To help you choose the right structure for your business, walk through these three steps.
Should you structure your business as an LLC, or would it be better to remain a sole proprietor? What should I know about becoming a corporation?
All business owners must choose their business structure, so these questions have likely crossed your mind at some point. But the answer is a bit allusive – especially if you’re just relying on vague definitions from a government website.
Choosing the right structure for your business can protect your personal assets and save you money. To help you make a good choice, in this post I’ll walk you through the highlights of the most common structures in the US, and then show you three steps to choosing the right one for your business.
The Dangers of Making the Wrong Choice
Before we get into the types of business structures, let’s be clear about the potential impact of making a bad choice. Here are a couple of examples of what can happen when you don’t make the right decision.
I know a young freelancer who did a great job on a difficult assignment. Unfortunately her client was slow to pay the final installment of her bill. Frustrated, the freelancer tweeted about the situation and her trouble with the client. A couple of weeks later she received notice that she was being sued for libel. She didn’t have the means to fight it and because she was a sole proprietor, the $50,000 suit put her home at risk.
A graphic designer left his job with big dreams of building a freelance business. He figured, as a company of one, he didn’t have to worry about any fancy structure, like a corporation. But three years in, when he stopped doing his own books and finally saw an accountant—he discovered he could have saved $10,000 a year in taxes if he’d sought advice sooner and formed an S Corp.
I’ve heard a lot of stories like these. When you choose the wrong entity, it opens you up to several vulnerabilities. You could fall into liability traps, pay more taxes than necessary or find yourself tied to an useless entity that eats away your resources.
None of that is good for business.
The right choice will help you avoid these problems. And making a good decision isn’t as difficult as it may seem.
There there are a lot of different business structures out there. But, for most entrepreneurs and small business owners in America, there are three basic business types that make the most sense.
The Three Common Business Structures
Type One: Sole Proprietor
A sole proprietor is a business owned and managed by a single person. In this structure, there isn’t a legal difference between the individual and the business—even though you could use a trade name other than your own name for the business.
You receive all the profits and are responsible for all losses and debts. Your company’s profits or losses are passed through to your personal income tax form and taxed accordingly.
Some regions require sole proprietors to have a business license. But most places allow you to just start the business and go.
If there are more than one of you sharing ownership and management of the business, then you would be a general partnership—which is similar to a sole proprietorship. It just describes a business with multiple owners rather than just one and essentially has the same pros and cons as the sole proprietorship.
- Costs: A sole proprietorship is the cheapest type of business to start. It has the lowest set-up costs and ongoing fees.
- Time: Being a sole proprietor is generally low hassle. It has few reporting requirements, which means less admin. Less admin means you can spend more time on what you’re good at and what you enjoy.
- Liability: As a sole proprietor, you are personally liable for all damages. Your house, car and all personal assets are at risk if a legal claim is filed against you or a business debt is called and you cannot pay. In a partnership, you may have the added risk of being responsible for any liability costs caused by your partner.
- Taxes: Except for the fact that business losses can offset other personal income taxes, sole proprietors have no tax advantages in the US compared to other business entities.
As Jason Blumer of Blumer & Associates CPAs says, “If you’re brand new you probably want to start as a sole proprietor, because we don’t know the future. We don’t know what’s going to happen. But it’s very easy to start a business as a sole proprietor, which is just doing business in your name.” In a nutshell, sole proprietorships are the cheapest and easiest to administer, but offer no liability protection or tax breaks.
If you think you need more protection than afforded by a sole proprietorship or partnership then the next business type to consider is the Limited Liability Company or LLC.
Type Two: Limited Liability Company (LLC)
An LLC is not a corporation. It’s simply an entity that provides liability protection for its owners. It handles the financial side of things the same as a sole proprietorship or partnership would (in terms of how it deals with taxes). But – as the name suggests – it’s intended to provide limited liability protection from legal and financial claims.
