There are many business structures for you to choose from, all of which have very specific differences that can change your business dramatically. It’s important that you research your options and choose the one that’s best for you (but don’t worry if you need to, you can change the structure down the line).
Determining What Organization Will Work Best
Figuring out what system will work best isn’t hard but you will need to know what you want.
A few questions to ask yourself are who will own and control your business? Will there be multiple owners? Will you accept all the legal consequences of your business? Or will you make a corporation to protect you from the liabilities?
While answering these questions be sure to understand that each business structure is taxed differently. We suggest consulting a certified public accountant, or tax attorney to figure out which option will work best for you.
Another important factor to determine is funding. How you decide to finance your company will effect which structure you choose. If you plan on getting outside investors (angel investors or venture capitalist) you must have a stock option. If you want other business to be able to invest in your business your options for the business structure is limited.
Sole Proprietorship
Sole proprietorship is the cheapest, simplest and easiest business structure to form and operate. Only one person can own this type of business and all you will need is a business license.
The problem with being a sole proprietor is that you’ll be legally responsible for everything that happens to the business and all legal matters. You and your personal assets will be liable under this structure for the damages caused by your business
Also under this structure you’re responsible for all taxes. The profits and losses of your business must be indicated on your personal tax returns under Schedule C. You will have to pay Self-Employment taxes (under Schedule SE) and your Self-Employment taxes will include your Social Security and Medicare tax.
Fictitious Name Registration
You can look at operating your business under your own legal name (last name is also fine) or under a different name (you’ll have to register a “fictitious” name with your state).
When you register a fictitious name you become John Smith dba (doing business as) fictitious name. You business name will appear on your bank account, license and various legal documents. It is important to remember that in most states a small fee and an application is all that’s required to register your domain name.
Sole Proprietorship With Your Spouse
Technically the IRS identifies a sole proprietorship as having one owner. According to the IRS if your spouse works for your business they would be considered an employee in which case you’d have to withhold taxes. If your spouse has an active role in the ownership of the business, the IRS considers your business a partnership.
Some tax advisers suggest your spouse can still be involved in your business since your business income will be indicated on your joint tax returns under schedule C. According to the IRS your business is still owned by one person.
One way to bypass paying payroll taxes is to consider your spouse a volunteer but the downside is that they won’t get any credit for their social security.
The IRS considers a volunteer to be someone who does not work regular hours. Your spouse must meet the criteria of being a volunteer otherwise the IRS will fine you.
Partnerships
Exactly the same as a sole proprietorship except a partnership can have multiple owners. If you decided to use this structure, a good idea is to have the terms of ownership written down and signed to prevent disputes and legal issues.
If you decide to create a partnership, write a document indicating what percentage is owned by each person, what each person is responsible for, and how the profits and losses will be distributed among each partner.
When going into a partnership there should be a clear idea of how much money and time each partner will contribute. There should also be a clear idea of how decisions will be made.
Before starting a business all partners should know exactly what’s at stake if they don’t contribute and what will happen to each member’s share of the business if they don’t do their part.
The partnerships that last the longest are the ones where all partners openly discuss all the issues and agree upon a solid deal before launching.
Limited Liability Company
A Limited Liability company, also known as an LLC or LLP (Limited Liability Partnership) is a great structure for those looking for legal protection and having multiple partners. To get an LLC you’ll have to apply with the state and although it is harder to get than a partnership, they aren’t as difficult as filing for a corporation.
A great benefit of this structure is, you can fund your project by getting investors (and corporations) as members.
Incorporating Your Business
A corporation is considered in itself a legal entity. The owners of a corporation are its stockholders and the stockholders can be individuals or other business entities.
The Two Types Of Corporations
There are two types of corporations. The first is a C corp. which can have an unlimited number of shareholders usually without any restrictions as to who they are. The downside to a C corp. is that the corporation get’s taxed on its profits and the shareholders get taxed as well. This is known as double taxation.
The second is an S corp. which has a limited number of shareholders. Each shareholder in an S corp. must be individuals (US residents) and not other business entities.For tax purposes an S corp. must be operated on a calendar year. The benefit of this type of corporation is that double taxation does not apply.
Choosing To Incorporate
The great thing about incorporating is that you get legal protection and is a good choice if you plan on getting outside investors.
Deciding to incorporate has many tax advantages that in other structures would not be provided. You can take the company public with an IPO (initial public offer).
One disadvantage to incorporating is that applying for one requires a lot of paperwork and information. When applying you’ll have to submit articles and bylaws describing exactly how your business will be run and it must be approved by your state.
One important requirement for maintaining a corporation is that on an annual basis you must hold meetings and record minutes for these meetings. This can all be daunting at first but it’s really not that difficult.
If you choose to incorporate, there will be separate tax forms which are much more complex then the ordinary forms. If your corporation does not file taxes or record the minutes of your meetinga, the stockholders are legally responsible and they are no longer legally protected.
For this type of structure, expect to pay upwards of $1000 for an attorney to fill out the paper work.
If you decide to incorporate yourself you should still expect to pay a few hundred dollars for the filing fees as well as paying an annual fee with your state.
Changing The Legal Structure Down The Road
Ultimately you’ll just want the structure that’s best for you now and if required change at a later time. Most business start out as either a proprietorship but down the line someone else may join you and you can switch to a partnership. If you need new owners for investment reasons you can look at incorporating.
If your business gets big enough you may want to switch to a corporation to avoid the self employment taxes (changing from a proprietorship or partnership to a corporation is much easier than vice versa).
A corporation has many owners and many legal requirements. If you decide to switch it back to a partnership or proprietorship you’ll have to go through a lot of work. You must go through many procedures to legally dissolve the corporation before changing its legal structure.
The SBA website offers instructions for those wanting to change their business legal structure:
- www.sba.gov/smallbusinessplanner/exit
Consult a trusted business advisor before changing the legal structure of your business.