allows complete control over the business. The income taxes are filed on your personal income tax return and sales taxes are handled much the same way as other structures.
Some disadvantages that should be kept in mind are that your business liabilities are also personal liabilities. This means that if someone comes after your business, they can come after everything that you own as well. You also can’t officially raise capital to start the business… in other words, you can’t have investors. You can accept loans or gifts from people to start the business, but it’s important to keep in mind that these are personal rather than linked to the business because you are the business.
Partnership
A Partnership is a business owned by two or more people. These can include General Partnerships (GP), Limited Partnerships (LP), and Limited Liability Partnerships (LLP). This shares ownership and responsibility of the company while combining resources, skills, and expertise. These require registration with the state as well as with the IRS in most cases and will have annual responsibilities to keep that registration active; however, these are neither complicated nor very expensive.
Some potential disadvantages with LLPs are that there are limitations in their ability to raise outside capital. There is also the potential for conflict between partners, which is why it’s always a good idea to have a well thought out partnership agreement in place before business activities really start. And, while partnerships generally shield liability to the limited partners, general partners have unlimited liability and risks. Finally, although this is a pass-through structure and taxes are ultimately paid with the partners’ personal tax returns, a separate tax return must be filed at an additional expense.
Limited Liability Company
The LLC is a hybrid business structure that provides the liability protection of a corporation with the tax benefits and flexibility of a partnership with less formalities than a corporation. LLCs have a great deal of flexibility in management and tax options. Because there’s no firm limit on the number of owners, this makes them useful for everything from a single individual to large companies. This makes them very useful as subsidiaries for specific functions of larger companies (e.g., Amazon is a corporation, but operates a number of subsidiaries including Amazon.com LLC and Amazon.com Services LLC). LLCs are also commonly used in private equity to collect funds from multiple investors in order to put those funds into other companies. As with Partnerships, taxes are paid on the personal returns of the owners of the LLC and, if there’s a single owner, the business tax return can be filed as part of the personal return.
LLCs can also take on outside investment from individuals as well as organizations including other LLCs. They also protect the personal assets of owners by limiting losses to what is invested in the LLC, meaning they’re attractive to people looking to put money into private companies. Another advantage to LLCs is that they can be converted into S-Corporations or simply treated as an S-Corporation for tax purposes without much difficulty.
Though LLCs are flexible, there are some disadvantages based on how complex management and operations get. Like partnerships, there are some registration requirements that can increase in complexity depending on how the LLC chooses to operate. Also, the number of members in an LLC can increase the potential for disagreements, meaning partnership agreements are highly advisable before conflicts occur. Another disadvantage is that, unless the LLC is taxed as an S-Corp, income that passes through to owners of the business is subject to Self Employment tax. Finally, if there is more than one owner or in special circumstances, LLCs require separate tax returns to be filed with the IRS and possibly multiple states depending on the business operations and owners.
S-Corporation
A Corporation is a separate legal entity from its owners. We’ll talk first about the S-Corporation. This is a special type of corporation that passes its income, losses, deductions, and credits through to shareholders for federal tax purposes. This provides the benefits of a corporation without double taxation. This also provides the same limits in liability as LLCs. Like LLCs, S-Corps can take outside investment, allowing up to 100 members. An interesting advantage to S-Corporations is that owners active in the business are paid as employees rather than partners. This means their employment taxes taxed only on their earnings rather than the total income of the business. If the business is profitable, this can result in owners paying less in taxes.
Many of the disadvantages are similar to those of partnerships and LLCs. All members of an S-Corp must be individuals rather than LLCs or other corporations. This makes them somewhat less flexible than LLCs. Another disadvantage is that all S-Corps, even those with only a single owner, must file separate tax returns from the owners. This and other registration requirements can make them more complicated than LLCs, but this is highly dependent upon the complexity of the business.
C-Corporation
The C-Corporation is generally reserved for more complex businesses with multiple owners with the intention of scaling. Like LLCs and S-Corporations, they limit liability to owners. They also allow investment from individuals and other organizations such as LLCs and other C-Corps, which means they’re also capable of incredible flexibility and complexity. C-Corporations are also the most common form of business structure if ownership is expected to change regularly and if it’s intended to last past the lives of the founders. Larger and more experienced investors also tend to prefer investing in C-Corporations because the reporting requirements tend to be more strict.
Despite their scalability and potential for perpetuity, there are many disadvantages to C-Corps. First, their complexity makes them difficult to set up and maintain without some degree of expertise. There are also more regulations and oversight that go along with them (e.g., the reporting requirements mentioned earlier), which means it can cost more to stay in compliance… and even more in fines if you’re not. Another disadvantage, double taxation, is unique to the C-Corp. Whereas other structures are pass-throughs where all taxes are paid by the individual owners, the C-Corporation must pay income tax on its profits and the individual owners pay taxes on the dividends received.
Which business structure makes the most sense for your company means looking closely at what the business will do and how you expect the operations to change over time. While the LLC has the most flexibility and will work for most businesses getting started, it’s best to put in some thought about the ownership, goals, and operations of the business over the next few years. Doing things right the first time can save a great deal of time and money in the long run. If you want to do things right or just want to bounce some ideas around, give Brightleaf Consulting Group a call. We love talking about these things and helping people make informed decisions!
- John Thrush
