Selecting the Right Business Structure
The decision as to which business structure to select could make the difference in whether you are successful with your financial plan. Taxes, personal liability cost are some of the factors affected by the decision as to how to structure your investments and how to manage your resources.
Below are the 4 types of business structures that you should consider.
I. Sole Proprietorship
Why a sole proprietorship may be right for you:
Because legal and filing fees are at a minimum, there are low start-up costs.
There is the greatest freedom from regulation and paperwork.
The owner is in direct control with no interference from other owners.
Taxes may be lower than with other business entities.
Why a sole proprietorship may not be right for you:
Unlimited liability—means the proprietor is responsible for the full amount of business debts no matter how incurred and his personal property may be taken to cover debts of the business (this, of course, is a significant disadvantage).
Since the sole owner’s death or illness would terminate the business, there is an unstable business life.
There may be difficulty raising capital or obtaining long-term financing because you cannot readily sell an ownership interest in a sole proprietorship.
A Corporation is formed and authorized by law to act as a single entity, although it may be owned by one or more persons. It is legally endowed with rights and responsibilities and has a life of its own independent of the owners and operators.
Why a corporation may be right for you:
Personal liability is limited. The owners are not personally liable for debts and obligations of the corporation. They can personally lose only to the extent of their investment in the corporation, with the exception that they may be personally liable for certain types of taxes, such as payroll taxes withheld from the employee’s paychecks but not paid to the Internal Revenue Service and state tax authorities. If the business fails or loses a lawsuit, the general creditors cannot attach the owners’ personal property. Limited liability is one major reason so many businesses are incorporated.
Capital can be raised more easily than under other forms of ownership. This does not mean, however, that a new corporation can easily sell shares of stock. The sale of stock is highly regulated by both federal and state governments, and obtaining bank loans for a fledgling business may be no easier for a new corporation than for a partnership or proprietorship.
Ownership in a corporation is more easily transferable. Including transferring shares to family members as well as selling your interest to another person. However, in many small corporations it is advisable to put restrictions on the transfer of shares, especially if the stockholders must be able to work together. This is generally accomplished by stockholder agreements.
The corporation has a continuous existence, since it is an independent legal entity.
A corporation has a defined, centralized management. Control rests in the board of directors and its powers are exercised through the officers.
Many companies offer discounts, in areas such as travel, to corporation.
Retirement funds, defined-contribution plans, money-purchase plans, and other profit-sharing, pension and stock option plans may be more easily set up with a corporation.
Why a corporation may not be right for you:
Corporations are subject to more governmental regulations than either partnerships or sole proprietorships.
Corporations are the most expensive form of business to organize.
There is double taxation, since both the corporate entity and the individual owners have to file tax returns. (This may be avoided by forming an S Corporation.)
Record-keeping requirements are more extensive with a corporation.
Operating across state lines can be complicated because corporations need to “quality to do business” in states where they are not incorporated.
Ending the corporate existence, and in many cases even changing the structure of the organization, can be more complicated and costly than for partnerships and proprietorships.
If you decide that the corporation is the correct form of organization for your business, you must go through the legal steps required to create your corporation. These steps vary in complexity from state to state. With careful planning, most people can easily organize their own corporation without a lawyer, thus saving hundreds of dollars in legal fees.
III. S Corporation
An S corporation is a special type of corporation that, for tax purposes, is treated like a partnership or sole proprietorship. An S corporation has the same structure as a regular or C Corporation, yet maintains a pass-through tax status as in a partnership. Once you are incorporated, you must elect to switch to S Corporation status and then file your change in status with the state. You may always remove your S Corporation status later on.
As you will see below, an S corporation sounds a lot like a limited liability company. However, there are a few differences that are worth noting primarily that LLCs often require less paperwork, have lower filing costs, and offer greater protection for membership interests.
IV. Limited Liability Company
A limited liability company is also a business entity created by legislation. It combines the advantages of a
corporation with those of a partnership. This type of company is similar to a corporation in that it offers limited personal liability to its owners. It is similar to a partnership in that it offers the same tax advantages to its owners. Therefore, forming a limited liability company provides management with a great deal of organizational flexibility.
Why an LLC may be right for you:
Double taxation is avoided. Since it is not a corporation, there is no corporate income tax. Income is only taxes on the personal level, as in a partnership.
Personal liability is limited. All the personal assets of the partners are protected from corporate creditors. Managers and officers are also protected if they participate in the operation of the company.
There is relatively little paperwork and record keeping beyond a simple operating agreement or statement of the principles of the organization.
When a membership interest is transferred, only the right to receive distributions or profits is transferred; a voting interest must be agreed upon by the other members.
You can form a limited liability company yourself. The forms are available from the Secretary of State of the state in which you want to form the company. You do not need an attorney.
You can convert your present business to a limited liability company and begin receiving the benefits immediately.
It is relatively inexpensive to establish a limited liability company. It usually cost less than $500 to register with the state.
Annual registration fees are low, under $250 in most states.
Why an LLC may not be right for you:
There is a lack of widespread acceptance because the type of company is relatively new. Limited liability companies only have been recognized by the IRS since 1988.
Multi-state business may have tax problems if they conduct business in a state that recognizes limited liability companies and in another state that does not yet recognize them, or if the LLC fails to qualify in another state.
IRS rules that apply to insolvency may create problems for the owners of the limited liability company.
Limited liability companies do not enjoy the advantages of IRS rulings when there is a sale of worthless stock or stock is sold at a loss.
The sale of 50% or more of the ownership of the limited liability company in any 12-month period ends any tax advantages the company may have had with the IRS.
Limited liability companies may not engage in tax-free reorganizations.
Once seen as a daring corporate hybrid, the LLC is now praised for its organizational flexibility and innovation. It combines the best feature of corporate protection with the significant tax advantage of a partnership. Currently 49 states and the District of Columbus have regulations for establishing LLCs, however Hawaii does not currently recognize LLCs.