What Are Your Motivations for Implementing a Formal Business Structure?
When you are starting a new business you have a lot of decisions to make. If you are struggling with deciding on the right structure for your business, you are not alone. With so many legal entities to choose from it’s easy to understand how a business owner could get confused. It is one of the most important decisions you will have to make. This one decision will have an inordinate impact on everything from how your business operates to the availability of future growth opportunities. Whether you are starting a business from the ground up, buying an established business, or purchasing a franchise there are a few critical questions you should ask before making a decision about which business entity to adopt.
Common motivations for formalizing a business structure:
- You want separation between yourself and your business.
- Improve the business’ credibility.
- You want to reduce personal liability.
- You want to reduce tax liability.
- You want to bring on partners or other business principals.
- You want to bring on investors.
- You want to establish credit in the business’ name.
- Liquidity (Easier to sell or transfer ownership).
- Privacy and confidentiality.
- Easier access to bank services.
- Shelter an investment.
What challenges, issues, or problems are you trying to resolve? Taking time to consider your motivations and the reasons why you want to form a company will provide insight to guide your decision making process. You’ll also want to consider the advantages and disadvantages of each business entity.
Primary Considerations When Selecting a Business Entity
Choosing the correct structure for your business requires a good understanding of business law, your business model, and the specifics of your personal situation. Every business entity works slightly differently and each has its own advantages and disadvantages. Some types of business structures are extremely flexible while others are totally inappropriate for certain scenarios. As you examine the different types of companies, consider how each type would affect your specific needs in these five areas.
When evaluating your options you should consider the following five factors:
- How to best protect the owners from personal liability
- How to minimize tax exposure
- How business profits will be split
- How will decisions be made
- What is the compliance burden of a given business structure
Businesses, like people, are unique. They have different motivations, goals, and interests. How the business entity is formed, and making sure those unique motivations, goals, and interests are properly outlined in the formation documentation and agreements, is just as important as choosing the legal structure.
The lawyers at Walsh Banks Law have decades of combined experience helping individuals, entrepreneurs, and companies of all types and sizes work through the business formation process. We can help you work through these questions and explain, in-depth, how each entity may help or hinder the pursuit of your goals. We can provide insight and scenarios, relevant to your situation, which you likely have not considered.
We can also put together the proper documents, agreements and contracts so that the unique goals, motivations and interests of the business and its owners are properly outlined and documented, mitigating potential of future business disputes.
Protecting Owners From Liability: One of the primary advantages of using a formal legal company structure for your business is to protect the owners from being personally liable for the debts of the business. Without this type of protection, if your business is sued for anything from a breach of contract to someone slipping and falling in your parking lot, your personal assets could be at risk. If someone gets a high enough judgment against you they could place a lien against your family home or your personal bank account.
The two primary ways people can protect themselves from this risk is through insurance and forming some type of legal business entity. However, only properly setting up a legal business structure can completely shield business owners from personal liability for business issues. Insurance policies have a variety of conditions and they have policy limits. If your business were found liable for an amount that exceeds insurance limits, without some type of legal business structure your personal assets would still be at risk.
Minimizing Tax Exposure: Nobody wants to pay more in taxes than they have to. However, if you do not have a legal corporate structure of some kind, your tax flexibility may be limited. Taxes are a complicated area of law and they are constantly changing. Before making any decisions about the business structure, you need to evaluate how it will affect your personal income taxes and any corporate income taxes.
Some people may benefit from using a type of business structure where they receive profits as capital gains that are taxed at a lower rate. However, until you consult with a lawyer or accountant, you can only guess at how a given business structure might affect your taxes. Your tax exposure with any business structure will also depend on your ownership level and how the organization splits profits among the owners.
Distributing Profits: You are not creating a business just for fun. You hope to earn profits from all of your hard work. However, how do you plan on withdrawing your profits? Are there multiple owners? How will those profits be distributed? The type of business structure you have will not only affect your taxes, but it will also determine how you can withdraw profits and what types of profit splitting is allowed. Many business owners have found that by choosing the wrong business entity they ended up losing significant profits because a court found the way they were splitting profits was not legal under their business structure.
