Owning a small business is equal parts effort and reward, with a wide range of decisions that should be made correctly from the start. Doing so can reduce the amount of frustration that can detract from the enjoyment you get from being the boss. One of the most important and initial decisions to make is which business structure to use. Not all arrangements are right for all planned setups. Identifying the right one, the first time, can help you avoid the aggravation of having to switch down the line.
There are several factors that play a part in which choice is the best for what you have planned. These include:
Now that you understand the different factors that come into play, it is time to understand the primary structures available. The four main types are:
Each of these structures has pros and cons, which is detailed below.
By far, the most straightforward business structure you can have for your small business is the sole proprietorship. This type of arrangement works for individuals looking to run the entire business themselves. There is virtually no distinction between the organization and the person running it.
The pros to using a sole proprietorship start with how easy and cheap it is to set up. While each state does require specific permits and licenses to operate them, the number and complexity are minimal. A sole proprietorship is also the easiest regarding taxes as all proceeds from the business and personal income are combined for easy preparation. The owner also holds tight to the reigns of control. He or she is able to make all decisions without consulting a partner or shareholders.
The primary potential downside is that the owner is personally responsible for any liability or debts that result from the business. Credit problems also affect the owner as bad debts have the potential to impact personal credit severely. One other pitfall is sole proprietorships can have challenges with financing. Banks hesitate to take on the risk that can come from dealing with an individual rather than an entire corporation. As there are no shareholders with this structure, finding investment partners can also be difficult.
As its name would indicate, a partnership includes two or more people that run the business together, or act as silent investors. Partnerships come in two main types, general and limited. General partnerships share revenue and responsibilities equally with each participant, while limited ones can also have members that invest only, without taking part in liability or business decisions.
While the setup cost and complexity are not as low as with a sole proprietorship, a partnership is still one of the more straightforward structures to launch. Having more than one person can also increase the number of financial capabilities that the business can draw from. It also allows a diversity of skills and experience that can combine to produce a wellspring of ideas that may be difficult operating the business alone.
As with a sole proprietorship, liabilities and debts are the responsibility of the individuals running it, rather than the business entity itself. Problems can also occur when there is a disagreement between partners, which requires a degree of finesse and compromise on all sides. Profits are also distributed evenly among partners, even if one partner does more work than another. However, profit distribution can be detrimental to the harmony of the partnership if things become unbalanced.
A limited liability company, also known as an LLC, combines certain aspects of a partnership or sole proprietorship with those of a corporation. The most important of the former is that revenue is viewed as personal income, making the complexity of filing taxes much more straightforward than a corporation. Regarding the advantage on the corporate side, members enjoy protection from liability that can occur as a result of doing business. This translates into protected personal assets if the company is sued.
Depending on the state in which you set up your LLC, the costs can be quite a bit higher than with the previous two structures. Income is also considered self-employment, which means taxing comes at a higher rate than either sole proprietorship or partnership. Some states dissolve an LLC if one member leaves, leaving remaining members in the lurch concerning obligations needed to close the business properly.
There are two main types of corporations, the S Corp and the C Corp. S Corps are usually the realms of larger businesses, with advantages to small companies sparse at best. A C Corp is much more enticing for the following reasons.
Under a C Corp, all shareholders and members are exempt from liabilities, such as that with the LLC. Taxing is considered from personal income and avoids the double taxation found in an S Corp. Members and shareholders can leave a C Corp with no repercussions to the business as a whole. It is also much easier to secure funding or investments than some of the previous structure types.
The downside to a corporation is that it is much stricter in how it operates. Shareholder meetings, bylaw updates, stocks, and extensive record keeping are all factors that can require you to have dedicated departments to manage. Shareholders must also receive adequate compensation, called distribution, which can trigger an IRS audit if specific red flags are present.
Scale Funding has been a leader in financial resource for small businesses since 1994. If you are interested in launching a new business venture and would like advice on how to structure it from consummate professionals, we urge you to contact us at your earliest convenience. Call (800) 707-4845.