Starting a new business is an exciting journey, especially when your business has been an idea for so long. Taking the proper steps to see your business come to fruition is essential, including choosing the right type of business. When deciding if you should create an LLC, corporation, or have a sole proprietorship, there are a few things to consider when bringing your business to life. Depending on what business entity you choose can significantly impact your legal responsibilities, tax obligations, and liability.
When you are forming a business with other partners, these decisions are especially important. Co-owners of a business have a special relationship and having candid discussions with your business partner (or partners) about how that relationship should be structured is essential to avoiding conflict later. The right business entity is the first step to a successful co-owned business.
It’s crucial to have an attorney advise you before choosing a business structure. In the meantime, here are five factors to consider when selecting the best structure for your new venture.
1. Liability Protection
When you form a new business, keep your personal assets separate from your business assets. You will also want to protect them, and different business entities offer varying levels of personal liability protection for business owners.
Sole Proprietorship and Partnership: These structures provide little personal liability protection. Your assets could be at risk if the business incurs debt, it cannot repay or encounters legal issues.
Limited Liability Companies (LLCs) and Corporations: These structures offer strong liability protection, ensuring that (so long as you maintain proper separation of personal and business assets) your personal assets are generally shielded from business liabilities.
2. Tax Implications for Different Business Structures
Understanding how different entities are taxed may help optimize your financial strategy when forming your business. Each tax situation is different. A good attorney will collaborate with your existing tax advisor to structure your business in an appropriate way based on your circumstances. Here are some considerations when choosing an entity.
Sole Proprietorship and Partnership: Profits are taxed directly as personal income, which can simplify tax filing but may result in higher taxes if the business is highly profitable.
LLCs: An LLC offers flexible income tax options. By default, LLCs are taxed like sole proprietorships or partnerships. However, you can elect to tax an LLC as an S-Corporation or C-Corporation to be subject to corporation-style taxation rules. One common reason to consider S- or C-Corporation status is to reduce self-employment taxes.
Corporations: A C-Corporation is taxed separately from its owners, which may lead to double taxation on profits and dividends. An S-Corporation allows profits to pass through to personal tax returns, avoiding double taxation. However, the decision to be taxed as an S-Corporation can have unintended consequences when you have multiple owners due to IRS regulations about how an S-Corporation is allowed to operate.
3. Management and Control
When selecting an entity, you want to consider how you want your business to be managed and the level of control you wish to maintain. Your involvement will depend on the business structure you choose, if you have business partners, and a few other factors.
Sole Proprietorship: You have complete control, making it easy to manage and make decisions.
Partnership: Control is shared among partners, which requires clear agreements, communication, and strong relationships to be successful.
LLC: This entity gives you the power to shape your business as you see fit. You can choose to manage it yourself or appoint managers, giving you the adaptability to respond to changing business needs.
Corporation: Typically, corporations are governed by a board of directors and officers, which can benefit larger businesses but may introduce more complexity. In addition, state law typically imposes more stringent compliance obligations on corporations when compared to LLC’s.
When sharing control with business partners, it’s important to set out clear responsibilities and to decide how decision-making will occur. Deadlocks between co-owners can be especially problematic, and well-written company management documents can help prevent these issues before they even start—or at least help each owner understand what happens in the event of a deadlock.
4. Fundraising and Investment
Depending on how you structure your business, you may need to improve your ability to attract investors and secure funding. Determine how you’d like to raise capital before selecting an entity to ensure your goals align.
Sole Proprietorship and Partnership: Raising capital and receiving investors may be difficult for these entities because they can’t issue stock.
LLC: This entity offers more flexibility in raising funds, as you can bring in investors by offering membership interests. LLCs are generally considered less effective for complex ownership arrangements, but LLCs are often used even when you are taking investments from others. Whether to take investments through an LLC or a corporation depends on the nature of the investors and the longer-term objectives of your company.
Corporation: This entity is the most traditional structure for investors as it provides several attractive features relating to corporate governance that investors find valuable. In particular, corporations issue stock and can have multiple classes of stock, making it easier to raise capital and attract investors.
5. Regulatory and Administrative Requirements
Different entities come with varying levels of regulatory compliance and administrative upkeep, which are essential to be aware of when selecting an entity for your business. Failing to comply with these regulatory and administrative burdens can cause unexpected problems—it can even put your ‘limited liability’ protections at risk.
Sole Proprietorship and Partnership: These entities generally have the fewest regulatory requirements and administrative burdens, making them easy to maintain.
LLC: This entity requires more paperwork than sole proprietorships but less than a corporation. You’ll need to file articles of organization and maintain an operating agreement.
Corporation: This entity involves the most regulatory requirements, including filing articles of incorporation, creating bylaws, holding regular board meetings, and maintaining detailed records.
Most of these business entity types will require you to ensure that you comply with the newly enforced Corporate Transparency Act (CTA), a federal law requiring many companies to disclose the identities of their major owners to the federal government. More information can be found in our blog post about the CTA, available here.
Choosing the right business entity is an essential step in your business journey. At Clyde Snow & Sessions, we have over 75 years of experience and pride ourselves on guiding entrepreneurs, real estate investors, and start-ups through every step of this critical decision. Our expertise in business law ensures that we will help you make the best choice for you and set you up for success. Contact one of our attorneys from our business group today to help you build a strong foundation for your business’s future.