One of the most crucial decisions you’ll have to make when setting up a new business is what structure to use. The choices range from a simple sole proprietorship to the C corporation structure used by Fortune 500 companies.
The form you select dictates crucial issues, such as legal liability, tax treatment and the kinds of shareholders you can have.
“It’s certainly as important as the nature of your business and the way that you operate,” says Eric Siegel, president of Siegel Management Co., a business consulting firm in Bryn Mawr, Penn. “It’s easy to do this fast and wrong.” He and others recommend you consult an attorney, an accountant or both.
“In working with those advisers, you need to know what your objectives are with the company, your plans for operations and perhaps more important your plans for capitalizing the company,” Siegel says. “It’s not one-size-fits-all, but it’s not brain surgery either.”
Here are some of your options along with experts’ views of them.
If you are working for yourself with no partners, this is the simplest structure. You are your own business. You simply report your income on Schedule C of your 1040 tax form. But in addition to your normal income tax, you pay a self-employment tax for Social Security and Medicare.
- Potential users: Freelance business consultants, freelance journalists.
- Advantages: Simplicity, savings on overhead expenses — only one tax return, one bank account.
- Disadvantages: Self-employment tax (15.3 percent), no limit on legal liability.
That tax totals 15.3 percent (twice the rate you’d pay if you were working for a company) of your business income after deductions. It only applies to your first $102,000 of adjusted income. You can deduct one-half of the self-employment tax money you owe from the total amount that’s subject to your normal income tax.
You are personally liable for all the debts of your business. “That can include everything from your electricity bills to someone coming into your store, falling and then suing,” says Richard Rampell, chief executive of Rampell & Rampell accounting firm in Palm Beach, Fla.
Someone providing a simple service from his/her home — a business consultant or a freelance writer for example — may select this structure. If you don’t expect lawsuits, remaining a sole proprietor saves you the legal and accounting expenses of a formal company.
Tony Decello, a financial adviser at Deloitte Tax in Cleveland, says many of his clients initially favor a corporate or limited liability company, or LLC, structure to shield themselves from liability. But doing so doesn’t make sense for an individual, “unless you’re making significant money to justify two sets of books and two bank accounts,” says Decello, who has represented top golfers and tennis players.
And even as part of a corporation or LLC, an employee is personally liable for his/her own actions. “People will sue the entity and you,” he points out. “It’s often cheaper just to buy commercial liability insurance.”
If you choose the sole proprietor option, you can still give your business a name other than your own to make it sound more professional. Simply register as a business with your municipality.
Brendan Murphy, a journalist and business consultant, named his business Curragh Publishing (borrowing the word for a small Irish boat) and opened a bank account using that name.
Limited Liability Company, or LLC
As the name implies, your liability is limited under this structure. You can also avoid the double taxation that comes with a C corporation. Under that structure, the corporation pays its own income tax, and then shareholders are taxed when they receive dividends.
With an LLC, you can choose to have income passed through to the company’s members. The company pays no income tax, but the members are subject to self-employment taxes. An LLC can have any number of members — from one upward.
And unlike an S corporation, which has to distribute dividends in proportion to number of shares held, LLCs can divvy out profits however they choose. “You have a lot more flexibility using an LLC than other structures,” says Saul Brenner, a partner at New York City accounting firm Berdon LLP.
Limited Liability Company, or LLC
- Potential users: Any business that doesn’t need to go public or attract venture capital quickly.
- Advantages: Flexibility in ownership and dividend payment structures, limited legal liability, no double taxation.
- Disadvantages: Self-employment tax, no tax deduction for dividends, uncertain legal environment compared to a corporation.
“You have the advantage of limited liability that you get through corporations, but a lot more flexibility as to allocation of income. You can get different people involved as equity owners with different classes of membership. It’s far superior.”
S corporations aren’t subject to double taxation and offer limited liability. Employees aren’t subject to self-employment taxes.
- Potential users: Businesses that want the legal certainty of a corporate structure, but the tax treatment of an LLC.
- Advantages: Limited liability, no double taxation, no self-employment tax.
- Disadvantages: Inflexible ownership structure — profits and losses must be allocated in proportion to ownership shares, you can’t have corporate or foreign owners.
But be careful about pushing out all your income as dividends to avoid having to pay Social Security taxes. “If the IRS sees you didn’t take out any of your income to pay salaries and didn’t pay Social Security taxes, it can make you reclassify some of your income as salaries.
And keep in mind that an S corporation is limited to 100 shareholders and one class of stock. If you have a business for which you need a lot of investors — a real estate development company for example — that could be a serious disadvantage.
This is the most common structure among larger companies. “It’s the favorite form for startups looking for eventual venture capital investors or a public offering,” Rampell says. That’s because of its simplicity.
But he and others caution against blindly adopting this structure. For example, a startup that suffers losses during its first two years would do better as an LLC, Rampell points out. That’s because LLC members will be able to write off the losses on their personal taxes.
“In a C corporation developing-year losses get wasted until you make a profit,” he explains. “And in an S corporation you can only deduct the money you’ve invested or directly loaned to the company.”
The journalist Murphy started a C company called FXOTICA.com in 2000 as a currency trading service. That idea didn’t succeed, and he hopes to re-launch it as an African business development service.
If he was starting now, Murphy would reconsider the C corporation choice. “In the early stages I spent tens of thousands of dollars to set up structures and issue shares,” he says.
“It gets very expensive. In those days, people were raising a lot of money with the dreams it would turn into a very large business. In today’s environment, the expenses for that structure are prohibitive. As a small business, you want to keep your legal and accounting expenses down.”
- Potential users: Businesses that want to go public or garner venture capital investments.
- Advantages: Limited liability, flexible ownership structure, tax deduction for dividends, no self-employment tax.
- Disadvantages: Expensive to establish and maintain, double taxation.
Some C corporations try to avoid the double taxation problem by giving out all their profits in compensation. But that’s not a wise strategy. “You get into issues of unreasonable compensation,” Brenner says. “The IRS can say your compensation is too high, that some of it is disguised dividends.”
Many experts say LLCs represent the top option for most startups. “One of my partners has a saying: ‘If you go to a lawyer, and he sets you up as anything but an LLC, he’s committing malpractice,'” Brenner says.
Gary Schildhorn, a lawyer for Eckert Seamans in Philadelphia, cites an anecdote in which his clients benefited from the LLC structure. Two salesmen who had worked in a staffing company business wanted to start their own firm.
“They could bring their old accounts to the new company, and they also wanted to include a third colleague who could bring a lot of knowledge and experience to the table,” Schildhorn says. “But the third guy had a noncompete contract with his old firm lasting for 12 months.”
They started an LLC with only the first two as members. But the third guy was granted an option to purchase a percentage of the company, and once he did so, he became president.
Thus, thanks to the flexibility of the LLC structure, “they were able to assure him he’d be part of the company, even though he was restricted from joining them for a few months,” Schildhorn says.