Over the course of running your business from day to day, I’d imagine that examining the merits of your company’s business-entity structure rarely makes it to the top of your to-do list. And yet, the truth is your business’ legal structure can weigh pretty heavily on your financial future. It can affect everything from liability issues to tax bills and even financing opportunities.
If you suspect your current structure isn’t meeting your needs, you owe it to yourself to look into the options. And if you’re reading this, you’ve probably already chosen a business structure at least once in your life. Even so, it’s worth reviewing the five primary structures before we dig into why you might want to change things up.
Sole Proprietorship: This is the most basic business entity, designed for one-person operators who don’t plan to take on fixed assets or hire employees. The sole proprietorship makes no distinction between the individual and the business entity for legal or tax purposes.
Partnership: Defined as a single business in which two or more individuals are owners, partnerships can be structured as a general partnership, limited partnership or a joint venture. They’re essentially the multiple-owner version of a sole proprietorship. Taxes and potential liability pass through the business to the individual owners.
Limited Liability Company: A hybrid of corporate and noncorporate business structures, LLCs offer the legal-liability protections of a corporation combined with the flexibility and tax simplicity of a sole proprietorship or partnership. For tax purposes, you can choose to establish your limited-liability entity as a single-member Limited Liability Company, a Limited Liability Partnership or a Limited Liability Corporation.
C Corporation: C Corporations are separate legal entities owned by shareholders. This structure removes the business’ founders from legal and monetary liability. Forming a corporation is paperwork-intensive and creates complicated tax issues, so it’s most often used by companies with large-scale growth aspirations.
S Corporation: Structurally similar to traditional C Corps, S Corporations often are chosen by business owners who wish to avoid double taxation when removing profits from the business. That’s because S Corps allow profits and losses to be “passed through” to the owner’s personal tax returns, circumventing the need for complex dividend filings.
As you re-read these descriptions, does one, in particular, stand out as the obvious choice for you? If so, does that seemingly clear winner match your current business structure?
No? Before you fall prey to the grass-is-greener syndrome, stop to consider whether there are compelling reasons to stay put. Each structure has its pros and cons. Changing your business entity can be a complex process, so it’s critical to keep your focus on the long-term implications — not just the short-term benefits.
Here are a few trigger events that might mean a structural change could be a genuinely good thing for your and your business.
1. When you need to protect personal assets.
Have your personal assets grown considerably since you first started your business? Are you considering hiring your first employees, opening a retail or manufacturing location or taking similar public-facing steps that might increase your risk of liability? Any one of these is a strong signal it could be time to transition to a more formal business structure.
2. When you’re looking for outside investors.
You may discover your current business entity precludes you from eligibility to receive funds from certain angel investors or venture-capital firms. If you want your most-desired investors to consider your business, you might need to do some legwork first and change your structure to meet their needs.
3. When you could save substantially on taxes.
Many small-business owners initially establish a C Corporation, only to later regret the steep cost of being taxed twice-over on profit dividends. If this issue arises and you plan to continually take profit dividends from your business, you might want to consider moving to an S Corporation structure. In other situations, an attorney or tax consultant might raise the possibility of implementing a different business entity that allows you to take business-specific write-offs or capitalize on other tax saving opportunities.
A word of warning: Taking advantage of niche tax benefits is the short-term view most likely to lead you astray. Before making a structural change on this basis, carefully consider whether your potential tax savings will continue to apply from year to year, especially as your business grows.