What Type of Business Structure is Right for Your New Business?

Joel SowalskyOne of the first questions that you face when you start a new business is how should it be set up. What type of business entity or structure should you use? There is no simple answer, as it involves many factors, including the type of business, the industry in which it will operate, the number of people creating the business, the immediate and future cash needs of the company, how many employees you expect to have, and the overall growth and development plans of the company. You should review these factors with an experienced lawyer and/or accountant to determine the right structure for you.

I will outline here the most common choices for setting up a small business, identifying some of the main advantages and disadvantages of each. Although your business structure usually can be changed after you create it, the change can be time-consuming and costly, so it is best to try to get it right the first time.

1.  SOLE PROPRIETORSHIP.

This type of business has no formal structure at all. You can start your business under your own name (John Doe, doing business as John Doe & Co.) or almost any name, as long as the name is not being used by someone else in your market. Virtually no cost or paperwork is involved in creating a sole proprietorship, and you will have complete control over your business. All income, expenses, profits and losses will be recorded on Schedule C of your annual personal tax return; your company will not be separately taxed on its profits. The biggest disadvantage of a sole proprietorship is that you will be personally liable for any losses, debts and court judgments against your company. Still, if you anticipate doing almost all of the work of your company by yourself (without employees), and you can obtain liability insurance to cover your risks from the business, then this may be the best structure for you.

2.  PARTNERSHIP.

Sometimes called a General Partnership, this type of structure happens automatically when two or more people come together to form and operate a business for profit. While it is not required, it is best to have a written partnership agreement that outlines the rights and obligations of each partner. There are no substantial filings or registration costs involved in setting up a partnership, and there usually are no annual registrations or other state formalities required to maintain it. Partnerships must obtain a tax identification number and file an “informational return” with the I.R.S. but, like the sole proprietorship, there is no separate taxation of your partnership, and all profits and losses are passed along directly to the partners in proportion to their ownership interests. The major disadvantage of this structure is that, like a sole proprietorship, each partner will have personal liability for any losses, debts and court judgments against the partnership, even if he or she did not directly cause them. Nonetheless, partnerships are commonly found among small groups of professionals and others who wish to do business together and who are able to buy liability insurance to cover their risks, and it may be the best structure for you.

3.  CORPORATION (C-Corp).

A corporation is created under state law, and it is an independent legal entity. Most large, major businesses in the United States are corporations, and virtually all publicly traded companies are corporations. When created, maintained and managed correctly, a corporation will protect your personal assets from any losses, debts and judgments against the corporation. As an owner of a corporation, you can take some money out as wages and some as dividends, and you will pay self-employment taxes only on the wages.

Corporations require substantial paperwork to create, have a rigid management structure, permit different classes of stock, and they have various ways for investors to control company decision-making and to get their money back on a preferential basis. In Massachusetts, it costs $275 to file the organizational papers initially with the Secretary of State and $125 annually after that. Money generally is raised by selling shares of stock. Stockholders must be U.S. citizens or resident aliens, and they exercise their authority in proportion to their investments in the company; the more stock they buy, the more authority they exercise. There are no limits on the number of stockholders, but the role of the stockholders is largely limited to electing the Board of Directors. The Directors, in turn, elect the Officers, who run the company.

Meetings, at least annually, must be held by stockholders and directors, and records of meetings must be maintained in corporate record books. In addition, formal corporate votes must be taken and recorded regarding matters of significance to stockholders and the company. Many people believe that this mandatory recordkeeping is a good thing for a company, but for some people, it is too cumbersome.

A C-Corp is taxed as a separate legal entity, and it must pay federal corporate income tax. It is the entity-of-choice for people who want to retain money, equipment, inventory and other assets in their company without necessarily being taxed on them. When a C-Corp earns taxable profits, it must pay taxes on those profits, and when the C-Corp distributes those profits to you, whether as wages or dividends, you must pay taxes on them, too. This often is viewed as a “double taxation” of profits, and it causes some small business owners to consider other types of structures for their new companies.

4.  SUB-CHAPTER S CORPORATION (S-Corp).

An S-Corp is a special type of corporation. It is created just like a C-Corp and shares most of the protective, management, record-keeping and investment attributes of a C-Corp. But, upon formation, there is a special corporate vote and an IRS filing, which then eliminates separate taxation of the S-Corp. No corporate income taxes are paid by S-Corps; instead the profits and losses are passed along directly to the stockholders in proportion to their ownership interests.