- Liability: An LLC gives you more protection from legal or financial claims than a sole proprietorship. It provides what some call a ‘liability shield.’ That’s because the LLC is a separate business entity—meaning you are no longer personally liable for business debts or damages. Legal and financial claims can be made against the business, and it could lose everything and go bankrupt. But that’s a lot easier to swallow than losing your home and going personally bankrupt.
- Time: LLCs require less reporting and record keeping than a corporation.
- Costs: LLCs are more expensive to set-up and maintain than sole proprietorships. It requires registration fees and annual professional fees to handle reporting requirements. Some states also levy an extra tax on LLCs for the right to have liability protection.
- Taxes: Jason Blumer adds that an LLC, “Doesn’t help from the tax side. It does give you limited liability protection, but the tax set-up is really exactly the same as a sole proprietor. There are no tax savings at all.” So, if you have a business that is not likely to be hit with legal filings or financial claims, an LLC may not be your best choice.
This is why Blumer says, “When you move from a sole proprietorship to anything else, there has to be a valid reason that makes sense for your business.”
The chief reason to move to an LLC would be that the increased costs of setting up and running the LLC compared to a sole proprietorship are offset by the benefits of having liability protection. However – if you make enough profit – a corporation would give you tax savings an LLC cannot.
Type Three: Corporation
A corporation is a legal entity that is separate from its owners, employees and shareholders. You create a new legal personality that takes on the burden of liability and financial responsibility for the business.
When we think of corporations we often think of large organizations. They don’t have to be, but most corporations do have shareholders, and boards of directors, and rules of governance and reporting—and hence a lot of reporting requirements.
An S corporation is the most popular type of corporation for freelancers and entrepreneurs.
The S just stands for the Subchapter of Chapter 1 of the Internal Revenue Code that describes their structure. The S corporation is a business entity that is legally separate from its owners.
It was designed to combine the liability benefits of LLCs with the tax benefits of corporations. S Corps may or may not have their own state tax burden. However, S Corps don’t pay separate federal taxes like other corporations. Instead, the income or losses are divided among the shareholders and passed to each person’s personal tax return.
- Liability: Like an LLC, S Corps provide a liability shield that protects shareholders from legal and financial claims. The company can be hurt by those claims and even go bankrupt, but the individual owners will not be responsible.
- Taxes: S Corps offer the best tax advantages. As long as your profit is at least in the $50,000 range the tax savings from organizing as an S Corp will likely be greater than the professional fees required to run it.
For a great comparison of how taxes are dealt with in an S Corp versus a sole proprietorship or LLC check out this short five-minute video from Blumer & Associates, CPAs, PC.
- Time: S Corps are required to do most of the same reporting as regular corporations. Because of this, they need more accounting and legal attention than sole proprietorships or LLCs. They require the most time.
- Costs: Generally S Corps can be an expensive entity to set-up and maintain because of high registration costs and professional fees related to their reporting requirements.
Jason Blumer says, “Moving to an S Corp can be a pain. Now you have to do corporate tax returns and you have to do payroll. And you typically move into a double entry accounting system at that time.” It’s important to consider your business’s current and future situations before making your choice.
Choosing an S Corp too soon can lead to money needlessly spent on reporting and professional fees. At the same time, not forming an S Corp when your profit indicates you should will cost you annual tax savings.
Three Steps to Making the Right Choice
Now that you know the basics, it’s time to make a choice. These three steps will help you decide which one is right for you.
Step #1: Be Clear About Your Vision
Your vision drives your business and should determine what kind of structure you will need in the future. As Jody Padar of New Vision CPA Group told me, “The first thing a business owner should do is ask, what’s my business purpose? That’s going to determine why you choose one business entity over another.”
Let’s say you’re a graphic designer. As the owner of the business, you might consider what you want your company to look like in three years.
Is your goal to remain a company of one that allows you to make a decent living with the least possible hassle? Or do you plan to compete with the mid to large-tier agencies by building a design studio that generates hundreds of thousands of dollars profit?
The answers to those questions will affect the type of entity that makes the most sense for you.
