Choosing A Business Structure

July 10, 2018by Brian Walsh

New owners often overlook administrative details, especially those affecting the formation of the business, to focus on the “real business” – arranging financing, buying equipment, setting up an office, and hiring employees. The Service Corps of Retired Executives (SCORE) considers the choice of business structures one of the most important business decisions founders make, even though its impact may not appear for months, even years in the future.

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 building 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 MotivationsFor Implementing A
Formal Business Structure?

Are you trying to resolve a business challenge, issue, or problem? Or are you just formalizing your business because someone told you to?

If you are choosing and implementing a business structure just because someone told you needed to, stop. Just because is not a good reason. You need to take the time to understand the “why.” Otherwise you could make a choice that could do more harm than good. Taking time to consider your motivations and the reasons why you want to formalize your business into a company will provide insight to guide your decision making process on which business structure you ultimately decide to implement.

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.

Six FactorsTo Consider When
Choosing A Business Structure

As you examine the different types of business structures there are six essential factors that you will want to pay particular attention to.

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.

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.

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1. How to best protect the owners from personal liability?

One of the primary advantages of using a legal entity for your business is to protect the owners from debts and other liabilities related to 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.

2. How to minimize tax exposure?

Nobody wants to pay more in taxes than they have to. However, if you do not have a legal business structure of some kind, your tax flexibility will be limited.

Taxes are a complicated, constantly changing area of law. 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.

3. How will profits be distributed?

How do you plan on withdrawing your profits? Are there multiple owners? How will those profits be distributed?

You are not creating a business just for fun. You hope to earn profits from all of your hard work. 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.

4. How will decisions be made?

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.

5. What is the 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.

6. Will You Need To Raise Capital?

If you are planning on obtaining outside funding, then the business structure you choose will have significant influence on the type of capital available to you.

For instance, banks are pretty leery about providing business loans to sole proprietors and partnerships; at least that is without personal guarantees. Although LLCs and partnerships rely on owner contributions and loans to raise capital they can raise capital by adding partners or members to the business. However, doing so is far less flexible than raising funds through a corporation. For that matter, raising capital through a C Corporation is far more flexible than raising capital through an S Corporation.

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.

Business StructuresCan Be Grouped
Into Two Broad Categories

At their most basic level, business structures can be separated into two distinct categories informal or formal.

Informal Business Structures

Informal business structures; such as, sole proprietorships and partnerships, have minimal to no registration requirements and do not provide separation between the owners of a business and the business itself. Because of this lack of separation, the law sees the owner of the business and the business as one entity. These types of businesses usually start off as hobbies, are very low risk, and are often very small with a small customer base and don’t require or are not planning to obtain outside financing.

The only distinct advantages of informal business structures are that they can be started faster, have lower upfront costs and are simpler and cheaper to operate and maintain.

While fast and cheap may sound good, informal business structures have some serious disadvantages as well. First, and most importantly, they provide no liability protection. This means the personal assets of the owners are at risk if debts can’t be paid or the business is sued. There are zero tax benefits for these types of structures. And due to a lack of credibility and a low potential for outside funding they have very limited growth potential.

Formal Business Structures

In contrast, formal business structures; such as, limited liability companies ( LLC ) and corporations, are more complicated and expensive to start and maintain. But, they have the added value of being seen as a separate entity from the business’ owners. This separation provides owners a level of protection from the business’ liabilities, like bad debt or business related lawsuits.

Greater personal liability protection is usually the primary motivator for implementing a formal business structure. However, these structures also provide tax benefits, make it easier to obtain outside funding and investment, more flexible profit distribution, and provide a structure for managing the business.

What Are

Common Types of
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.

1. Sole Proprietorship

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Anytime you provide a product or service you are operating as a sole proprietor. When you start a business on your own, the default structure is a sole proprietorship. Unless you file paperwork to become an LLC, a corporation or some other entity the business will remain a sole proprietorship.

A Sole proprietorship is considered an informal business structure. Since there are no paperwork or registration requirements it is the simplest business structure to start. And since there are no annual filing requirements or corporate formalities it is the easiest to maintain.

Anytime you provide a product or service you are operating as a sole proprietor. When you start a business on your own, the default structure is a sole proprietorship. Unless you file paperwork to become an LLC, a corporation or some other entity the business will remain a sole proprietorship.

A Sole proprietorship is considered an informal business structure. Since there are no paperwork or registration requirements it is the simplest business structure to start. And since there are no annual filing requirements or corporate formalities it is the easiest to maintain.

