Most small businesses – more than 70 percent, according to the SBA – are sole proprietorships, the simplest legal structure for businesses. Not only is it easy and inexpensive to set up this type of business, but tax prep isn't as complex as it is with other business structures and you keep full control over your business – and its profits. With this type of entity, there isn't any legal distinction between you and your business; all business earnings, losses and liabilities are yours.
This structure works well for many businesses. As your business grows and your profits increase, however, it may be worthwhile to sit down with your CPA to talk about when, or if, you should consider upgrading your business structure. Get their advice on whether forming a limited liability company or incorporating could save you money, limit your liability, or help your business grow.
Before you decide to upgrade your business structure from a sole proprietorship to an LLC or corporation, there are drawbacks to consider. They're more expensive to set up and maintain, as there are compliance regulations and fees, and they vary depending on the structure you choose and your state.
LegalZoom's Jane Haskins, Esq., writes that "it costs money to set up and dissolve a corporation, and corporations have additional recordkeeping and annual reporting requirements that sole proprietorships and partnerships don't have. If your business is small and just starting out, those extra obligations can outweigh the advantages of incorporating."
Here are some points to think about and discuss with your CPA.
One of the most common reasons business owners upgrade their business structure is to reduce personal liability by legally separating personal and business assets. If you have a sole proprietorship or partnership and your business experiences financial troubles or is sued, your home, vehicles, personal bank and retirement accounts are at risk, as they may be collected on to pay down your business debts.
In the same vein, a top concern with a business partnership is that you share responsibility for all business losses or debts. Even if these losses are sustained due to an action or decision made by the other partner and you had nothing to do with it, you're still liable, and your personal assets may be vulnerable.
If you set up your business as an LLC or corporation, your business is its own entity with its own assets; your personal assets aren't tied to the business and can't be used to collect on business debts. Writing for the small business mentoring organization SCORE, CorpNet CEO Nellie Akalp says, "These structures protect your personal assets (and those of any other shareholders) from debts, losses, and court rulings against your business. With a C corp, that liability protection usually extends to directors, officers, and employees as well."
If your business is just you – for example, if you're a professional service provider such as a consultant, contractor or doctor – you may still be able to set up your company as a separate legal entity, such as through a single-member LLC.
Each business structure handles taxes differently, and some may help you save money. For example, with a sole proprietorship, your taxes are simpler than with other structures, but you're taxed on all your business's profits – not just the amount you pay yourself or withdraw for your own use – and you must pay self-employment taxes (Social Security and Medicare taxes) on all your earnings.
With a C corp, the business pays a corporate income tax on all profits. These profits are then taxed again at the individual's tax rate when they're paid to shareholders as distributions, or dividends. Even though profits are double-taxed, the ability to split the profits between the business and yourself as a shareholder may lower your tax rate.
With an S corp, the business pays you a reasonable salary and takes care of the Social Security and Medicare taxes. The remaining profit is distributed to shareholders, and you pay your individual income taxes on your portion. This option may save you some money on your Social Security and Medicare taxes, but only if your business is making enough of a profit above your salary (which experts caution against setting artificially low, as the IRS looks closely at these amounts).
If you have an LLC, you can decide whether you want to be taxed as a sole proprietor, C corp or S corp.
To determine which structure is best for your specific tax situation, you'll need to consult your CPA.
Changes in ownership
If the ownership of your business changes, you may need to upgrade your business structure as well. For instance, if you start out as a sole proprietor and take on a business partner, you'd need to convert to a partnership or another structure. If you start out as a partnership and decide to buy out a partner so you have full control of the business, you'd need to change the structure to a sole proprietorship or single-member LLC. If you have a family business and want to add multiple people as shareholders, you'd need to switch the business structure to an LLC or corporation.
In addition to minimizing your tax burden, the right business structure will allow you to decide how you want to accept financing, if this is something you need to help your business grow.
With a sole proprietorship, your financing options are limited to those you can personally guarantee. You'll need a healthy personal credit score to qualify for a business credit card, loan and line of credit, and you'll be personally responsible for them if your business can't meet its obligations. You may also be required to put up collateral, such as your house, against the debt. If your business is an LLC, you can avoid personal liability for the financing you receive, unless you sign a personal guarantee or put up personal assets as collateral against the loan.
If you're willing to share ownership of your company, you can form a partnership and accept investments in exchange for shares of the business. However, keep in mind that this may affect how you run your business. Small business lender Bond Street advises, "When taking on new partners, it's important to decide whether they'll play an active role in the management of the business or operate as silent partners. If it's the former, weigh the impact on business operations against the opportunities created by the access to new capital."
If you're interested in bringing in outside investors, such as an angel investor or venture capital firm, to help you turn your startup into a big business, you'll need to set up your business as a C corp. This allows you to issue different classes of stock that you can exchange for investment capital.
Share your experience!
If you've changed your business structure, leave us a comment. What prompted the change? What results did you see from the upgrade? What advice would you give other business owners thinking about switching from a sole proprietorship to another structure?