If you’re serious about your business, one of the first things you should do is organize it. But answering the “How should I organize my business?” question isn’t as simple as you might think. So let’s walk through the basics…
First off, a disclaimer: None of this article should be considered legal or tax advice. As with all major business decisions, you should consult a lawyer and/or tax professional.
That said, here are a few points of guidance…
Initially, you may think that organizing your business isn’t a true need, but more of a luxury that only big companies have ot think about. That mindset couldn’t be further from the truth. Legally organizing your business has so many implications! For starters, doing so protects you as an individual. How, you ask? Again, there are lots of reasons, but imagine this scenario… Say you you run into a legal dispute with a customer. With no organization in place, they can come after you instead of the business. That puts a lot more than your business on the line.
You also want to legally organize your business for tax purposes. Depending on which legal entity you opt for impacts the business’ tax obligations as well as your own.
Lastly, think of legal organization as a key. Without it (and the government issued paperwork and numbers), you’re going to have difficult obtaining things like a business bank account, loans, insurance, setting up payroll, etc.
Naturally, there are a few choices when it comes to establishing a legal organization. Starting with the simplest, most basic, we have the sole proprietorship. In this situation, the individual and business are one in the same. The business is not taxed as a separate entity. On the plus side, sole proprietorships are easy to set up and shut down. Moreover, business income can go straight into the owners pocket or wherever he/she sees fit. The downsides of a sole proprietorship are worth considering, however. Most obviously, the one-in-the-sameness of individual and business leaves a lot of exposure (see above). Additionally, the financing of a sole proprietorship is limited to whatever the individual can put up or borrow individually. Translation: if you seek outside investment in your business either now or in the future, going the route of a sole proprietorship isn’t ideal.
One step up, we have the partnership. This is a business with two or more owners. A partnership agreement is drafted up by a lawyer and business earnings are distributed according to that document. What each owner takes is recognized as personal income. Again, a partnership is pretty easy to set up and it allows for the business to tap multiple capital sources to fund the business. But on the flipside, a partnership creates a unique type of legal risk exposure. Say one partner does wrong by a customer. That customer can bring legal action to both partners.
There’s also the limited liability company, more commonly known as the LLC. In the plus column, the LLC provides legal protection for its members. Additionally, an LLC can select how they’re taxed: either as a sole proprietor, partnership, S corp or C corp (the latter two of which we’ll get to next). On the downside, raising money can be hard as an LLC. And increasingly, states are finding “creative” ways to squeeze a little more cash out of LLCs. For example: some states have instituted a business privilege tax or a franchise tax.
Next on our list, the C corporation. Without getting to B-school here, a C corp is the most common form of legal entity formation. Main benefits include…
- Personal protection for owners. (Translation: individual owners or shareholders can’t be sued for something the company did.)
- The ability to raise money. Investors like to see incorporation.
- Share compensation to employees. Example: LinkedIn is a corporation. In order to attract great talent early on, they offered shares as compensation. A quick scan of the news can tell you how that’s worked out for those early employees.
Alas, there’s a downside to going the C corp route: taxation! Not only are C corp profits taxed, but so too are the dividends distributed to shareholders. So for the CEO who’s a majority shareholder, you’re looking at getting taxed twice on the same dough.
A branch off of the C corp tree is the S corp. Since the S corp is somewhat difficult to explain, we’re going go straight to the source: the IRS…
“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.”
From that description you can get a sense of the pros and cons of an S corp.
As you can see, there is no one size fits all when it comes to organizing your business. There are tax implications to consider as well as legal/risk exposures. Plus, as a business grows and ages, it can change forms (i.e., a sole proprietorship can one day become an LLC or an S corp). And it bears repeating: none of the contents in this article should be considered legal or tax advice. Always talk to a lawyer or a tax specialist before making a decision as important as business entity formation.