Structuring Your Business
The first businesses had a simple structure: one owner for one business. Then more money was needed and partnerships emerged. Liability became an issue and corporations were developed. Today, business owners have a variety of structures that can be adapted to the needs and complexities of their venture.
Your small business requires a structure. Which one? The answer depends on many factors, as well as state laws. The factors include investment options, liability, and taxation. Your business plan (see Chapter 7) will define the business structure even before you select a management team. The following is a summary of the most popular configurations. They include sole proprietorship, partnership, limited liability company, S Corporation, and C Corporation.
The easiest time to set up the most appropriate business structure is in the planning stage. Once the business is established, it is more difficult to change it. Review your options and seek professional advice from a business attorney and/or accountant. An hour or two of consulting can save you time and money. Maybe your tax consultant will trade services with you.
A proprietor is a business structure with a single owner. The exception is that some states allow a category called sole proprietor (husband and wife) comprised of a married couple. The sole proprietor does business in his/ her/their name and pays personal rather than corporate income taxes.
A sole proprietorship is relatively easy to set up in just a few days. The profits from the business are treated as the owner's personal income, just as if they were wages. The owner(s) will pay federal and state income tax as well as federal self-employment tax. As an employee, you have half of required Social Security and Medicare taxes deducted from your wages; your employer pays the other half. As a sole proprietor, you must pay both sides of these taxes, currently more than 15 percent of your business profits.
The majority of new businesses started each year begin as sole proprietorships. Some eventually take other business structures to attract capital or reduce owner liability. Others retain this structure as they are passed on. At any time, a business can reorganize under a new structure, though it typically occurs when the business wants to move to a new stage in its development.
Some businesses require additional knowledge or capital to begin or grow. A partnership is a business structure with two or more individuals as owners. Each partner's contribution to the business is defined and they agree on how the resulting profits will be split. The specific terms are included in a partnership agreement.
Beware of companies that offer to incorporate your business for a small fee. Corporate attorneys charge $1,000 or more to handle incorporation for simple businesses. Those that are more complex or have numerous stock levels will cost much more. Discuss your incorporation needs with an experienced business attorney and ask for ways to minimize costs. Most offer pricing options.
For taxes and liability, partners are treated like separate individuals. If the agreement says Partner A gets two-thirds of the profits, that partner will probably be responsible for paying two-thirds of the taxes. It also outlines who has what management responsibilities.
Some partnerships are limited. That is, one or more partners are limited in their rights or responsibilities. It's called a limited partnership. Partners may be limited in what authority they have in the daily operations or in the business liability they accept. A partner without these limits is called a general partner. Your attorney or accountant can help you establish the most appropriate business structure for your new or growing venture.
Limited Liability Company
A limited liability company (LLC) is a hybrid. In some situations, owners are treated as individuals and, in other conditions, as investors in a corporation. The structure is defined in an operating agreement. The LLC business can be managed by an owner-manager or a hired manager.
LLCs are established for two reasons: liability and taxation. The structure is set up to define what will happen if the business loses lots of money. Can creditors come after individual owners? Do they have limited liability? As with other complex business structures, consult with professional advisors to determine which is the most appropriate for your venture.
A corporation is a separate legal unit. It is not the owners; it is, within the law, its own entity. The corporation can be owned by individuals or other corporations, called stockholders. The corporation operates within the law under its own by-laws. Ownership shares are transferable. If an owner dies, the shares are sold or transferred and the corporation lives on. The liability of shareholders is limited, typically to their investment.
An S Corporation (S Corp) is a modified corporate structure based on Subchapter S in Chapter 1 of the Internal Revenue Code (IRC). S Corps are different in that the profits made by the corporation are passed on to the shareholders who must pay taxes on them as individuals. The S Corp does not pay taxes on income; it passes the obligation on.
To become an S Corp, the business must be a domestic corporation or a limited liability company with fewer than 100 shareholders. There must only be one class of stock and the corporation's profits and losses must be passed on to shareholders proportionately. Setting up an S Corp requires professional assistance, but it isn't as difficult as establishing a full corporation. S Corps are especially popular structures for consulting businesses and partnerships that want to grow beyond two or three partners. If you are setting up an S corp, it's a good idea to seek legal counsel.
A C Corporation (C Corp) is a full corporate structure based on Subchapter C in Chapter 1 of the IRC. Unlike S Corps, the C Corp must pay income taxes. The profits or dividends passed on to shareholders are then taxed as income. So-called double taxation is the primary reason many smaller businesses prefer other business structure forms.
The primary advantages to C Corps are that shareholders have limited liability and they are more flexible in ownership. It can have more stockholders than an S Corp and have numerous classes or levels of stock. The New York Stock Exchange (NYSE) and other stock exchanges primarily trade in C Corp stocks. These are termed publicly traded stocks; anyone can buy them and invest in these corporations.
A share of stock represents a share of ownership in a corporation. It is a share in the equity or value of that corporation. A shareholder or stockholder is an individual or business entity (including another corporation) that owns at least one equity share. In most corporations, a shareholder can participate in corporate elections. If publicly traded, the shares can be bought and sold to others through a stock exchange.
Other options include incorporating in a state other than the one where your business operations are. For example, you can incorporate in Delaware or Nevada. The advantage to a Delaware corporation is that the state's laws benefit larger businesses. More than half of all publicly traded corporations on the NYSE are incorporated in Delaware. Nevada incorporations offer similar benefits to privately held and smaller corporations. Establishing a C Corp is complex and requires professional advice. As you design your business, understand the opportunities and limitations of each structure.