When you are forming a new business, there are numerous tasks that need to be completed. Raising capital, hiring staff, developing a marketing strategy, and putting in countless long days in the beginning to bring the business from zero to profitability, just to name a few. But before you begin operations, one of the most important things you need to figure out is your entity structure.
The legal entity you choose for your business will have a major impact on your liability exposure, how you conduct operations, taxes, and many other areas. Each business structure has its own advantages and disadvantages, and the best type of entity for your business will depend heavily on unique factors such as the industry you are in, the size of your company, how many owners you have, and your long-term objectives. The key is to determine which entity structure contains the attributes necessary to best help your business accomplish its goals.
There are five main business entity structures that are recognized by the IRS. Here is a look at each one of them:
A sole proprietorship is the simplest and most basic type of business entity. This is a common choice for solo entrepreneurs who are just starting out, have very few or no employees, and have limited interaction with vendors, suppliers, and subcontractors. In many cases, sole proprietorships are operated from a home office, and there is no business that they are renting or leasing. A sole proprietorship is easy to start because there is no separate legal entity to form. Essentially, all you need is a business bank account and the required licensing and you are in business. The major downside is that the profits and losses for the business are included on your personal tax return, and the owner is personally liable for any debts and lawsuits against the business.
A general partnership can also be started without forming a separate legal entity. This type of business structure may be suited for a small business with two or more owners that is just starting out and, like a sole proprietorship, the business has few or no employees and other complex arrangements. With the general partnership, owners are also exposed to personal liability that may result from the business. This can be more problematic than with sole proprietors, because you may be on the hook for the potential negligence or misconduct of one of the other partners.
Limited Liability Companies (LLCs)
One way to address the concern about liability exposure within a business is to form a limited liability company (LLC). An LLC is a hybrid structure that allows owners, partners, and shareholders to limit their personal liability while enjoying the flexibility and potential tax benefits an LLC has to offer. LLCs have fewer formal requirements than corporations, but members can choose to be taxed as a sole proprietorship or a corporation. This makes them a popular choice for all types of small businesses.
A Subchapter S corporation, commonly known as an “S Corp”, is a corporation that must have been created in, and be based in the United States. Ownership is limited to a maximum of 100 shareholders, and shareholders must be private U.S. citizens, very specific types of trusts and estates, or certain types of exempt organizations, such as a qualified pension plan. The main advantage with an S Corp is that business income and losses “pass through” directly to shareholders without first having to pay corporate tax on the money. This allows an S corporation to enjoy the same limited liability for its shareholders has a C corporation, but without the double taxation. The main drawback to an S Corp, aside from the ownership restrictions, is that it can only issue common stock. The inability to issue preferred stock can make it more difficult to attract investors if the business needs to raise capital.
A C corporation is the most complex type of business structure, with limited liability and very few restrictions on ownership. A C Corp can have an unlimited number of shareholders, and the shareholders may be other individuals, corporations, trusts, foreign citizens or entities, and virtually any other type of individual or legal entity. You are also allowed to issue any type of stock, such as cumulative, convertible, callable, and other forms of preferred stock in order to lure investors and for other purposes. As we touched on in the discussion about S corporations, the main drawback with a C Corp is the fact that corporate profits are taxed twice; once at the corporate tax rate, and again at the dividend tax rate when they are received by shareholders as dividends.
What Type of Business Structure is Best for You?
As you can see, there is a lot to consider when deciding which legal entity to structure your business under. While it is possible to change business structures later on, this can be costly and complicated, depending on your circumstances at the time you decide to change. This is why it is much better to choose the business entity that best fits your needs from the outset.
At the offices of Davis, Bingham, Hudson & Buckner, P.C., we have over four decades of experience assisting clients with business entity formation and all other types of business legal matters in Alabama. We can thoroughly examine the specifics of your business, and your needs and future goals to help you choose the right entity structure from the start. Call our office at 334-821-1908 to schedule a consultation. You may also send us a message through our online contact form.