How Do I... Choose a Business Structure

Choosing how to structure a business can be daunting for any small business owner or entrepreneur. Should a firm be a limited liability company (LLC), an S Corporation or something else?

"It's the No. 1 most misconstrued, misinformed decision that small businesses make today," said tax expert Gene Fairbrother of Dallas.

Much of the decision-making process should center on a company's current or potential tax situation and other financial parts of the business. When choosing how to structure a business, Fairbrother says don't consult solely with an attorney on the matter, but to high-tail it to an accountant or business consultant with tax expertise.

Business owners often choose to structure a business as a corporation or an LLC because, unlike sole proprietorships and partnerships, they offer liability protection. That means the owner of a company can't be held personally responsible for his or her company's debts.

Here are the kinds of business structures often chosen by small businesses:

Sole Proprietorship: Someone who owns an unincorporated business by himself or herself.

Partnership: Unlike the sole-proprietorship, which files taxes on the same form as the owner's personal income, a partnership files a separate income tax return for the business. The partnership, made up of at least two people, passes the business's net income or losses to the partner's personal income tax return via a separate federal form. The partnership benefits from so-called "special allocations." These allocations enable the partnership to customize the distribution of income and loss through the partnership agreement. You are completely and personally liable for your partner's actions, except for in a "limited partnership" where a partner has limited liability.

Corporation (sometimes referred to as a C Corp.): This the most common type of business structure, although less common for very small businesses. Corporations can have an unlimited number of shareholders, making it optimal for firms that plan to publicly trade stock or have a large number of shareholders. With a corporation, the net business income is subject to corporate income tax. The money remaining after the corporate income tax is taxed a second time when they are distributed as dividends to its owners.

S Corporation: This structure can be taxed as a "pass-through" entity, which means that the company's income is "passed through" to its owners or partners. All corporate profits and stock dividends are reported by the owners as personal income. It marries the tax benefits of a sole proprietorship or partnership with the limited liability and clout of a corporation. Current tax law says the number of shareholders may not exceed 75 for an S Corporation, according to Fairbrother.

LLC: With a limited liability company, the owners are basically self-employed. So if the owners make more money than fair market salary, in an LLC, you'll pay extra employment taxes, because all of your income will count as "self-employment" income. With an LLC, you'll have to make personal quarterly estimates and you'll calculate and file your self-employment tax with your personal tax return.

Fairbrother, who is the lead business consultant for the National Association for the Self-Employed, said he "very seldom suggests operating under a sole proprietorship and never under a general partnership." He recommends an LLC or a corporation.

He offers a "worst-case scenario" to explain why:

Imagine John is the sole proprietor of a business and Sally is his employee. Sally is driving them in the company van on company business when they become involved in a significant auto accident. The occupants of the other car sue John's company for $10 million. Even if Sally was driving, John is going to be personally liable if he's the sole proprietor of the business. The plaintiffs could take John's house, his car and everything else. As a sole proprietor you're ultimately responsible for your business. But if the company was structured as an LLC, the business may be liable for the accident, but not John's personal assets too.

"The primary reason why most people look at starting an LLC is to limit personal liability for assets of a business," said Fairbrother. "In a sole proprietorship or general partnership, no matter whose fault anything is, the business owners are personally liable for every act of the business."

He says he often fields calls from business owners who tout the benefits of sole proprietorship, but he still disagrees. When a client tells him that as a manufacturer's rep, for example, with no employees and no contractors, they don't need their business to be an LLC, he says hogwash.

"My response is that you are selling those people a product and if that product has a problem, the [people who are upset] are going to come back to the makers of the product and the people who sold product and possibly sue you," he said.

Some small firms choose a sole proprietorship because it does not require higher fees associated with creating and operating a corporation. You also don't have to set up a separate payroll to pay yourself.

Filing your taxes, as a sole proprietorship, is likely to be easier than it is for a corporation. You just need to file an individual income tax return and list your business losses and profits. The IRS considers your individual and business income the same and self-employed tax implications will apply.

