A Quick Review of Business Entities: Do You Need to Reconsider Your Structure?
Women’s Venture Fund
While it is important to select the correct business structure at the outset, you can change your entity down the road as your revenues grow, your business takes on employees and /or you seek to form partnerships with individuals or even other businesses. Here is an overview of the entities available:
This is the most common entity chosen by start-ups due largely to its simplicity in setting up—there are no legal forms required. In New York and New Jersey, you can achieve this structure in three easy steps:
- Choose a business name. If that name is other than your legal one (i.e. a brand), you need to file a fictitious name certificate with the county clerk.
- Obtain the necessary licenses and permits.
- Apply for an Employer Identification Number (EIN).
As a sole proprietor you don’t have to file a separate business tax return which also adds to its popularity with start-ups.
However, under this entity, you are personally responsible for all the liabilities incurred by your business. In addition, you are least attractive to lenders because they have no redress should you default on a loan.
If you choose to set up a general partnership, all profits and liabilities are shared equally by the partners while a limited partnership gives partners a share of profits and liabilities according to a specific percentage of ownership. Under this type of entity, not only are you liable for your own actions, but also the actions of your partners. Like a sole proprietorship, you don’t have to file a separate business tax return which makes tax preparation easier. Individual partners report their share of the business on their personal tax returns. The business (as a partnership) does not pay income tax.
Corporation (also known as a C Corporation)
Rather than being owned by an individual business owner, a corporation, which is usually a larger enterprise, is owned by shareholders and is responsible for debts and liabilities. (The shareholders are not responsible for debts and liabilities and their personal assets are protected. However, they do have to report their salaries, bonuses and/or dividends on their individual tax return.)
On the down side, there are many administrative duties of a corporation since federal, state and local governments require additional bookkeeping to be in compliance with regulations. Another drawback is that the corporation can be double taxed: Once when reporting a profit and again when it pays its shareholders their dividends.
Limited liability company (LLC)
An LLC can be comprised of individual owners, partners, a corporation or another LLC—all designated as members who are required to profits, losses and taxes personally. The IRS does not tax an LLC (because the ‘members’ pay taxes); and record keeping is at a minimum. The members are considered self-employed and must make tax payments to Medicare and Social Security based on net income.
When it comes to liabilities, members have some (limited) protection.
Like an LLC, an S corporation allows the shareholders to avoid double taxation by requiring the shareholders to bear the burden of taxes. The S corporation itself does not pay taxes. While this structure limits the personal liability of the shareholders, it does not render them entirely immune to liability. It is important to know that to restructure to an S corporation you must have previously operated as an LLC. An S corporation can have up to 100 shareholders while an LLC can have as many members as it likes.
Lenders are very familiar with this structure and more willing to consider them for loans over sole proprietorship, partnerships and LLCs. If you choose an S corporation as your business entity, you must hold annual shareholder meetings and keep additional records for reporting to the government.
The above post is just an overview. Especially since issues around incorporation can be complicated. You should consult your CPA or arrange to work with a WVF advisor to determine which structure fits your business at any particular stage of growth. Start and continue your venture on the right foot!
Join us on September 29th to discuss this and other financial concepts and tools critical to entrepreneurs.
Details: Hacking Your Entrepreneurial Finances.