How to Choose the Business Structure that’s Right For YouBy Nina Kaufman, Esq.
At some point in their business planning, most entrepreneurs wonder: “How can I protect myself if things go awry?” Even if they have few personal assets, they may want to avoid the possibility of seeing their name in the caption of a lawsuit, for how can you concentrate on business with that looming over your head?
One of the simplest ways to protect yourself is to form a separate business entity. That way, the entity (not you, personally) takes the “hit” from any lawsuit that might occur in the course of your business. That’s also why they are called “limited liability entities,” because they limit your personal liability. Limited liability entities come in many forms including the C-corporation, S-corporation, limited liability company, limited partnership, professional corporation (or, in some states, professional association), limited liability partnership, and professional limited liability company. Think of it like cherry pie, apple pie, chocolate chip cookies, Swiss almond ice cream, chocolate layer cake, raspberry Jell-O®, and rice pudding. They’re all desserts that satisfy a sweet tooth, but are slightly different in their form and composition, and certain desserts aren’t right for everyone. So it is with limited liability entities: all will shield your personal assets (provided it’s formed correctly and you observe the niceties that go along with that form), but some are better than others for certain situations.
For the most part, small business owners tend to choose the S-Corp (“S,” for Subchapter S of the Internal Revenue Code, which gives the S-Corp its special tax treatment) and the limited liability company – the apple pie and chocolate chip cookie of business forms.
How do you know which choice is right for you? You need to weigh and balance a number of considerations. Some may be more important to you than others. Let’s look at just a few of the significant ones:
1. Who are the intended owners of the business?
Some forms have restrictions on who, or how many, people can own it. For example, in many states, professional corporations can be owned only by people who are licensed members of the company’s profession (e.g., only architects can own an architecture firm). Also, an S-Corp cannot be owned by foreign nationals who are not resident aliens in the U.S., so you could not use that form with overseas investors. An S-Corp can have as few as one, but no more than 75 owners (called “shareholders”). By contrast, a limited liability company (LLC) does not have these limitations, although in a few states, there need to be at least two owners. So ask yourself: Can I form the entity with me alone? Will others own the company with me? Will I have investors (even family or friends) who are not U.S. residents? Am I a licensed professional? Your answer may rule out the choice of certain business forms.
2. What kind of flexibility do you need in distributing profits?
For a one-person business, this may not be so much of an issue. But what if you’re in a situation where there’s more than one owner? Especially where you’re doing most of the work and putting in the “sweat equity” and the other owner is a “silent” or financial contributor? Do you want to distribute profits on an even basis? Do you want your co-owner (called a “member” in an LLC) to have the same amount of management control as you? An LLC can provide you with a great deal more flexibility because the percentage of the company you own/control is not tied to the percentage of profits you receive. For example, in a two-person LLC, you could control 75% of the management of the LLC to ensure that the company achieves the growth you want; but you might choose to receive only 25% of the profits because the other member has made a substantial financial contribution to get you started. You can’t do this in an S-Corp because you can have only one class of stock. Your ownership percentage mirrors the profit percentage to which you’re entitled.
3. What will you pay in taxes?
Both S-Corps and LLCs provide certain “pass-though” tax advantages to small business owners. This means that the profit or loss generated by your business gets reflected on your personal income tax return instead of being first taxed to the company and then again to you when you receive your distribution (hence, the dreaded “double taxation” of C-Corps). LLCs are generally taxed like partnerships, which means a complete pass through to your personal tax return. However, some states do not allow a complete pass-through for S-Corps – so even though your company may not pay federal tax, it may still be subject to state taxes. There are also local taxes that you may need to factor in as well. To get a sense of what your tax bite might be, ask your accountant to run the numbers based on your projected income and expenses. The difference could be significant.
4. How much does it cost to form and maintain the businesses structure?
Costs of formation vary, depending on the state in which you live. In some states, like New York, the costs of forming an LLC far exceed that of an S-Corporation. However, these initial costs need to be weighed against the ongoing accounting costs of corporate tax returns (which can be higher than the returns for an LLC), and the legal costs of keeping up with corporate formalities like – you guessed it – meeting minutes. LLCs do not generally have the same documentation requirements (although it’s a good idea and good practice to do so anyway).
As dessert is a rare treat for me, the decision of “apple pie or chocolate chip cookie” is an important one because I want to be truly satisfied with my choice. Similarly, the choice of business structure is a significant one that can be difficult (and costly) to change. So be sure you’re making the right decision for you and your business. We’d strongly recommend that you consult with an attorney and an accountant before taking this important step. Don’t have them? You can find them easily, as long as you don’t let the prospect of doing so daunt you. Check out our program, How to Choose and Use Attorneys, to find out how you can take control of the attorney screening process and find the professionals who are right for your “team”!