How to Pick the Right Structure for Your Small Business

Posted November 1, 2011 in Uncategorized by

If you’re starting a small business, one of your initial concerns may be, "Which business structure is right for me?" A recent Small Business Administration study finds that within the first four years of a small business’s life, about one in 10 reorganizes, usually moving to a more complex legal form of organization (LFO).

Of course, you’ll save yourself some headaches if you choose the right LFO at the outset. But how do you know which business structure is right for you? In short, there’s no one-size-fits-all answer. But there are several factors that can help you with your decision.

In last Thursday’s blog, we reviewed the six most common small business structures. Today, let’s look at the variables that can help you pick the right LFO for your small business.

Money, Money Money

The cost to setup and maintain the business structure: The cost to create a legal business entity varies from state to state. For example, it costs about $600 in state fees to create a limited liability company (or LLC) in Illinois, where I live. But the state fees to create an LLC are less than $100 in California. In comparison, it costs only about $50 (the cost of a "doing business as" ad) to start a sole proprietorship in Illinois.

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You’ll also want to consider annual costs related to your business structure after your company is created. Some states require certain business structures to pay ongoing fees or file annual reports that may need to be prepared by an accountant or auditor. These costs—which are directly tied to the business structure you select—can add up quickly.

The tax advantages and disadvantages: Not all business structures treat taxes similarly. For example:

  • Certain business structures, such as the sole prop and partnership, use what’s known as "pass through taxation." This means that the business’s income and losses are reported on each owner’s individual tax return.
  • A corporation is subject to what’s known as "double taxation," meaning it pays taxes on its income and its owners pay taxes on any income—be it dividends or salaries—they receive. However, corporations have the advantage of being able to deduct some expenses that other LFOs can’t.
  • An S corporation can deduct the same expenses as a corporation, but it’s a pass-through entity not subject to double taxation like a regular corporation. Shareholder employees of both corporations and S corps benefit by being able to take some income in the form of dividends, which are taxed at a lower rate than their salaries.

If you already have a small business, talk to a tax lawyer or adviser and share your income statement with him. He can walk you through the tax impact of each LFO. If you haven’t yet started your business but have written a business plan, your tax adviser can review your projected financials, do the same analysis and suggest a LFO based on the professional annual expenses tied to each business structure as well as the tax impact of each business structure.

Legal Considerations

In addition to talking to a tax professional, you should also meet with a small business attorney to review the legal advantages and disadvantages of each business structure. There are several factors that will influence your decision.

The potential risk exposure: When discussing legal forms of organization, you’ll often hear liability mentioned. What we’re really talking about is, if someone sues your business, to what extent are your personal assets—your home, your retirement account—at risk? Some business structures do a better job of shielding personal assets from liability.

Your initial instinct may be to only consider LFOs that offer limited liability. But you also have to take into account the likelihood that you’ll be sued. If you have a retail business where customers could slip and fall, you’re more likely to be sued than an artist selling his artwork at someone else’s gallery. You also face more liability if you plan to use credit—such as a bank loan or credit cards—or pay vendors to help run and grow your business. If your risk exposure is minimal, a business structure such as a sole proprietorship may be appropriate.

Whether you expect to have employees: Certain business structures are better-suited for businesses that have employees. With a corporation or S corporation, for example, you can deduct the cost of group-term life insurance as well as health and accident insurance plans.

Whether you hope to eventually sell the business: Sole proprietorships are the most popular business structure for new small businesses. It’s easy to start up and shut down a sole prop, and the associated costs are minimal. But one big disadvantage to the sole prop: You are the company. If you die, it does too. And it can be a bit complicated if you want to sell the company or transfer ownership to someone else.

When you’re just starting a small business, you may not be thinking long-term: Can I grow the business and then sell it to a bigger competitor? Do I want to leave the business to my kids one day? Will I always be actively involved in the day-to-day operations of the business? But these questions deserve at least some consideration.

What Happens If You Pick the Wrong Structure?

One of the most nerve-wracking aspects of selecting a business structure is the fear that you’ll pick the wrong structure for your company. As the SBA study shows, small businesses can change the LFO within the first years of life, but it’s relatively rare. How can you decrease the odds of having to make a switch?

"The most common mistakes likely fall into two baskets," says attorney K. Thomas Stevens of Stevens & Associates, P.C. "First, not looking sufficiently to the long-term fit of the structure to expected operations, and second, how the corporate structure might be viewed by critical outsiders."

As an example of the "bad fit" mistake, Stevens says small businesses in the real estate industry are usually structured as LLCs, so if you organized your real estate development business as a corporation, it might not be a good long-term fit. And if you’re expecting to grow your business with money from a venture capital firm, Stevens says they’ll typically want your business to be organized as a Delaware corporation, which might require a conversion in corporate structure.

"There are costs and irritations associated with changes, contracts and banking relationships would require changes," Stevens says. "It’s all part of a thoughtful, ongoing process. A business entity isn’t formed and then remains static. It’s a living thing, requiring some attention."

Jennifer E. King co-authors the blog.

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