A frequent question among my SCORE clients is: What type of business structure should I setup?
There are several different types of business structures to consider. All have there advantages and disadvantages. The first thing to think about when considering a structure is the needs of the business and the needs of your investors (if you have any). The three most common I recommend is: Sole Proprietor, Limited Liability Company (LLC) and a Corporation. A good comparison chart of the different legal and tax implications can be found here.
There are a couple of other types that I deal with less frequently. These are: Partnerships or Limited Liability Partnerships (LLPs), S-Corporation and Non-Profits. An LLP is usually used for professional partnerships such as a group of lawyers or doctors. The S-Corporation is not used as much since the advent of the LLC, so I typically don’t recommend them. Non-Profits have their own unique set of criteria and fall under various rules, depending on the type (see 501(c) for more details as well as this IRS site for 501 (c) 3). They are not that hard to setup and are akin to a corporation in structure.
Lets now take a look at the three most common structures I recommend and how they might work for your particular business.
A sole proprietor is the easiest to setup and shut down. There are no federal forms to fill out to start one. All profit is taxed as personal income and you can shut it down by just stopping doing business. All business expenses can be written off just like any other business. It has no liability protection and cannot change ownership easily since it is tied to the person. To change owners, the sole proprietor usually just sells all of the assets to the new owner.
Usually a sole proprietor will setup a fictitious business name or a Doing Business As (DBA) so that they don’t have to use their name as part of the business. If you do use your name, then you can skip the DBA step. