Business Entities

Business Structure

In this article I will look at various types of business structures for your business.  In particular, sole proprietor, LLC, and C-corp?  I know there exist one other, partnership, but that is generally for the professional types of business, such as attorneys, CPAs, doctors, etc.  

The main question I hope to address is “How should I structure my small business”.  

The audience I am addressing this too is basically, the one or two person small business (ie handyman, house painter, coffee shop, donut shop, uber driver, personal mechanic, etc..) 

In no way is this to be an exhaustive report on these business entity types, but hopefully, it will give you the information you need to make an intelligent decision.

Corporation

There are two types of corporation structures.  One is the S-corp the other is the C-corp.  Suffice it to say that a S-corp is taxed like a LLC and is limited to 100 shareholders. 

A business structured as a C-Corporation is considered a separate entity.  It has its own id and is considered a legal person. It is owned by those who have shares in the company - shareholders.  All shares are of equal value with ownership determined by the number of shares held by individuals or other entities.  

Due to this separation a corporation is responsible for its own actions and not the shareholders of the corporation.

Consequently, a corporation has to pay taxes on its profits separate from its shareholders.  Shareholders are paid with monies remaining after corporate taxes have been paid.   This is known as double taxation, first monies earned as profits are taxed at the corporation tax rate,(currently 21%), then when these monies are distributed to the shareholders the shareholders must pay a dividend tax on monies they receive.

Advantages

1. Liability
2. Retained Earnings

Liability avoidance is the number one reason for forming a corporation.  Shareholders are not responsible for any of the corporations liabilities.   For example: If an employee of the company is injured or killed the shareholders can not be held liable for this misfortune.  

A corporation does not have to distribute all of its profits to its shareholders whereas LLCs, S-corporations and sole proprietors must pass through all profits to its members / owners. 

Monies not distributed to shareholders is known as retained earnings. Corporations can set aside monies for future growth that is free from taxation at the personal level.  Because the corporate tax rate is less than the personal tax rate corporations have more money available for growth.

Disadvantages

1. Dual taxation
2. Tax preparation

Taxation is the biggest disadvantage of the corporation structure.  

First there is the dual taxation of profits.  Second, is the filling of taxes.  Since corporations must file an 1120 tax form, which is more complicated than an individual form, it will cost more for a tax consultant to prepare it than a completing a schedule C for an individual.

Limited Liability Companies

A Limited Liability Company, ie LLC, is a hybrid of the sole proprietor and the corporation.  An LLC has the liability protection of a corporation and the pass through of profits to its members like a sole proprietor thus avoiding the dual taxation of corporations.  LLC owners are considered members,

An LLC is not as hard as most people think. Here are the basics to form an LLC.  See article by the attorney Bethany K. Lawrence on the NOLO website.

Basically, 

1. Choose an available business name that complies with your state's LLC rules.
   • Go to your SOS do a search for your business name
   • Keep searching until you find an available name
2. File formal paperwork, articles of organization, and pay the filing fee 
3. Create an operating agreement detailing the rights and responsibilities of the members.
4. Obtain licenses and permits that may be required for your business.

Advantages

1. Liability
2. Profits taxed at personal tax rate

Just like the corporation the LLC is protected from liabilities arising from the business.  

All profits are considered passed through to the members thus there is no corporate tax rate to pay before the receiving the monies earned.

Disadvantages

1. Profits taxed at personal tax rate 

Unlike corporations you can not hold profits over for future growth, ie retained earnings. All monies earned as profit will be taxed at the higher personal tax rate.

Purpose

There are only two reason for even addressing the business structure question.  

1. Liability
2. Money
3. Time
4. Growth

Liability

There is no liability protection with a sole proprietorship.  You are personally responsible for all liabilities of your business.  Which means any assets you own are subject to appeasing that debt.  