If there will be multiple owners of a business or if it is anticipated that later there will be a need for venture capital financing, it is especially critical to make sure you have a company structure that will allow the profits to be distributed in a way that is fair and that meets all of the stakeholders expectations.
Decision Making: When you are just starting out you mat not worry too much about the formal decision making process in your business. But, as your business grows issues about who has the authority to make what decisions could undercut your ability to make deals or grow as quickly as you want to. It is even more important to make sure the lines of authority are clear when multiple people own the business.
Different business structures allow for different types of decision-making processes and lines of authority. If you want to avoid a legal battle in the future over who is in charge of your business, you have to choose the right business entity. You will also want to make sure those details are spelled out in any legal formation documents drafted by your business lawyer.
Compliance Burden: When choosing a business entity you are also committing to doing what is needed to maintain the legal status of your business. Different types of companies have different types of compliance burdens. You need to make sure you understand what the costs of compliance will be for your business. Are you required to have any annual meetings? What types of documentation of these meetings is required? What are the annual fees for keeping the business in solid legal standing with the State of Florida? What documents must the business maintain and what forms must be filed? Each type of business structure comes with a different compliance burden. You will need to know the answers to all of these questions before you decide what business structure is right for you.
Common Types of Business Structures
The most common types of business structures are, sole proprietorship, partnership, limited liability company, and corporation. Each business structure has a unique use and purpose. Depending on the purpose of the business and your motivations for choosing a formal business entity, they each have their pros and cons.
Choosing the wrong type of business structure for your needs or if you fail to properly setup the business entity, you could find that your growth opportunities are limited or that you have unintentionally opened yourself up to unforeseen legal and financial liabilities. You may find yourself in a situation where you have to reorganize, which can be costly and time consuming.
What follows is a brief discussion about each business structure and their pros and cons related to common motivations and considerations.
Major business entity types in Florida include:
- Sole Proprietorships
- Partnerships (General Partnerships and Limited Liability Partnerships)
- Limited Liability Companies
- Corporations (C Corporations and S Corporations)
When you start a business on your own, the default structure is a sole proprietorship. Even if you never incorporate or complete any paperwork, your business will still be considered a sole proprietorship. Most small businesses start out as a sole proprietorship and many operate for years without a more formal business structure. However, there are a lot of risks to running your business this way.
Any business in any industry can be a sole proprietorship so long as there is only one owner. By definition, if there is more than one owner a business cannot be a sole proprietorship. If there is no formal incorporation documents, you will have some type of partnership.
Legally, a sole proprietorship should do business under the name of the owner. If you want to have a separate business name, you would need to complete the legal documents for a “Doing Business As” (DBA) name. Without properly setting up a DBA you cannot even have a checking account in any other name but your personal name.
Pros of Sole Proprietorship
This is one of the few business structures for where there are not really any advantages that are distinct from what you can get with other types of business structures. The reason so many people remain sole proprietorships is because this structure doesn’t require any maintenance and it doesn’t require any legal filings.
With a sole proprietorship there is no need for a separate tax return. You should complete a Schedule C, but you can file it with your personal return.
If you are seeking any kind of financing, you may be able to get better rates by making yourself personally liable for the loan than the rates you would get with commercial financing.
When you are a sole proprietor you are not required to hold any annual meetings, keep any kind of minutes, or pay any annual fee to keep your business structure in compliance with the law.
However, you can use one of the various pass-through options discussed below to get the benefit of your profits being taxed as personal income. You can always sign a personal guarantee with any type of business structure if a lower interest rate is critical. You don’t have to pay fees for incorporation, but you will most likely have to pay fees to set up a DBA.
