Small businesses are the backbone to the American economy. There are over 30 million small business in the United States that account for 64% of jobs nationwide, who create 1.5 million jobs every year. Anybody can form a small business but if you are trying to form a business for the first time, you may find yourself with more questions than answers. In this first series of our business blog, we address the first step towards being your own boss: choosing the right business structure.
What to Consider When Organizing a Business
There are many ways to organize a business – here, we talk about all of them including their pros and cons. There are many factors that could affect how you organize your business, however, two major issues you should always consider are:
- Insulation from personal liability for the debts of the business, and
- How you want to pay taxes on the profits of the business.
Definition of common terms used throughout this blog:
- Limited liability – the owners have little to no personal liability in the business’s debts, essentially, the owners are protected unless the corporate veil is pierced (to be discussed in the next blog).
- Pass-Through Entity or Flow-Through Income – the business does not pay tax on its profits, instead, the profits are passed through (or flow through) to the owners, who then claim the profits as income on their individual income tax return.
- For the purposes of this blog, owner and partners are used interchangeably.
Types of Business Structures
This is the simplest and least complicated type of business formation. This business has only one owner (hence its name).
Pros: A pass-through entity, there are not complicated state laws surrounding a sole proprietorship, making it very cheap and easy for the owner to operate. The business owner only needs to register the business name as an assumed name if the business name does not contain the business owner’s last names. Unless requiring a license, sole proprietorships do not have to register for federal or state identification number unless it has employees.
Cons: This business formation leaves the owner personally liable for the debts of the business. This means that if the business does not have enough money to pay its creditors, the creditors can come after the owner’s personal finances and assets. The owner’s ability to raise capital is limited to personal funds and personal funds from other people, limiting the size of the business. If the owner dies, the business may end unless transferred to heirs. Even when transferred, a new sole proprietorship is created in its place.
A business formation for two or more people. In a general partnership, partners will share equally in the rights and responsibilities of managing the business, equally in the profits and losses, and have equal ownership of the business. There is usually a written partnership agreement between the owners.
Pros: A pass-through entity, it is easy to create and allows for a potential to raise more capital with more than one owner.
Cons: Joint and several liability in a partnership means that one partner may be liable for another partner’s actions. In other words, if another party was to sue the business, that party can choose to sue any one of partners. If a partner loses the lawsuit, the other party can collect from the remaining partners.
Has at least one general partner and at least one limited partner. The general partner(s) runs and manages the business while the limited partner(s) only contribute assets and have no role in the daily operations or management of the business.
Pros: A pass-through entity, it limits the liability exposure of the limited partner to only the amount of capital he contributed. The limited partner is protected in that the creditor cannot come after his personal assets. If you are limited partner, you get to share in the profits without having to help manage the business.
Cons: The general partner is personally liable for business debts while the limited partner has limited liability. The limited partner has limited say in the operations and management of the business even though his assets could be at risk.
Limited Liability Partnership
This structure is similar to a General Partnership except that the owners enjoy limited liability.
Pros: A pass-through entity with limited liability, this structure protects the partners’ personal assets while allowing both to participate in the daily operations and management of the company.
Cons: More partners participating in the daily operations and management of the company could lead to slow decision-making.
Corporation (Standard Corporation or C-Corp.)
This business structure has a board of directors and shareholders. A Corporation is subject to different governing laws and must meet certain requirements such as: creating corporate bylaws, holding an annual general meeting for the shareholders and the board of directors, public disclosure of share performance in an annual report, and more. The shareholders have limited liability in the company.
Pros: Corporations have an awesome ability to generate capital by issuing preferred stock and common stock while protecting the owners from personal liability. There are tax deductions available to corporations that are not available to others.
Cons: In terms of taxation, Corporations are the only type of business that must pay tax on its profits. This is sometimes called, “double taxation,” as the business pays corporate income tax on its income, and then the shareholders pays personal income tax on their dividends.
S Corporation (Small Business Corporation, S-Corp)
Similar to a Corporation, S Corporations must have a board of directors that is elected by the shareholders. Unlike a Corporation who is governed under Subchapter C of the IRS, S Corporations are governed under Subchapter S of the IRS. Subchapter which limits the number of shareholders to 75. This helps keep an S Corporation a small business, a characteristic of an S Corporation.
Pros: A pass-through entity, S Corporations avoid double taxation. Its ability to still raise capital by issuing common stock still make it attractable to investors.
Cons: Unlike Corporations who can issue both preferred and common stock, S Corporations can only issue common stock. S Corporations have to be careful on how many stocks they are issuing as having too many shareholders can negatively affect their S Corporation status.
If you feel overwhelmed with information, you are not alone. Many new business owners struggle with how to structure their business so it most benefits them. Let us help you. At Thooft Law, we have successfully registered and setup business entities in numerous states, including Texas. Furthermore, we draft business agreements, review contracts, conduct civil litigation, and act as an in-house legal counsel for businesses.