What is the Best Entity Structure for Your New Business
Getting into a new business is a major step in a person’s life, and it is a risk that can pay great rewards (both financially and with greater personal freedom) if the venture is successful. Whether you are starting a new business or buying an existing business, one of the most important keys to success is to have the right ownership entity structure from the start. Doing this will help ensure a smoother operation while putting you (the owner) in the best possible position to succeed.
There are five main business entities for owners to choose from. Here is a closer look at each one:
Sole Proprietorship: Becoming a sole proprietor is the simplest and easiest way to be in business. In fact, this is the default entity for anyone that starts a business. A sole proprietorship does not require you to file any business formation paperwork, and you will not need to submit a separate tax return. The owner simply files under their own Social Security number rather than obtaining a separate federal tax ID number for the business.
The downside to a sole proprietorship is that the owner has no legal buffer between themselves and the business. For example, if the business is sued, the owner can be personally liable, and their own assets could be at risk. Any debts that the business incurs are also the responsibility of the sole proprietor.
Partnership: A general partnership works similarly to a sole proprietorship, the primary difference being that there is more than one owner. With this type of business structure, no additional paperwork is required, and the partners share equally in the profits, losses, and liabilities.
There is another form of partnership, referred to as a “limited partnership”, which does require filing of paperwork to register the entity. With a limited partnership, duties, roles, and responsibilities can be customized. For example, some partners may be actively involved in running the business, while others may be “silent partners” who are just investors that want to share in the profits.
Limited Liability Company (LLC): A limited liability company (LLC) is often the next step up from a sole proprietorship or partnership. LLCs combine some of the benefits of these more simplified business structures with the liability protection that comes with the creation of a separate entity. An LLC can have a single owner/member, or it can have several. What makes this type of entity attractive for smaller business owners is that members receive the liability protection afforded to corporations, but the company profits “pass through” directly to the owners, so they can be treated as personal income that is not subject to double taxation.
S-Corporation: An S-Corporation, (named for Subchapter S of Chapter 1 of the Internal Revenue Code), combines many of the features of an LLC and a corporation, but without some of its disadvantages. Like an LLC, an S Corp. is a “pass-through” entity in which owners receive liability protection, but there is also more flexibility on how the revenue from the business is classified.
For example, some of the profits from an S Corp. can be paid to owners as salary, while some of it can be distributed as dividends. This allows owners to reduce payroll/income tax liability, which can be very beneficial financially.
Although an S corporation offers many of the same benefits as an LLC, it is a more complicated type of entity. S-Corps are more costly and time-consuming to form and maintain, with requirements such as creating bylaws and having board meetings.
C- Corporation: A C Corporation, often just referred to as a corporation, is the most complex type of business structure. C-Corps involve complicated procedures such as creating articles of incorporation, assigning a board of directors, having board meetings, and the issuance of stock. Unlike an S Corp., there is no limit to the number of shareholders a C-Corp can have, and this is considered a good entity structure for businesses who are trying to attract outside investors.
Aside from the complicated entity structure, perhaps the biggest downside with C corporations is the double taxation. Profits are taxed at the corporate level, then what is left over is distributed to owners/shareholders and subject to dividend or capital gains taxes.
Purchasing a Business Makes the Decision Easier: Choosing the right entity structure when you are going into business can be a difficult decision, and this is one that you will want to discuss with a financial or tax professional. That said, this decision becomes a whole lot easier if you purchase an existing business.
A business that has already been operating for several years will already be formed using one of the entities, and if the business is already running smoothly, then there might not be any reason to make changes to its entity structure.
There are several other advantages to buying an existing business over starting one from scratch as well. When you buy an established business, you can bypass the grueling startup phase and go straight to profitability. And if you have the skills and ability to run the business effectively, your chances of being successful are vastly increased.
Contact a Reputable Business Broker: If purchasing a business for sale and inheriting their well-established entity structure sounds attractive to you, then the next step in your journey is to contact an experienced business broker in your area. Business brokers specialize in matching buyers with the right available businesses to fit their criteria, and they also work closely with buyers throughout each step of this complicated and often confusing process.