Cons of Sole Proprietorship
The biggest disadvantage of being a sole proprietor is the liability risk. Your family home and the rest of your personal assets are always at risk when you don’t have a formal, legal business structure.
You are personally liable for all business debts. If someone sues your business because of an injury, a breach of contract, or any other reason, they are suing you personally. If they get a judgment against you they can put a lien on virtually everything you own until the debt is satisfied.
You can remain a one-person business and still form a business entity that will protect your assets like a corporation or LLC. Different business structures also give you more tax flexibility than you can have as a sole proprietor.
If you are serious about your business, there is no reason to remain a sole proprietor. It creates too many business risks.
General Partnerships and Limited Liability Partnerships
If more than one person owns a business you cannot be a sole proprietor. If you have not completed any formal incorporation documents, you have a general partnership.
A general partnership means that all the owners share in the profits and liability of the business. If there is not a written agreement about who owns how much of the business, the law will assume that everyone is an equal partner.
General partnerships have all of the disadvantages of a sole proprietorship. But, instead of just being on the hook for your own mistakes, you are also personally liable for the business mistakes and negligence of your partners.
Florida allows people to form a limited liability partnership (LLP). This type of company allows people to form a partnership where all of the partners avoid personal liability for the actions of the business.
Pros of LLPs
LLPs allow you to have a business owned by multiple people and still shield your personal assets. Anyone pursuing a claim against the business will be limited to the assets of the business.
LLPs are a type of pass through entity. That means that any profits are passed-through to the partners and taxed at their personal income rates. For most small businesses this gives the owners greater tax flexibility.
Having an LLP ensures that there is a formal document that lists everyone’s percentage of ownership and how decisions are made. This helps the business run smoothly and can prevent major power struggles based on misunderstandings later.
You can create any type of profit split that you want with your partnership agreement. You do not have to make everyone equal partners.
Cons of LLPs
LLPs are not a great fit for every type of business. LLPs are not as flexible as limited liability companies when it comes to ownership issues and profit sharing.
LLPs must be properly maintained if you want to benefit from the asset shielding features. This means holding an annual meeting and keeping proper records. Failure to do this can allow a creditor to ask a court to pierce the corporate veil and put the personal assets of the partners at risk.
Whenever you want to make changes in ownership, including adding a new partner, you will need to revise the partnership agreement.
The LLP will need to file a separate tax return and send tax forms to all of the partners indicating how much money they earned in profits from the organization. Sometimes, when a business makes significant amounts of money, having an LLP can become cumbersome and expensive from a tax perspective.
Limited Liability Companies
The most popular formal business structure for small and medium businesses is a limited liability company (LLC). Owners of an LLC are called members. The legal document that establishes the LLC and sets the conditions for how the company will be run is called the operating agreement.
An LLC can have a single member or multiple members.
Florida law has a special type of LLC for certain professionals like doctors and lawyers. The professional limited liability company (PLLC) is used to provide professionals with the same tax advantages and protections from certain types of liability that LLCs provide with one key difference. Certain professionals are not allowed to shield their personal assets from professional malpractice liability with a corporation or LLC.
LLCs are used in every industry and can work well for both large and small businesses. Often LLCs are used as holding companies to provide extra layers of protection.
Pros of LLCs
LLCs were first created to allow small businesses to benefit from the liability protections of a corporation, without all of the formalities. LLCs are relatively cheap to maintain compared to LLPs and corporations.
LLCs are another type of pass-through entity when it comes to taxes. All profits are distributed to the members according to the operating agreement. However, the profits can be split however the members decide. The agreement can allow each member to share the profits equally, on a pro rata basis as determined by the capital invested, or any other formula. Real estate investors often use LLCs to reward the sweat equity of members who did not put up any capital, but instead handled the physical labor on a particular project.
LLCs are also flexible when it comes to setting up the line of authority and decision making processes. As long as everything is detailed in the operating agreement, the members can create almost any type of internal organization they want.
