Paperwork, paperwork, paperwork…
There are very few people who relish this side of creating a business, but it can be dangerous to ignore. Consider your options for getting all the licenses in order, and putting in place any other legal details before you open your doors.
This article is an introduction to the various kinds of business structure and their advantages and disadvantages. For a different take, please also read 'Setting up your business structure and rules – analternative take.'
Structuring your business
The good news is that you have choices. There are various ways that you can structure your business. If you are uncertain as to which way to go, consult an accountant and a lawyer for advice.
When asked about how to structure a business, Mark Kalish, co-owner of EnviroTech Coating Systems, Inc., advised, “Each situation I’ve been involved with has been different. You can’t just make an assumption that one form is better than another.” He went on to say that people who gloss over properly structuring their business are often dismayed in the end.
Sole Proprietorship
If you plan to work your business yourself, you might opt for the simplest approach and keep it a sole proprietorship. In this case, there is no need to register your business, which will allow you to start immediately. As your business is not registered, your accountant will simply file a schedule C for you when doing your income taxes.
Advantages
- There are no costs related to this structure.
- You can start immediately.
- No legal paperwork (applause, applause).
- You control everything and reap all the profits.
- Taxes are easy, because your business isn’t taxed separately.
Disadvantages
- You are personally liable for any debts and lawsuits, because there is no legal separation between you and your business.
- If you want to raise money, you may have trouble. Since you can’t sell stocks, people will be hesitant to invest in your business and banks will be reluctant to loan you money.
- If your profits are high, the IRS will tax your heavily.
Survivorship: When the owner of a business dies, so does the business. Asset distribution would be determined by the terms of the owner’s will.
Partnership
In a partnership, two or more people own a business. Of course, as you can imagine, things get a bit more complicated when you take on a partner. All agreements need to be documented carefully and formally. There are three main types of partnerships:
- General Partnerships: Usually in this case, the partners agree to split everything according to the percentage of their investment.
- Limited Partnership: This is a partnership that gives partners limited liability (as well as limited managerial input).
- Joint Venture: This is a short-term general partnership, as in the case of a single project.
Advantages
- Partnerships tend to be easy and inexpensive to structure.
- You share the risks and financial commitments with others.
- You can utilize the skill sets of your partners and don’t have to be a one-man (or woman) show.
- You can sell your share and quit if things don’t go the way you like.
Disadvantages
- Partnerships can be challenging, especially if the personalities of the partners don’t mesh well.
- If one person sells their share, you may wind up with a new partner you don’t want.
- There are no tax advantages, so if your income soars, so will your tax obligations.
Survivorship: The partnership dissolves upon the death of a partner. The partnership agreement would determine what happens to the deceased partner’s financial interest.
Limited Liability Company (LLC)
A limited liability company is a relatively new choice for business owners, which began in the United States only in 1977. As its name indicates, it limits your personal liability, protecting you from debts and lawsuits. The owners are referred to as “members.”
Keep in mind that each state has different laws governing how to form an LLC, but there are some basic commonalities. You must:
- Create a business name that is unique, with the letters LLC tagged on at the end.
- File the articles of organization to legitimize your LLC.
- Obtain all your necessary licenses and permits.
- Announce your new business in your local paper (only some states require this).
Advantages
- If someone sues your company, your personal assets are safe. Sometimes you may be asked to waive this, by giving a personal guarantee, which would negate this benefit of the LLC.
- The paperwork is minimal compared to other corporate structures, like an S-Corp.
- You can open bank accounts with an LLC, using your company name. You can also own property, take out insurance, and get loans under the shield of the LLC.
Disadvantages
- It has a large filing fee to start up, plus annual renewal fees.
- Some find the structure of the LLC confusing.
- Some states impose a tax on an LLC. They can be called different things, such as a franchise tax, margin tax, etc.
- In most states, if one member leaves the LLC, things get complicated. Unless your operating agreement accommodates such a change, you may need to dissolve the LLC and start a new one.
Survivorship: The LLC will live on past a member’s death, so their financial interest will pass to their heirs. However, the articles of organization may set a termination date for the entity.
Corporations
Corporations are the most complex business structure you can select. You have two choices for corporations: C-corporation and S-corporation. The C-corp is the regular corporation, while the S-corp, using Subchapter S of Chapter 1 of the IRS code, allows for specialized tax benefits but limits investment options.
Advantages
- It is a well-recognized structure that people respect. Investors feel more secure putting their money into a corporation.
- Your liability is limited.
- You can raise funds through your corporation.
- There are good tax benefits to having a corporation.
- Having a corporation might attract more qualified employees, especially if you offer stock options.
Disadvantages
- There is a ton of paperwork involved to maintain a corporation.
- There are expensive administrative fees (although the filing fee is less than an LLC).
- Corporations are more complex, with stricter operational agreements. You are required to hold scheduled director meetings, record meeting minutes, etc.
- Most likely, you will need to hire an attorney to help you.
Survivorship: The corporation is its own entity, so it will outlive the stock holders. The shares of the owners are usually passed on to their heirs.
A few other details
DBA: If you don’t choose an LLC or a corporation, you might want to apply for a DBA (Doing Business As). If you’re a sole proprietor, for instance,and want to set up a bank account, you’ll need a DBA if you want to collect checks with your company name.
Licenses and permits: Depending on the kind of business that you are setting up, you may need special licenses and permits. Check your state’s websites (as well as your county’s and city’s websites) for details on what you may need.
Employer Identification Number (EIN): If you plan to have employees, you’ll need an EIN. An EIN is similar in importance to your social security number and can be obtained for free from the IRS. If you’re a sole proprietor without employees, you can skip this step.
Sales Tax Permit: If your state collects sales tax and you plan to sell a product or provide a taxable service, you will need to apply for a sale tax permit with the Department of Revenue. You must collect and pay sale taxes,filing the appropriate paperwork periodically.
