One of the most important decisions you will ever make about your small business is how to structure it.
Selecting a structure is not as exciting as prototyping a product or creating an amazing website, but it’s something that has to be done, and you want to be sure it’s done exactly right.
Choosing the appropriate structure for a small business is essential as it can have an impact on the growth and success of the company.
There are many structures to consider, such as corporations, limited liability companies (LLCs), partnerships, and sole proprietorships. Every structure has advantages and disadvantages, so it’s crucial to consider the goals and needs of the company.
Options for a small business structure
Spending time considering the right structure will do you well as you move into the future. A little thought goes a long way when the structure you select has implications on how your business profits are taxed by the Internal Revenue Service (IRS). It plays into how personal property is protected, the management of the company, and the plans you have.
Below, we’ll delve into the different small business structure options and what to consider before choosing one.
C corporation
A C corporation has its profit taxed at the business level as well as on an individual level when shareholders access distributed earnings. These individuals have only limited liability for the debts of the company.
When you structure a business as a C corporation, several classes of stocks can be used, and the number of shareholders available is unlimited.
S corporation
An S corporation is different in that only one class of stock is available, and shareholders max out at 100. All of these people must meet the IRS residency requirements or have a green card. Shareholders cannot be other for-profit businesses.
While shareholders have limited liability, profits are only taxed on their returns.
Limited liability company
LLCs are a type of hybrid business structure. This small business structure limits the amount of personal liability of the owners (also known as members), similar to a corporation, but the profits can be taxed either on a corporate or member level.
Partnership
With a partnership, a business is owned by multiple people or businesses. The profits are split up between all the owners and then reported on their individual tax returns.
Partnerships come in many forms, such as limited liability partnerships (LLPs), limited partnerships, general partnerships, and limited liability limited partnerships (LLLPs).
Sole proprietorship
This type of business structure means the company is owned by a single person. This same individual will report all the profits on their tax return each year. When it comes to simplicity, sole proprietorship fits the bill. It’s very straightforward to start and run.
Important factors to consider when choosing a small business structure
When you’re selecting a structure for your small business, various factors should be considered. Everything from your tolerance for risk and tax preferences to management structure and appreciation for complexity will have an impact on which structure is right for your small business.
Long term goals
It might seem like you should choose a small business structure based on the business today, but that can be a bit shortsighted. The right business structure should also take into account where the business might be five to ten years from now, which can make things even more challenging.
If you need money for fast growth, a C corporation offers the ability to have several classes of stock and as many shareholders as you want. This works well for those who want to become publicly traded or who are seeking venture capital investments rather than being privately owned for the near future.
You should also think about what occurs if you or another of the owners goes bankrupt, exits the business, or passes away. A corporation will continue to live on after these things occur. However, the other forms of business structures often dissolve unless you take certain steps to prevent that ahead of time.
Administrative complexity
In the case of non-corporations, fees and paperwork are limited and simple. Most people can handle them without a lot of assistance, although an accountant and lawyer are still good investments. Most ongoing requirements come up on an annual basis.
However, for corporations, the process becomes much more complicated. An accountant and lawyer are a must. You’ll also have legal and tax requirements that vary by state to ensure the corporation is (and remains) compliant. Not hitting deadlines, filing the right forms, and paying appropriate fees will lead to penalties.
The formality of the management structure
When there are several owners, choosing a business structure is more complicated. Partnerships, for example, have agreements listing how profits are divided and what occurs if a partner dies, declares bankruptcy, becomes disabled, or retires.
Corporations must have a board of directors to oversee the division of the company for the shareholders. LLCs can either be managed by members or overseen through a management team, which may include both members and nonmembers. An operating schedule is often used to define roles.
Preference for taxing business profits
S corporations, partnerships, and sole proprietorships are known as pass-through entities. This also includes some LLCs, provided they aren’t taxed as corporations. The idea is that profits move directly to the business owners, who then report the profits on their tax returns.
On the other hand, C corporations are separate from their owners. Profits are taxed at the corporate level. If and when dividends are paid, they come from after-tax income, and shareholders will also need to pay taxes on the proceeds.
Tolerance for risk
Running a business increases your chance of being caught up in a lawsuit. It’s a simple fact as companies interact more with people, governments, and businesses. In addition, those interactions tend to involve money, which also leads to a higher chance of lawsuits.
For example, as a sole proprietorship, when the business is sued, your own personal assets could be targeted by someone who wishes to collect damages. The same applies if you default on a business loan or sign a personal guarantee with a lien placed on your assets. The investment can be recovered from your personal property.
In the case of a general partnership, the personal assets of partners can be used to pay a debt. It differs from a limited partnership, where the partners are liable only up to the amount of their investment into the business. Then there are corporations and LLCs, where liability is limited for shareholders and members, so your assets are safe.
Final thoughts
Choosing the perfect structure for a small business is only possible when you consider a variety of factors. Everything from personal liability and capital needs to taxation, management, and growth potential should be considered. After all, the ideal structure for one small business may be different from the next one.
Every small business structure has a set of pros and cons. Making the choice requires a deep dive into the goals and needs of the specific business. Working with a tax professional and lawyer can help you determine the business structure that will work best for you. Otherwise, remember to consider the current business and what it could look like in the future.
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