However that ease of use does come at a price. With a sole proprietorship there is no distinction between the owner and the business. Unless you file a DBA (Doing Business As) you must do business in your own name. And you cannot pay yourself wages but instead draw funds.

What you should know about sole proprietorships:

  • Personal Liability Protection: Because the law makes no distinction between a sole proprietor and the business you are personally responsible for all debts, fines and legal judgements incurred by the business. In other words your personal assets can be taken to satisfy any debts incurred by your business.
  • Tax Exposure: Sole proprietorships are pass-through entities. This means that all profits and losses pass through from the business to the owner and are subject to personal tax rates. Moreover, unlike a corporation or LLC, you will be taxed on total net income that includes all funds you may set aside to grow the business.
  • Raising Capital: If you borrow funds from traditional institutions like banks or credit unions you will likely have to personally guarantee the loans. Otherwise, you may be stuck borrowing from close family and friends. Because there can only be one owner of a sole proprietorship you cannot sell stock to raise funds either
  • Maintenance: Except for maintaining proper records, permits and licenses there are no yearly maintenance requirements.

Most sole proprietorships are very small businesses that involve very little risk; like, consultants, small service providers, or freelancers. However, because of the high risk of personal liability and the other detractors to this business structure we highly recommend that you consider implementing safer and more flexible structure like an LLC.

2. Partnerships (General & Limited)

A partnership is an informal business structure. It is essentially a sole proprietorship with more than one owner.  Unlike sole proprietorships partnerships have rules set out by state law –  Chapter 620 Florida statues and must register with the Division of Corporations.

Although there are several types of partnerships recognized in Florida, we’re going to go over the two most common – general partnership and limited partnership.

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General Partnership: In a general partnership all the partners equally share in the business’ profits and losses and all associated debts and liabilities. Each partner participates in, and equally responsible for, the management and day-to-day operations of the business. General partnerships have all 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.

Limited partnership: In a limited partnership there are general partners, who manage and operate the day-to-day operations and there are limited partners, who are only investors. Limited partners have less liability, usually restricted to what they have invested, because they have no control over the operations of the business. General partners, on the other hand, are liable for all the business debt and liabilities.

There are three other types of partnerships recognized by Florida law: LLP (Limited Liability Partnership), LLLP (Limited Liability Limited Partnership, and FLP (Foreign Limited Partnership). We’ve left these out because they have specific use cases that ninety plus percent of people reading this post won’t relate to.

To defer costs and limit the risk involved in starting a business, many initially start out as partnerships. If this is the route you’ve decided to go, we would highly recommend having a business attorney put together a partnership agreement for you. A partnership agreement is essentially a contract between all the participants that outlines how the business will be managed, assignment of roles and duties, contributions, distribution of profits and losses, how decisions will be made, and disputes resolved; as-well-as a host of other issues.

3. LLC (Limited Liability Company)

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LLCs (Limited Liability Companies) are the most popular formal business structure for small to medium sized businesses.

They were originally created to allow small businesses to benefit from the liability protections of a corporation, without all of the formalities.

LLCs are used in nearly every industry and can work well for businesses of nearly any size.

Owners of an LLC are called members. An LLC can have a single member or multiple members. Multi-member LLCs must elect to either be member managed or manager managed.

In many ways a single-member LLC can be thought or as a hybrid of a sole proprietorship and a corporation. Similarly, a multi member LLC can be thought of as a hybrid between a corporation and a partnership. In essence an LLC is a hybrid between informal and formal business structures.

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.

Florida LLC law also provides for 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, it doesn’t shield their personal assets from professional malpractice liability.

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.

What you should know about LLCs.

  • Personal Liability Protection: 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. 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.
  • Tax Exposure: 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. 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. 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.
  • Raising Capital: 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.
  • Maintenance: 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.

4. Corporations

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.

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General Advantages of Corporations

  1. 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.
  2. Tax advantages related business expenses and deduction of employee benefits like health and life insurance.
  3. Because corporations can issue stock it is easier to attract investment capital.
  4. Banks tend to be more willing to provide credit to corporations.
  5. Forming a corporation may help a new business develop credibility with customers, vendors, investors and potential employees.

General Disadvantages of Corporations

  1. It is more complicated, expensive and time consuming to form a corporation relative to other business entities.
  2. To maintain corporate status certain corporate formalities must be adhered to. Corporate maintenance can be complicated, time consuming and expensive.
  3. 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.

Need help choosing a business structure or setting up a business entity? Give us a call (407) 259-2426 or Schedule a Free Confidential Consultation

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