Are you looking to start a business?
Struggling to figure out what types of business entities to create?
Trying to optimize the structure to minimize taxes and potential liability?
S-Corps, C-Corps, LLC, B-Corp, and more. We discuss why it is important for your company or your investment.
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Margo’s Guide to Types of Business Entities
Starting your own business is quite possibly the most exciting decision you’ll make your entire working life. But once you take that leap of faith you’re faced with a great big stack of questions.
Most of these are of the exciting variety—which products or services am I going to sell? How am I going to get my new brand out there? What am I going to do with all that cash when I’m heading up the next Google? (OK, maybe don’t spend too much time on that last one).
But alongside the fun stuff there are some rather more boring—but equally important—questions you need to be asking.
People call me up on an almost daily basis to ask for advice about one of these questions in particular:
Which types of business entities are right for me?
The truth is, there’s no right or wrong answer here (when is there ever?!). But there are clear pros and cons to each structure, and generally speaking there will be an option that makes the most sense for your business.
And this question isn’t just for new businesses either—over the years I’ve seen a shocking number of firms that are losing a ton of money by virtue of being classified under a sub-optimal business entity.
Since sharing is caring, I’ve put together this quick guide covering some of the most important aspects of the common entity types young businesses tend to adopt.
Sole proprietorships are the first of the types of business entities most entrepreneurs consider when starting their company.
They’re simple to set up and run, and the business owner has full control over all aspects of the business. All the company’s profits and losses are the responsibility of the business owner, who is also the sole decision maker. In fact, the simplest way to look at Sole Proprietorships is to view the business and the owner as effectively the same thing.
While this total control is a benefit in some senses—when it comes to decision-making, for example—the lack of separation between business owner and business has important implications when it comes to financial liability.
Here are the pros and cons:
- Simple setup
- Full control of decision-making
- Business losses offset income earned from other sources
- You as the owner are completely responsible for any losses your business suffers
- In addition to the above, your liability is completely unlimited. This means your own assets are on the line if your company goes bankrupt, and could therefore be seized to satisfy business debts or legal claims filed against you
- As owner, you’ll pay personal income taxes on your business’ net profits
- It’s generally difficult to raise money as a sole proprietorship, meaning you’re likely to have to finance your business using your own resources, such as savings, personal loans, or home equity
Corporations are rather more complicated than sole proprietorships, allowing business owners to make their companies entirely separate entities. Crucially, this entity is also distinct from its owner in the eyes of the law, meaning the owner’s liability is limited, and the business itself has its own set of legal rights. This means a corporation can raise capital, buy real estate, sue, and be sued.
Corporations are owned by a list of shareholders who then elect a board of directors. It’s the responsibility of the board of directors to oversee the day-to-day running of the company, like hiring and firing and other key decision-making.
This may sound all sound very complicated and more suitable for larger businesses. But it is, in most cases, possible to be both the sole shareholder and director at the same time, meaning you can set up a corporation all on your own, if you so choose.
Here are the pros and cons of a corporation:
- Limited liability – the owner’s personal assets are safe in the event that the business experiences financial difficulty
- Raising funds – corporations may sell stock to raise funds
- Indefinite existence – even if a shareholder passes away or sells their shares, the company will continue indefinitely.
- Challenging and expensive setup – it can be expensive and time-consuming to set up a corporation. You’ll very likely need an attorney to help get you started, adding further expense.
- Complex accounting – corporations are subject to more complex tax rules than a sole proprietor would be used to, meaning tax preparation and bookkeeping services will likely be needed.
- Double taxation – perhaps the biggest drawback to corporations is that of double taxation. The business is regarded as a separate legal entity and as such is subject to taxes. But since dividends distributed to shareholders are also taxed at a personal level, the business owner of a small corporation may end up paying tax on their income twice.
As we’ve seen, there are some major benefits to incorporating, but for small business owners the issue of double taxation is a significant one.
There is, however, a way to incorporate a small business while avoiding this pitfall altogether—by opting to take advantage of a particular corporate structure known as an S Corporation.
Named for subchapter ‘S’ of the revenue code (and not for ‘small’ corporation as many people believe), S corps share many of the same properties of good old regular corporations. But crucially, S corps are considered ‘pass-through’ entities for tax purposes, meaning income and losses are passed through to shareholders and included on their tax returns. As a result, there’s only one level of federal tax to pay.
While S corps have similar obligations to regular corporations when it comes to compliance and documentation, the resolution of the double taxation issue alone is reason enough for many small businesses to adopt the S corp business structure.
Here are the pros and cons of an S Corporation:
- Single layer of taxation – the avoidance of double taxation is very likely the single biggest benefit of the S corporation business structure. Taxes are paid only at the shareholder level, and not at the corporate level.
- Limited liability – just like with regular corporations, owners of S corporations can rest assured their own personal assets are safe in the event their company experiences financial difficulties (providing they haven’t acted outside of the law, or against the duties and responsibilities of their position).
- Can only issue common stock – unlike regular corporations, S corps are only able to issue common stock, which may hamper efforts to raise capital.
- Challenging and expensive to set up – Much like regular corporations, S corps are relatively complex to set up, and you may need to enlist the services of an attorney.
Limited Liability Company
The limited liability company, or LLC, is a business structure that takes advantage of the benefits of both corporations and partnerships.
As the name suggests, LLCs offer business owners a degree of protection from personal liability, meaning personal assets typically won’t be at risk should the business face financial difficulties.
Like S corps, LLCs also avoid the issue of double taxation, with profits and losses ‘passed through’ to the business owner’s personal income. But unlike S corps, LLCs don’t need to adhere to any particular corporate structure, meaning they’re relatively flexible when compared to other traditional types of business entities.
Here are the pros and cons of LLCs:
- Limited Liability – in most cases (though not all), the owner’s personal assets will not be at risk in the event their company experiences financial difficulties.
- No double taxation – as a pass-through entity, LLCs avoid the double taxation issue some other business structures face.
- Flexible structure – LLCs are more flexible than corporations. They can, for example, be managed by their members, or by managers, which can be particularly useful if members aren’t experienced in the running of businesses.
- No stock – unlike corporations, LLCs don’t have shares or stock certificates to offer. This can make raising capital a challenge.
- Pricier staff incentives – also unlike corporations, owners of LLCs aren’t able to deduct the cost of benefits from profits, meaning it can be more expensive to offer staff incentives.
- Limited life – in many states, LLCs have a limited life and must be dissolved if a member leaves the company, goes bankrupt, or dies.
Choosing the best types of business entities for youy company is a big – often daunting – decision. But it’s worth spending the time to get it right. This topic is both broad and deep – we’ve only scratched the surface here.
If you’d like to learn more, feel free to reach out!
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Today's Guest: Margo Masri
As a multiple award-winning accounting firm, MM Accounting and CFO Solutions offers highly-customized financial services specifically designed to take your business to the next level – and beyond.
Utilizing cutting-edge accounting techniques and drawing on a wealth of industry-specific experience, MM Accounting is your trusted partner for enhanced business growth, increased automation and efficiency, and a truly class-leading customer experience.
Margo's Online Presence:
- Kirk Chisholm | Innovative Wealth
- Barbara Friedberg | Barbara Friedberg Personal Finance
- Megan Gorman | The Wealth Intersection
- Miranda Marquit | Mirandamarquit.com
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