Because there is no “double taxation,” the S-Corp is the entity-of-choice for many small companies, especially small service companies. But, this tends not to be the right choice for a company that wishes to grow substantially by obtaining many outside investors or by “going public.” There is usually only one class of stock in an S-Corp, which may not work for many investors, and there usually is a limit on the number of stockholders in an S-Corp.

5.  LIMITED LIABILITY COMPANY (LLC).

The LLC is the newest and most popular structure for creating new companies. When created and managed correctly, an LLC will protect your personal assets from losses, debts and judgments against the company. It requires a minimum of paperwork to set up and maintain, and it is very flexible for creating any kind of management structure you may want or need. In Massachusetts, it costs $500 to register the company initially with the Secretary of State and $500 annually after that. Even if you are a 1-person company, having your small business structured as an LLC may present a better, more professional image than a sole proprietorship, and many larger companies would rather contract with your LLC to obtain your personal services than hire you individually as a contractor.

As opposed to corporate stockholders, membership in an LLC ordinarily has no U.S. citizenry or residency requirement. LLCs also are extremely flexible for allocating gains and profits among members, and the profits and losses typically are passed along directly to the members in proportion to their ownership interests, without separate taxation of the company.

But, LLC’s are not for everyone. In an LLC, as opposed to corporations, self-employment taxes must be paid on all company profits every year; for the owners, there is no division between wages and dividends as is found with corporations. Also, in most LLCs, all members have an equal vote on those decisions that are left in the hands of members, irrespective of the amount of their contributions and investments in the entity. So, this structure may not be best for you if your plan is to give your employees small interests in the business. LLCs also tend not to work well if you will be seeking to raise money through outside investors, as the investors likely will want to influence management decisions in proportion to their investments, and the corporate structure generally provides more flexibility for establishing preferential repayment terms for equity investors.

6.  LIMITED PARTNERSHIP.

With the growth and development of S-Corps and LLCs, the Limited Partnership has declined in popularity, but it still is used in complex real estate financing and other ventures and is worthy of brief mention. This structure has one or more “general partners,” who manage the business of the partnership, and one or more “limited partners,” who are investors who share in the profits and losses of the business. Unlike other types of business structures, in a Limited Partnership the investors must have no say or control whatsoever over the management or operation of the business. The general partners have personal liability for any losses, debts and court judgments against the Limited Partnership, but the risk to the limited partner investors is limited to their investments in the business. The entity is created by a Limited Partnership Agreement, and the Limited Partnership typically must be registered with the state. In Massachusetts, it costs $200 to register initially and $500 annually after that. Money is raised by Limited Partnerships by adding more limited partners. Like a General Partnership, there is no separate taxation of the entity, and all profits and losses are passed along directly to the partners in proportion to their ownership interests.

General Counsel says:  The creation of an entity and structure for your new company is very important. You certainly can do it yourself, but you should be aware of the many options and the many different ways to tweak those options. In our opinion, a DIY, out-of- the-box solution rarely is the best way to go. We have seen many small business owners who have tried to do this themselves and have made costly mistakes and omissions. You really should consult with an experienced business lawyer and/or accountant who can advise you on the best way to set up your new company and the most expedient, cost-effective way to create that structure.

PRIORITY ISSUES DESCRIPTIONS
At DailyGC, we provide legal advice and counsel on the full range of legal problems and legal-related business issues that small businesses and startups routinely face in their management, sales, operations and administration. The following are examples of these kinds of problems. You may use these descriptions on your Priority Issues Identifier Form� or you may write your own descriptions.
Business Contracts and Relations:
� Customer Contracts and Disputes
� Vendor Contracts and Disputes
� Collections
� Bank/Lender Relations and Issues
� Landlord/Tenant Relations and Issues
� Bonding/Insurance
� Nondisclosure and Confidentiality Agreements
� Procurement and Management of Outside Counsel
Employment:
� Recruiting/Hiring Practices
� Employment Agreements
� Employee Compensation and Benefits
� Employee Manuals, Policies and Procedures
� Compliance with Government-Required Benefits Programs
� Payroll Compliance with Court Orders
� Discrimination and Harassment Claims
� Management and Discipline of Problem Employees
� Terminations
� Unemployment Insurance Claims
� COBRA Procedures
� Hiring Independent Contractors
Dispute Resolution:
� Case Analysis and Assessment
� Mediation/Arbitration
� Strategies for Litigation, Discovery and Negotiation
� Settlement Analysis
General Corporate:
� Entity formation
� Corporate Governance and Record-Keeping
� Shareholder Relations
� Compliance with Governmental Regulations
� Compliance with Corporate Contractual Obligations
� Contract Review, Analysis and Negotiation Coaching