One of the most important, and yet the least understood part of your business financing is how your business will be structured.
You can choose one of six options: Sole Proprietorship, General Partnership, Limited Partnership, Limited Liability Company, C Corporation or S Corporation. You will find that each of these differ to the degree of liability that you, as an individual will have and also how each is subject to taxes.
- A Sole Proprietorship means that you, and you alone, own the company and are responsible for both its assets and its liabilities. This is the most common and by far the simplest of structures, but as a sole proprietor, you can be held personally liable for the debts and financial obligations of the company. This risk also extends to any monetary obligations or penalties gained as the result of an employee of yours. Business financing will be much harder to come by and will also have more risk attached, as investors will not usually invest in sole proprietorships. Both a good and bad point, depending upon how you feel about it, is that you will be completely in charge. You will have the responsibility for making every type of business decision there is, from inventory, to suppliers, to employees, to the type of toilet paper you put in the restroom and if it will roll over or under. Some of the pros for having a sole proprietorship include the fact that if you decide to sell or transfer, you don’t have to get anyone else’s approval. There are few legal costs associated with forming a sole proprietorship and there are few formal business requirements. You also will not be responsible for corporate tax payments, but if this is the only reason that you are considering a sole proprietorship, you might want to think again.
- A General Partnership is when you contract with one or more other people in order to run the business with equal responsibilities and liabilities. These can be operative or financial and must be spelled out in regard to who has what responsibility and how much financial liability each partner has. These are formed by individuals and are taxed much the same as a sole proprietorship is taxed. Some of the advantages include the fact that business financing is more readily available as you can pool your financial resources, though don’t plan on looking to investors for business financing. General Partnerships are also situations that investors go into very cautiously. Finding business financing through an investor may be difficult, if not impossible. You also have others whose expertise and strengths you can depend upon to provide ideas and take on projects that may be beyond your own scope. A General Partnership comes with limited startup costs and there are few formalities to go through in order to form one. Some of the disadvantages are the difference of opinions that can occur. Partnerships can be fraught with discord as the parties have differing visions or goals. Partners are also personally liable for the business’s debts and financial liabilities, something I have counseled against over and over. It is also a situation where it is “One for all and all for one”. In other words, if one of you makes a business blunder or even breaks the law, all of you can be held liable.
- A Limited Partnership can be formed to bring in more expertise or skills or even money, but in this situation there must be at least one general partner that shares equally in the business’s financial obligations and responsibilities. Limited partners are often silent partners to the extent that they are not necessarily involved in the day-to-day running of the business, but may have other interest, financially or otherwise, and they will share in the profits of the business. Various reports will have to be filed with the Secretary of State for your particular state and each state has laws on the books that regulate the responsibilities and obligations of the partners in this type of business. Again, additional business financing may be difficult to come by, as investors are also cautious of this type of business structure, but with the partners in place, additional business financing may not be necessary and you are more likely to attract investors to a Limited Partnership than to a Sole Proprietorship or General Partnership. The reason for this is that the general partner in this relationship can be a corporation or LLC, which can be attractive as far as mitigating financial liability. The con is that the corporation or LLC can also be a part of and have a vote in the major decisions that affect the partnership. Your biggest problem may be in finding the general partner required, as they assume personal liability. Limited partners, on the other hand, can leave the business or be replaced without having to dissolve the Limited Partnership.
- A C Corporation is a traditional business structure that leaves you with little or no personal financial liability. It is established as a unique business entity and is a for-profit, state-incorporated business. Fees are paid and numerous legal documents filed, to include the Articles of Corporation. Unlike the above structures, business taxes are filed separately from personal taxes with the IRS and corporate taxes are paid on a quarterly, bi-annual or annual basis. Any debt the corporation incurs will not be the personal responsibility of the owner or owners. Business financing can be obtained by the corporation, not by the individual, and the corporation can own property, enter into business deals or even file law suits independently of the owners or shareholders. A big plus in having a C Corporation business structure is that the corporation can take advantage of corporate benefit health plans and group life insurance plans, up to a specified amount per employee. Retirement options are often better than those offered by non-corporate plans. The biggest downside is the double taxation that takes place. Besides paying corporate income taxes, the dividends paid to shareholders are also taxed at the applicable tax rate. Though the corporate tax rate can be higher, the initial taxes can be much lower. The first $50,000.00 is taxed at a rate of 15%, while a sole proprietor will be paying 28% on his or her personal income tax from the first dollar.
- The S Corporation, which happens to be my favorite business structure option, is much the same as the C Corp in reference to liabilities, but an S Corp is not double taxed. An S Corporation is only taxed on the personal level, which for the first $50,000.00 may be higher, but in the long run will be lower than what a C Corp will ultimately pay. It is also really easy to convert from an S Corp to a C Corp if your business grows to such an extent that you wish to change your business structure. Most of the paperwork will already be in place and the financials will be well-documented, so converting from one to the other is fairly easy and pain-free. An S Corp can have no more than 100 shareholders, for example, which would be one reason to convert to a C Corp. An S Corp also has residency requirements that a C Corp will not, but as long as you meet the criteria, I would definitely look at structuring your business as an S Corporation as opposed to any other. Business financing is usually the easiest to obtain when you are an S Corp, though both the S and C Corps commonly receive investor financing. The biggest difference between an S Corp and a C Corp is in the taxation and the additional risks associated with the higher taxation.
- A Limited Liability Company, or LLC, is a relatively new business structure that basically incorporates the advantages of a Sole Proprietorship with that of a Corporation. Basically, it operates as a separate legal business entity, but without having to incorporate and be subject to the rules, regulations and taxation of a Corporation. A fairly simple operating agreement is drawn up and agreed upon by the members, and then filed with the state, but shareholders are not required and the formalities that a corporation must adhere to are not upheld in the case of an LLC. Most LLCs must have two or more members, but some states are doing away with that requirement and allowing a single member to form an LLC. This is kind of a “you can have your cake and eat it too” form of business structure, and though I personally don’t care for an LLC, I can appreciate the advantages of an LLC, such as the personal liability protection and the more relaxed requirements when it comes to paperwork. Business financing is more readily available than for an SP, GP or LP, but not as easy to come by as if you had a Corporation. Some investors though are becoming much more comfortable with this newest form of business structure, just making sure that the structure of the LLC is designed to provide the investor with a specified amount of control.
So, do your research. I definitely suggest obtaining the services of either a business attorney or a financial advisor, especially if this is your first look at business structure and how it could possibly affect your business financing. And, I’d like to remind you that I always recommend separating your business finances from your personal finances; more than ever in today’s economy, well-informed decisions and erring on the side of caution will give you some form of financial protection.