Selecting a corporate structure is one of the most important startup decisions that a business owner makes. But choosing the wrong one is a common mistake.
According to Jerome Katz, professor of management at Saint Louis University, small businesses that choose the sole proprietorship structure — and 70% of small businesses do — should revisit their decision. “This is the scariest of all three because everything you have is on the line,” Katz says. “Yet it’s the dominant corporate structure, and one that many startups choose.” While sole proprietorship is the cheapest way to start (it can be formed by simply choosing a location and finding a few customers), the owner, who has absolute authority over all business decisions, is held personally liable.
To avoid future problems, tap the advice of an accountant or lawyer who is familiar with small businesses and can guide you through the process, says Judith E. Dacey, CPA, and owner of Orlando-based Small Business Resources Inc. “The selection of an entity that will build your business foundation has far-reaching consequences,” she adds. “There’s no one-size-fits-all solution. The choice should be customized to fit your new business.”
Here are a few general guidelines to help you sort through the pros and cons of business structure.
Sole Proprietorship: A business that is owned by one person or a husband and wife. Unless the business is formed as a corporation or a limited liability company, it will be a sole-proprietorship by default.
Pros: This structure costs the least to set up and losses are deductible against other income.
Cons: The sole proprietor is responsible for 100% of all business debts and obligations. This liability covers all of the proprietor’s assets, including his or her house and car. The death, physical impairment, or mental incapacitation of the firm’s owner can result in the termination of the business.
Partnership: An agreement between two or more business partners to carry on a trade or business. Each partner contributes money, property, labor, or skills and each expects to share in the profits and losses.
Pros: Startup expenses are kept to a minimum. Legal documentation is more straightforward and less complicated than that needed for incorporation.
Cons: One or more partners must assume business risks and purchase considerable insurance to protect the business.
Limited Liability Company (L.L.C.): A hybrid between a partnership and a corporation in that it combines the “pass-through” treatment of a partnership with the limited liability accorded to corporate shareholders.
Pros: The business can be transferred to new owners by agreement and losses are deductible against other income. If partnership tax treatment is taken, profits and losses can be allocated as preferred to owners and, if desired, owners can select to be treated as a corporation or S-corporation for tax purposes.
Cons: L.L.C.s cost more to set up and file taxes for. In addition, case law is untested, so in the event of litigation, outcomes are not certain. Potential customers may be concerned that an L.L.C. doesn’t have to stand behind its product because its product liability is limited by law.
C-Corporation: A separate legal entity formed under state law that has authority to act in a manner that is distinct and independent of its shareholders. A C-corporation is subject to U.S. federal income taxation at the entity level — the income or losses of a C-corporation do not flow through to shareholders.
Pros: A good way to shield yourself from financial and legal liability. Owner enjoys limited liability for business debts and fringe benefits are deductible as business expenses.
Cons: Active owner must be paid as an employee, C-Corps cost more to
set up and file taxes for, and losses are deductible by the corporation only. There’s also the potential for double taxation (when the corporation is taxed and dividends of remaining profits are taxed again when distributed to owners).S-Corporation: This is basically a C-corporation that has elected a special tax treatment with the IRS. While C-corporations pay corporate income tax on the profits they generate, taxes are deducted from the individual stockholders of the S-corporation.
Pros: Personal assets will not be at risk because of the activities or liabilities of the S-corporation. S-corporations generally do not have to pay corporate-level income tax. Instead, the corporation’s gains, losses, deductions, and credits are passed through to the principal owners and shareholders and are claimed on individual returns.
Cons: S-corporations cannot have more than 75 shareholders and corporations. And nonresident aliens, and most estates and trusts, cannot be shareholders.