Hi Folks, Dave Waring here from Fitsmallbusiness.com and today's lesson of the day.
In our last lesson we continued our series on how to start a successful business with
a look at how to put together a partnership agreement.
In today's video we are going to continue that series with a look at how to choose the
right legal structure for your business.
The business structure that you choose affects everything from how your earnings will be
taxed to how much personal liability you have when something goes wrong with your business.
If you choose the wrong structure for your business you could not only end up paying
more of your hard earned money away in taxes, but could also be putting your personal assets
(like your home) at risk.
Here are the primary factors to consider when choosing a business structure.
How much personal liability you have for the business.
How you want your earnings and profits from the business to be taxed.
How easy it is to set up.
How it affects partners and the business's ability to raise money.
Now let's evaluate each of the primary business structures based on these factors.
Sole Proprietorship
A sole proprietorship is the simplest business structure.
In fact you don't even have to do anything to set it up.
If you are providing a product or service to the public, do not have any partners, and
have not setup any other legal entity for the business, then you are automatically a
sole proprietorship.
Evaluating the sole proprietorship business structure:
Liability: There is no distinction between business and personal.
You are personally liable for any mistakes debts etc that are incurred by the business.
If you are selling arts and crafts online then this may not be a big deal.
If on the other hand your business involves taking on a lot of debt or removing large
trees from beside people's houses, then this is likely a large issue.
Taxes: With a sole proprietorship you pay taxes on all earnings of the business (revenues
minus expenses) and cannot pay a portion of the money over and above your salary out as
a distribution (which is generally taxed at a lower rate).
You pay a similar income tax rate on money from your sole proprietorship as you would
pay had the money come from an employer.
Ease of Setup: This is the easiest business structure to set up.
No paperwork required to set up as a sole proprietorship.
If you want to do business under a different name from your own will need to register a
Doing Business As form (DBA) which can learn more about on the SBA's website here.
Funding: You will generally not be able to raise money from outside investors as a sole
proprietorship.
Partnership Issues: Sole proprietorships do not have partners.
The equivalent of a sole proprietorship with partners is a general partnership which we
will discuss next.
Bottom Line
For businesses that have no partners and do not have the potential for large legal and/or
financial liability starting as a sole proprietorship may not be a bad option.
However once the business starts growing you are likely going to want to change to one
of the other entities outlined below.
General Partnership
Like a sole proprietorship, a general partnership is a very basic business structure.
If two or more partners agree to do business with each other and do not set up another
type of business structure, then they are automatically a general partnership with no
official paperwork required.
Liability: There is no distinction between business and personal.
This is an even more important point with General Partnerships, because you are liable
not only for yourself, but also for your partners.
So for example if one of them goes out and runs up a lot of debt for the business or
makes a mistake and the business is sued then you are liable as well.
Taxes: Like sole proprietorships, General Partnerships are taxed only at the personal
level, and all income from the General Partnership is subject to taxation regardless of whether
it is left in the business or paid out to the partners.
You pay a similar tax rate to what you would if the money came from an employer.
Ease of Setup: No paperwork required to set up as a General Partnership, unless you want
to do business under a different name in which case you need to file a doing business as
form with your state.
Although not required it is highly recommended to put together a partnership agreement for
General Partnerships which you can learn more about in our video on partnership agreements.
Funding: You will generally not be able to raise money from outside investors as a General
Partnership.
Partnership Issues: Unless you have a partnership agreement in place to the contrary, any partner
may decide to dissolve the partnership, and the partnership automatically dissolves should
one of the partners declare bankruptcy.
Bottom Line:
Because of the additional liability and potential disputes that arise under a general partnership,
we do not recommend operating as a general partnership.
If you do not have the funds currently to set up as one of the other business structures
below, then at a minimum make sure you setup a partnership agreement.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) separates the individual and the business from a liability
standpoint, and provides a lot of flexibility in how the business is run and taxed.
It is therefore generally the first entity that should be considered when setting up
a business structure.
Liability: An LLC business structure treats the individual business owners and the business
separately from a liability standpoint.
In this way LLC's act like a corporation.
Taxation: After setting up an LLC, if no election is made with the IRS, then income from the
LLC will pass through to the owners in the same manner it does with a Sole Proprietorship
and General Partnership.
However, LLC's can also elect to be treated as a C-Corp or an S-Corp from a tax standpoint.
We discuss how C-Corps and S-Corps are taxed later in this video.
Ease of Setup: You will have to file paperwork with your state to set up an LLC.
However there are many online services (like Rocketlawyer.com and Legalzoom.com) that can
help you do so and it is not very burdensome.
Along with the state filing fees it should generally be less than $500.
Funding: Choosing an LLC will likely not prevent you from raising money, unless you or those
who are investing in you are planning to take the company public.
Partnership Issues: Most states allow what is known as a single member LLC so you generally
do not have to have a partner in order to setup an LLC.
Unlike a general partnership, LLC's are seen as a separate entity from their partners and
can therefore continue to operate should one of the partners decide to leave the business.
