The First Key Decision
Last week I discussed the first of two key decisions you have to make when starting a business. If you missed it click here to read it now.
In the article I explained how important it is to have a solid business model. It’s the business model that determines how and what you will do in your business.
I also talked about the revenue model. It’s a subset of the business model. It outlines the different streams of revenue that will bring in income for the business.
The Second Key Decision
Today, let’s look at the other key decision you will have to make: which business structure or legal entity to select.
But what is a legal entity or business structure? And why do I have to choose one in the first place?
Good questions!
Let’s start with what is a legal entity.
A legal entity is a business or organization with standalone legal rights and obligations. This is comparable to the rights and obligations you have as an individual.
The kinds of legal rights and obligations of the business are determined by the business structure selected at startup.
This point is so important that it’s worth repeating.
Depending on the legal structure selected, your business has different rights and obligations.
And that’s why choosing a business structure is a key decision in your business!
Disclaimer
Before I write another word…here is my disclaimer.
I am not an attorney or accountant. The information contained in this article is informational in nature and does not replace qualified legal or tax advice.
With that out of the way, let’s continue!
Business Structures
There are a handful of business structures to choose from. Included is a brief description of each based on two main criteria:
- Asset protection/liability for business debt.
- Entity taxation of business profits.
Sole Proprietorship:
This is the simplest structure of all. Even though tempting because of its simplicity, it’s a structure you may want to stay away from.
- No asset protection; personal liability for all business debts.
- Owner taxed at individual tax rate.
Partnerships (General and Limited):
- Asset Protection/Liability:
- Entity Taxations:
- General Partnership: personal liability
- Limited Partnership: personal liability for general partner, no personal liability for limited partner
Limited Liability Company (LLC):
- No personal liability.
- Note: banks and businesses often ask for a personal guarantee on loans or other purchases, particularly when business is new.
- Individual tax rates of member/s unless LLC elects corporate taxation.
Subchapter S Corp (S Corp):
- No personal liability of shareholders.
- Taxed at individual tax rates of shareholders.
C Corp:
This is the most involved structure, both with respect to formation and formalities/maintenance.
- No personal liability of shareholders.
- Taxed at the corporate level; taxed on distribution to shareholders.
Are you left wondering…? “Which one is right for me? How do I choose?”
That’s the million-dollar question, isn’t it?
The best answer depends on your specific situation. Things are rarely clear cut and this is no exception.
Keep in mind that there is not one “right” answer here. Different situations call for different solutions.
Here are a few considerations to help you get started with selecting the best structure for both you and your business. Keep the following in mind when you’re trying to evaluate which business structure is best for you.
- Liability: what type of business or practice do you want to start? What is the projected level of liability?
- Asset protection: are there family assets to protect? Do you or your spouse own assets you need to protect?
- Taxation: are you single or married? Do you own other businesses or income producing assets? How will the business be taxed? Pass through taxation or entity taxation?
- Location: what state is the business in? Does state law allow or require you to organize in a certain way, i.e. Professional Corporation/Professional Service Corporation?
- Ability to obligate the business: will you practice alone or will there be business partner/partners who could obligate the business with debt?
- Succession: what will happen to the business if you want to retire or just do something else? What will happen if the owner should die?
- Ease of management: will you manage the business by yourself or are there others that will manage the business with you? How will disputes be handled?
- Raising capital: is there a need to raise capital to start the business or perhaps during the life of the business?
I know, this is a lot to digest… But don’t let it overwhelm you.
Think about what you’re trying to accomplish for your personal situation and for your business. Get some help from a trusted advisor and move forward.
If need be you can change your business structure later down the road. However, I suggest that you only do this if you absolutely have to. In other words, don’t pick a business structure thinking “I’ll just change it later…”
What would happen if …?
Perhaps you’re wondering what would happen if you just don’t bother with picking a business structure for now?
Well, it would depend on if you’re working by yourself or with a partner.
If you’re working alone, without a business partner, the default legal structure is that of the “Sole Proprietorship”.
In other words, if you’re starting a business without picking a structure this is what the business would default to. Not a good option for any business, if you ask me. No protection whatsoever!
If you’re starting a business with a partner without picking a structure, your business would default to a “General Partnership”. Again, not a great choice.
Here you could be held liable for debts taken on by your business partner, regardless if you knew or didn’t know about the debt.
So here is what to do next…
Get clear on what your needs are with respect to asset protection, liability, and taxation. Get help from a tax or a legal professional, or perhaps from both.
Ask yourself these questions:
- What are the long term goals for my business?
- Would the business entity I’m considering help me accomplish these goals or would it make it more difficult?
And choose accordingly.
Your Turn!
Have you chosen your business structure? How did you come to that decision? What questions still remain?
Leave your comments below.
By Johanna Hofmann, MBA, author of “Smart Business Planning for Clinicians” and regular contributor to the NPBusiness blog.