The members of an LLC do not have to be people. Other LLCs, corporations, or partnerships can also be members of an LLC. This is one reason LLCs are often used as holding companies.
Cons of LLCs
LLCs are not perfect for everyone. Some businesses need the more formal structure of a corporation, board of directors, and shareholders for peak performance.
Because it is a pass through, LLCs in some instances can make ownership more expensive from a tax perspective than a corporation would be.
In order for the members to continue to benefit from the liability protections of the business structure, annual fees need to be paid and the appropriate corporate records must be maintained. While annual maintenance costs are not excessive, and are less than those for a corporation, they are not negligible.
Sometimes lenders will refuse to loan money to an LLC without a personal guarantee from one or more of the members or they charge higher interest rates. If a member signs a personal guarantee and the business fails to repay the debt, the creditor can pursue the personal assets of anyone who signed the guarantee to repay the loan.
The LLC will be required to file a separate tax return if there is more than one member. It will also need to file tax forms that delineate how much of the profits were distributed to each member.
Corporations, unlike other business structures, are considered to be legal entities distinct from their owners, known as shareholders. While shareholders own the corporation, it is managed by a board of directors that is responsible for hiring a management team. All corporations share similar advantages and disadvantages:
All corporations no matter the type share similar advantages and disadvantages:
General Advantages of Corporations
- Limited liability protection for shareholders. Because corporations are considered a separate legal entity distinct from its shareholders, owners are shielded from tax, debt and other liabilities of the corporation.
- Tax advantages related business expenses and deduction of employee benefits like health and life insurance.
- Because corporations can issue stock it is easier to attract investment capital.
- Banks tend to be more willing to provide credit to corporations.
- Forming a corporation may help a new business develop credibility with customers, vendors, investors and potential employees.
General Disadvantages of Corporations
- It is more complicated, expensive and time consuming to form a corporation relative to other business entities.
- To maintain corporate status certain corporate formalities must be adhered to. Corporate maintenance can be complicated, time consuming and expensive.
- Potential for Double taxation depending on tax designation.
Corporations can be grouped into four groups; for-profit, not-for-profit, social benefit and professional. Each of these designations have their own characteristics as well:
For-profit corporation: These types of corporations are exactly what they sound like. They exist to create a profit for their shareholders. When we think of the idea of corporations this is what we commonly have in mind. Corporation is essentially a legal designation. From a tax perspective their are two different types of corporations; C-Corporation and S-Corporation. Both types are defined by the IRS and derive their name from the sub-chapter of Internal Revenue Code the are defined by.
- C-Corporation: Is essentially a standard corporation. It is a separate legal entity that is taxed separately from its shareholders. There are no shareholder restrictions placed on C-Corporations.
- S-Corporation: Is a pass through entity, avoiding double taxation associated with C-Corporations by passing all profits, losses and deductions onto shareholders. To qualify as an S-Corporation
- The corporation must file IRS Form 2253.
- Have no more than 100 shareholders.
- Partnerships, corporations and non-resident aliens cannot be shareholders
- Can have only one class of stock.
Not-for-profit-corporation: Also known as 501c organizations. They are focused on providing a public good and are not intended to turn a profit. Because these organizations are “nonprofit” in nature they are exempt from paying taxes. There are a lot of restrictions placed on these organizations and are heavily scrutinized by the IRS.
Benefit Corporation: Is a for profit corporation whose focus is on creating a social benefit. The advantage of this type of entity is that they are not restricted by complicated 501c rules and regulations. But, they do have to pay taxes. Instead of being focused on profits directors and managers of a B-corp are focused on creating long term sustainable value as related to their legally defined social benefit.
Professional Corporation: Professional service corporations are a special business entity designed to allow licensed professionals that would normally not be allowed to incorporate to do so. Although a PC will protect its shareholders form business liability, and it allows for similar tax treatment it does not protect individual members from professional liability (malpractice). All shareholders must be licensed to provide the same professional service, be another professional corporation or PLLC.