"It's impossible for anyone to suggest the best tax or legal structure without evaluating the finances, projected finances and tax scenario; talk to a CPA, business consultant or accountant," advises Fairbrother.

Choosing an LLC or a corporation is entirely dependent on the taxable profits of the business and other financial parts of the business.

"What structure you choose depends on the situation; there's no one-size-fits-all," said Fairbrother. "Every business has to be looked at as a unique situation. Two businesses could have the same revenues, the same expenses and the same profits but for one a C Corp might be better than an S."

For example, if there's a growing company that's reinvesting a lot of profits into the business, a C Corporation might be better because the firm would pay a 15 percent tax rate while an S Corporation could pay a 25 percent tax rate or higher.

He offers a "very, very rough" guideline to help firms choose a structure, but cautions that no decision should be made without thoroughly crunching the numbers.

If the taxable profits of a business are less than $35,000, you might want to structure yourself as an LLC filing as a sole proprietorship. Many states used to require two individuals to set up an LLC. But now all states allow the "single person" LLC which is taxed as a sole proprietorship.

But if the taxable profits are more than $35,000 but less than $100,000, the S corporation is likely to be the favored choice. If a firm's taxable profits are greater than $100,000, then either a C Corp or an LLC filing as a sole proprietor probably are the best options.

In most states, it costs $200 to $250 to set up an LLC or most other business structures. It costs virtually nothing to start a sole proprietorship.

The best part is that it takes minimal effort to change a business structure. If you start with an LLC but later on find that you want to convert to a corporation, "there's just some paperwork," said Fairbrother. "Just set up a corporation and transfer your assets. It's pretty normal."

Researching business structures:

Go to a library or a large bookstore: Find the small business section where there are various books on how to form an LLC or corporation. A few hours pouring over them will probably give an entrepreneur a basic understanding of the different structures and how to establish them. Many of the books come with a CD offering step by step instructions. Fairbrother, who also reviews business books, recommends small business books published by Nolo Press.

"Even if you're one person, you are the president of your company, and you should have a handle on why your business is structured a certain way," he said. Fairbrother added that certainly anyone can use an attorney if they want, but "rather than hire a $200-an-hour attorney to tell you why and how to write annual minutes, go buy a book for $50 and learn it yourself."

Visit your state's Web site: Every state has a Web site. For example, the Texas and Virginia sites feature a business section where you can find information on how to start a business in that state. They also offer frequently asked questions and toll-free numbers to aid with questions on sales taxes and other information.

Meet with an accountant, business consultant or tax adviser:: Spend a few hundred dollars working with them to help determine which legal entity will be the most financially advantageous for you. "It could mean the difference of overpaying your taxes by thousands of dollars a year," said Fairbrother.

Determine whether you're going to file the paperwork yourself: Once you decide upon a legal structure, you need to determine whether you're going to file for it yourself. In most circumstances, you probably don't need an attorney. But if you have done your preliminary research and you remain confused, there's nothing wrong with hiring a professional or using an online service to incorporate you. But don't get caught up in online promotions pushing you to become incorporated in Nevada or Delaware, according to Fairbrother. "Your tax adviser will let you know if that move is right for you."

By Sharon McLoone |  November 15, 2007; 9:45 AM ET How Do I...
Previous: Study: Fraud Is Increasing Concern For Small Firms | Next: Seizing the Export Opportunity

Comments

Please email us to report offensive comments.



The Virginia Business Information Center (VBIC) does indeed discuss business structure issues with start-up entrepreneurs: 1-866-248-8814. Tomorrow, November 16th, there will be an "Entrepreneur Express" event in Falls Church where information and discussion on business structure and other topics will be offered. The event is free! More information is at www.vdba.virginia.gov/events

Posted by: VBIC | November 15, 2007 10:25 AM

The comments to this entry are closed.

 
 

© 2010 The Washington Post Company