The “Plusses” and “Minuses” of Different Formation Structures for a Business

One issue that plagues business owners is, “Do we have the right formation structure for what we want to accomplish as a business, for minimizing taxes and setting it up for our exit?” While there is a lot that goes into making these decisions, here are some highlights of the main “Plusses” and “Minuses” of three types of business entities.

Sole Proprietor

While the majority of businesses in America are set up as Sole Proprietorships, this structure isn’t the best structure for most businesses. There is no question; it is the simplest formation structure. But there’s more to this than meets the eye.

PLUSSES

Very easy to set up…almost no effort since it usually uses the individual’s social security number or a simple employer identification number to get started.

Business can start or stop almost immediately without much effort or expense.

Business profits are taxed at the individual owner’s rate.

​MINUSES

The biggest one is unlimited liability…the owner is liable for all debts and other legal issues.

The business usually ends when the owner calls it quits since there isn’t much “carry on” value to sell.

Raising capital can be difficult…not many people want to invest in another person, and it isn’t easy to sell or dispose of the interest.

PLUSSES

Very easy to set up…almost no effort since it usually uses the individual’s social security number or a simple employer identification number to get started.

Business can start or stop almost immediately without much effort or expense.

Business profits are taxed at the individual owner’s rate.

​MINUSES

The biggest one is unlimited liability…the owner is liable for all debts and other legal issues.

The business usually ends when the owner calls it quits since there isn’t much “carry on” value to sell.

Raising capital can be difficult…not many people want to invest in another person, and it isn’t easy to sell or dispose of the interest.

Limited Liability Company or LLC

Limited liability companies are probably the most favored by business advisers because they’re very flexible in design. You can create whatever sort of ownership structure you want. You can create whatever management structure you want, and you’re not bound by most state statutes that require certain formalities. There’s a subset of a limited liability company, and that’s called a professional limited liability company. These entities are organized by doctors, lawyers, accountants, architects, other licensed professionals.

PLUSSES

​Liability protection is a key advantage…this structure allows owners (or members) to protect their personal assets and liabilities from creditors.

There is flexibility in how these are structured so it allows the owners to be creative about how they are set up and run. .

Generally, the profits of the business are treated the same as with a sole proprietor for single-member LLCs and taxed like a partnership if it is a multi-member LLC.

Or, the members can elect to have the LLC taxed as a corporation. More on corporations below.

​MINUSES

Every multi-member LLC should have a written operating agreement.

There are ongoing tasks to maintain these structures, such as annual filings, and other requirements.

In the absence of a competently written operating agreement, owners can operate independently, which can cause issues among the owners.

​Corporations – “C” or “S”

Finally, there are corporations. There are two types of corporations for tax purposes. C corporatins and S corporations. C corporations refers to subchapter C of the Internal Revenue Code. The problem with C corporations for small businesses is that the income is subject to double taxation. The government first taxes corporate profits and then collects a subsequent tax when the corporation pays dividends to the shareholders.

A subchapter S corporation is taxed much like a partnership, but the shareholders have limited liability. Stockholders can protect their personal assets from the claims of business creditors. There are nuances because if the business owners sign personal guarantees when their company borrows money from the bank, their personal assets are going to be subject to the bank’s collection efforts.

PLUSSES

​Owners are separated from the risks and liabilities of the business.

Ownership is easy to transfer to others through stock sales, stock options, employee stock plans, succession plans, etc.

LIfe of the business can go on well past the owners’ time in the business.

Raising capital can be easier for a corporation.

​MINUSES

​More regulations, rules and compliance issues to be aware of and comply with.

​What to do next…

The most important thing to do is get advice before you decide on which structure is best for you, your situation, and your company. The interesting thing is that once you make a choice, you’re not stuck with the choice for the rest of your business life. There are statutes in most states that allow business owners to convert the ownership structure from one entity to another.

If you have any questions about structure or formation or any other aspect of your business, just ask and we’ll be happy to answer them. Or if you want to better understand how you can minimize and lower your risks (which every business owner wants) then please read some more about risk management and how you can help determine your own risk. I’d also be happy to meet with you (complimentary of course) to discuss your personal situation further and give you some insights about how you might want to proceed.

I hope you have found this helpful and given you a different way to look at your business. If it has, please share this with others inside your company and your colleagues who are running or leading other businesses. Our primary mission at Generations Law Group, LLP is to help everyone find productive ways to lower their business AND personal risk. This is just one way you can start to do this…but it will tell you a lot about you and what has happened over the past few years about your business risk. Let’s make sure your risk is as low as it can be while you continue to grow.