Like with General Partnerships however, there should be a well crafted partnership agreement
(called an operating agreement in the LLC structure) executed between the partners to
outline how the business will be run and how any issues will be handled.
Bottom Line:
LLC's offer the best of both worlds, liability protection and the flexibility to choose how
you would like the entity to be treated from a tax standpoint.
They also require less paperwork and maintenance than a C-Corporation.
For these reasons they should be the first option considered when seeking a legal entity
that provides liability protection.
**Rules can vary by state.
Visit see the state guides at Bizfilings.com to see if there are any differences in your
state.
C Corporations
The primary advantage to a C Corporation over an LLC is the ability to raise money by taking
the company public.
If you do not plan on raising outside money in this manner then the LLC offers very similar
liability protection and much more flexibility from a tax standpoint.
Liability: Like an LLC a C Corporation treats the individual business owners and the business
separately from a Liability standpoint.
Taxation: Income from a C Corporation is taxed at the current corporate tax rate of up to
35%.
Income that is paid out to shareholders in the form of salary is then taxed again at
the recipient's personal income tax rate.
Income that is paid out as dividends to shareholders is also taxed at the current dividend rate
of up to 20%.
If the corporation meets certain restrictions it can elect to be treated as an S Corporation
from a tax standpoint in order to avoid double taxation.
You can learn more about this when we discuss the S corporation later in this video.
Ease of Setup: Like with an LLC you must file paperwork to setup your C Corp.
The initial setup and cost for setting up is similar for LLC's and C-Corps and you can
use services like Rocketlawyer.com and Legalzoom.com to setup a C Corp as well.
However there are ongoing requirements to maintain a C-Corporation that do not exist
for the LLC.
In most states C-Corps have to hold formal board and shareholder meetings and keep minutes
of those meetings.
Reporting your taxes also requires more paperwork with a C-Corp than it does with an LLC.
Funding: If you plan to take your company public, then currently you must be organized
as a corporation.
Many venture capitalists also prefer to invest in companies which are organized as C corporations.
The reason why is that there is greater flexibility of ownership in a C Corp vs. an LLC or an
S Corp.
For example with a C-Corp you could have more than one class of stock which provide different
benefits and authority to different types of owners.
If you want to give stock options to employees you will also need to be registered as a C-Corp.
Partnership Issues: C Corporations are seen as a separate entity from their partners and
can therefore continue to operate should one of the partners decide to leave the business.
There should however be a well crafted partnership agreement (called a shareholders agreement
in the C Corporation business structure) executed between the partners to outline how the business
will be run and how any issues will be handled.
Bottom Line
Unless you are planning to raise a significant amount of money and/or take your company public
an LLC structure gives you many of the same benefits with more flexibility than the C-Corp.
S Corporations
Both LLC's and C Corporations can elect to have their business treated as an S Corporation
from an IRS standpoint.
This allows C Corporations to avoid the double taxation issue.
LLC's who elect to be treated as an S corporation can have money paid out to the partners over
and above a "reasonable salary" treated as distributions instead of income, which can
substantially lower their tax bill.
In order for your LLC or C Corp. to elect to be treated as an S Corp it must:
Be a domestic corporation Have only allowable shareholders
including individuals, certain trust, and estates and
may not include partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders Have one class of stock
Not be an ineligible corporation i.e. certain financial institutions, insurance companies,
and domestic international sales corporations.
Liability: The S Corp is simply a designation with the IRS for tax purposes, so the liability
is the same as it is for the underlying LLC or C Corp that elected to be treated as an
S Corp.
Taxation: Shareholders in the LLC that are active in the business must pay themselves
a "reasonable salary" which will be taxed at their personal income rate.
Money which is paid out to the shareholders over and above this amount will be taxed as
either a distribution or a dividend which is generally a much lower tax rate.
Unfortunately there is no specific guidance provided by the IRS as to what a "reasonable
salary is".
A good guideline however is that if a non shareholder would not accept the job at the
salary then its too low.
Ease of Setup: In order to be treated as an S Corp you must setup your LLC or C Corp first
and then file a form 2553 with the IRS to elect to become an S Corporation.
The reporting requirements for the S Corp are basically the same as for the C Corp.
If you are an LLC this increases your maintenance.
Funding: If you plan on taking your company public then you will need to have a C Corp
when doing so.
With S Corps you can only have 100 shareholders who must be domestic individuals and you can
only have one class of stock.
Bottom Line If you have an LLC then there is no reason
to elect to be treated as an S Corp until the business is producing enough profit to
pay yourself more than "a reasonable salary".
Once you get to this point then electing to have your LLC treated as an S Corp can result
in substantial savings.
If you have a C Corp and meet the restrictions for having an S Corp then electing to be treated
as an S Corp allows you to avoid the double taxation issue of a C Corp.
**Rules can vary by state.
Bizfilings.com has a great guide for each state here you can use to see if there are
any differences in your state.
That's our article for today.
If you have any questions or comments please leave them in the comments section below.
Also be sure to stay tuned for our next article where we will continue our this series with
a look at what state you should choose for your LLC or C Corporation.