In their book, Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting a business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors briefly review the different legal business structures you may want to choose for your small business.
Of all the decisions you make when starting a business, one of the most important ones is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.
The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. With a sole proprietorship, your business earnings are taxed only once, unlike other business structures. Another big plus is that you will have complete control over your business—you make all the decisions.
The tax aspects of a sole proprietorship are appealing because the expenses and your income from the business are included on your personal income tax return, Form 1040. Your profits and losses are recorded on a form called Schedule C, which is filed with your 1040. The “bottom-line amount” from Schedule C is then transferred to your personal tax return. This is especially attractive because business losses you suffer may offset the income you have earned from your other sources.
There are a few disadvantages to consider. Selecting the sole proprietorship business structure means you’re personally responsible for your company’s liabilities, so you’re placing your assets at risk, and they could be seized to satisfy a business debt or a legal claim filed against you.
Raising money for a sole proprietorship can also be difficult. Banks and other financing sources may be reluctant to make business loans to sole proprietorships. In most cases, you’ll have to depend on your financing sources, such as savings, home equity, or family loans.
If your business will be owned and operated by several individuals, you’ll want to take a look at structuring your business as either a general partnership or a limited partnership. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners. Unless you expect to have many passive investors, limited partnerships generally aren’t the best choice for a new business because of all the required filings and administrative complexities.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn’t pay tax on its income but “passes through” any profits or losses to the individual partners. On the other hand, personal liability is a major concern if you choose a general partnership. Like sole proprietors, general partners are personally liable for the partnership’s obligations and debts.
The corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.
The biggest benefit for a business owner is the liability protection the business owner receives. A corporation’s debt is not considered that of its owners, so if you organize your business as a corporation, you’re not putting your personal assets at risk. A corporation also can retain some of its profits without the owner paying tax on them.
Another plus is the ability of a corporation to raise money. A corporation can sell stock to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled. The corporate structure, however, comes with a number of downsides. A major one is higher costs.
Corporations are formed under the laws of each state with its own set of regulations. You’ll probably need the assistance of an attorney to guide you. In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.
Another drawback to forming a corporation: Owners of the corporation pay a double tax on the business’s earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
The S corporation is more attractive to small-business owners than a regular (or C) corporation because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay.
In addition, owners of S corporations who don’t have inventory can use the cash method of accounting, which is simpler than the accrual method. S corporations can also have up to 100 shareholders. This makes it possible to have more investors and thus attract more capital, tax experts maintain.
S corporations do come with some downsides. For example, S corporations are subject to many of the same rules corporations must follow, and that means higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of setting up an S corporation are also similar to those for a regular corporation.
Another major difference between a regular corporation and an S corporation is that S corporations can only issue one class of stock. Experts say this can hamper the company’s ability to raise capital.
In addition, unlike in a regular corporation, S corporation stock can only be owned by individuals, estates and certain types of trusts. In 1998, tax-exempt organizations such as qualified pension plans were added to the list. This change provides S corporations with even greater access to capital because a number of pension plans are willing to invest in closely held small-business stock.
Putting Inc. to Paper
To start the process of incorporating, contact the secretary of state or the state office that’s responsible for registering corporations in your state. Ask for instructions, forms and fee schedules on incorporating.
It’s possible to file for incorporation without the help of an attorney by using books and software to guide you. Your expense will be the cost of these resources, the filing fees and other costs associated with incorporating in your state.
If you do it yourself, you’ll save the expense of using a lawyer, which can cost from $500 to $5,000 if you choose a firm that specializes in startup businesses. The disadvantage is that the process may take you some time to accomplish. There is also a chance you could miss some small but important detail in your state’s law.
One of the first steps in the incorporation process is to prepare a certificate or articles of incorporation. Some states provide a printed form for this, which either you or your attorney can complete. The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the company’s shareholders, directors and officers; when stockholder meetings will be held; and other details important to running the company. Once your articles of incorporation are accepted, the secretary of state’s office will send you a certificate of incorporation.
Laying the Foundation
When making a decision about which business structure to use, answering the following questions should help you narrow down which entity is right for you:
- How many owners will your company have, and what will their roles be?
- Are you concerned about the tax consequences of your business structure?
- Do you want to consider having employees become owners in the company?
- Can you deal with the added costs that come with selecting a complicated business structure?
- How much paperwork are you prepared to deal with?
- Do you want to make all the decisions in the company?
- Are you planning to go public?
- Do you want to protect your personal resources from debts or other claims against your company?
- Are family succession issues a concern?
Even after you settle on a business structure, remember that the circumstances that make one type of business organization favorable are always subject to changes in the laws. It makes sense to reassess your form of business from time to time to make sure you are using the one that provides the most benefits.