As a freelancer who expects to make up to $50,000 a year you will not see any tax savings from becoming an S Corp. So there’s really no need to form one. Although, if you have potential liability issues, like copyright infringement as a designer or building liabilities as a contractor, then you might consider an LLC.
On the other hand, if your vision calls for you to make more than $50,000 profit per year then an S Corp would save you more in taxes than you would pay in fees.
Jody cautions, “So you really need to be thinking about this from the point of view of being a business owner.” As an owner you need to look to the future as well as the job you’re focussed on today.
For example, Jody says,
Sometimes small business owners make a decision because they read about it online. Which is like trying to diagnose your own illness on the Internet. They say, oh I’m just little, it doesn’t matter—but the choices they make today are going to have an impact for a long time. Not to say that you couldn’t reorganize, but once you’ve established your name and your brand—in three years, if you’ve screwed it up and now you’re bigger, do you want to have to go back and unscrew it up.
That’s going to be a waste of your time and potentially expensive. Having to mess with your name and brand may even cause confusion amongst your clients.
As Jody says, “When you’re smaller you have more to gain because money is a lot more important to you. It’s not that bigger companies can waste more money, but when you’re a new business owner every dime really counts.” So consider the intended future of your business before you choose your business structure. It’s best to get it right the first time.
Ask yourself what structure you need to set up today to make your vision a reality tomorrow.
Step #2: Assess Your Liability Risk
Different kinds of businesses have different potential exposure to liability. Some industries like design, consulting, and landscaping have relatively low liability risk. Whereas construction, journalism or financial planning may face greater exposure.
Assessing your liability risk is a factor in choosing the right business type for you. It’s always best to consult with a professional. But – as a general rule of thumb – if you work in a low-risk environment and don’t face real liability issues – a sole proprietor or partnership set-up could be the one for you.
However, if you work in an industry where liability exposure is relatively high, you would benefit from having a liability shield offered by LLCs and S Corps.
Choosing between LLCs and S Corps would then come down to the other benefits you might realize from one or the other, such as the tax savings that an S Corp affords above a certain profit threshold.
Step #3: Seek Professional Advice
You can’t know for sure that you’re making the right choice without consulting a professional. While it’s important to understand the basics we’ve covered off in this post, everyone’s business is different.
“The mistake most entrepreneurs make is they don’t get professional advice before choosing an entity. That can be a disaster because once you pick an entity, a lot of times you’re stuck. Nothing is forever, but on the flipside there are lots of entrepreneurs we’ve met who are four years in, and we could have saved them $10K plus per year had they sought our advice. So they’re penny-wise, but pound-poor.”
– Jody Padar
Many entrepreneurs make the mistake of going it alone. They find a website that offers discount incorporation and they dive right in. In the first year or two, they find they’re responsible for all the accounting and reporting and filing. It’s an admin nightmare.
Just because you can do it alone, should you? Would doing your own reporting really be the best way to spend your time? Jody reminds us to, “Think like a true business owner, and not just think I can do this myself—because those are the people who screw it up the most, the ones who think they can do everything themselves.”
As Blumer says, “Many people who go it alone are often scared of that $500 bill from a professional. But our prices are not costs, they’re actually investments.” At Blumer CPAs they call it “an investment of information-known-early.” Jason asks, “How important is it going to be to know information early?”
If an accountant can examine your business and help you choose an entity today that will save you $10,000 in taxes every year, wouldn’t that be worth the investment of a couple of thousand dollars? Otherwise, you may not figure out which entity was the right one for two or three years.
You’ll be in a better position to choose the right entity if you first seek professional advice.
The Last Word
Now you know the pros and cons of the most common business structures – and how each handles liability, taxes, costs and time.
Once you’ve defined your vision, considered your liability risk and spoken with a professional you’ll be ready to choose the best structure possible to support your business today and in the future.
about the author
Andy Haynes is a writer for FreshBooks. He is the co-author of two best-selling business books, a successful entrepreneur and business consultant.