I find it hard to even suggest a sole proprietorship.  However, realistically there are instances where a sole proprietorship is fine.  Mainly because it is easy.  Business that operate out of the home with no public exposure or current desire for growth.  Web designer working out of the apartment, online transcriptionist, employee who is transferring to a 1099 status who will telecommute. 

However, as you grow and start to accumulate assets you should take on a more defensive posture.  Any and all interactions with people, customers and or employees, brings more chances of risk and some form of liability.

If liability is of paramount importance then there really are only two choices of business entity structure to be considered.  LLC or a C-corporation.  Both give you protection from liability issues that your business may encounter.  

1. Corporation best 
2. LLC good
3. sole proprietor poor

Money

There are 3 types of money issues when discussing your business structure.  First is the startup fees, second is the annual refiling fees, and third and most important are taxes.  

Startup filing fees are minimal, $25 - $500.  

Annual filing fees are minimal, $0 - $300.

Taxes are the monies to be considered when choosing a business structure.  A sole proprietor and LLC will be taxed the same.  Both are taxed at the individual tax rate.  A corporation will have the dual taxation issue, but if a business is focused on growth then more monies can be used for future expansion.  

Thus a C-corporation will pay more in taxes then either a sole proprietor or LLC.

Time

Another consideration for deciding your business structure is the time that must be allocated to maintaining the business structure for legal reasons.  A corporation and LLC must meet at least once a year to maintain their legal structure.  

This may not seem like much and it is not.  But doing is always more difficult in reality.  An LLC and a corporation must generate and file an annual report and have an annual meeting.  The report and minutes must be retained by the business for seven years, 40 years if there were employees.  There are many software templates that make this task easy.  

If a business fails to file or meet its annual reporting requirements it runs the risk invalidating its business structure and exposing its shareholders / members to personal liabilities for the business.

Therefore, if your business is an LLC or C-corporation you must take the time to run it as such.

Growth

In regards to growth, the only structure that is most favorable to growth is a C-corporation.  Only a corporation allows for profits to avoid personal taxes for business growth.  This can be a difference of 4% - 18% of profits being used for growth instead of being paid in taxes.

Another concern relating to growth is future dissolution of your business.  There will come a day in which you will either sell your business or close it. It can be argued that it will be worth more as a LLC or corporation than a sole proprietor.   

Another point of consideration is expansion.  It is easier to expand as an LLC or corporation since it is simply a matter of distributing shares.  You can make a great employee a part owner by selling or giving him shares in the business.

Summary

Sole Proprietor:

If you want to make as much as possible with the least amount of costs and taxes and liability is not a big concern.

LLC:

If you want to make as much as possible with the least amount of taxes and liability is a concern.  

Corporation:

If you are serious about starting a business with a long term outlook.  If you are chopping at the bit to grow and possibly expand your business.  You realize it will take up more of your time outside of your core business, but will force you to think like a CEO.

So what is the best form of business structure for a small business owner.  

Recommend

I recommend the C-corporation for the following reasons.  

1. Liability 

Since liability is the primary reason for choosing something other than a sole proprietorship.  An individual might as well go with a corporation.

2. Costs

Corporations cost about the same as LLC in regards to start up and recurring fees

Taxes

LLC: If your intent is to make as much as possible for yourself then an LLC is better

Filing taxes is easier as a LLC.  Schedule C on your personal 1040s

Corp: If your intent is to grow your business then go with a corporation.

Filing requires completing form 1120 and may cost more regarding tax preparers

3. Growth = Retained Earnings

Only a corporation allows for retained earnings.  See tax advantages.

4. Time

• A corporation will take more time.  Both in terms of starting up and fulfilling annual reporting and meeting requirements.
• However, this can be a good thing.  It will force you to run your business as a corporation.  At least once a year you will have to slow down and evaluate your business and its finances.  
• There exist software templates for meeting minutes and annual reports that make fulfilling these requirements easier.

5. Dissolution

• Selling a business has its own intricacies and is really a function of business financials combined with market conditions. 
• Corporation and LLCs can sell shares sole proprietors cannot.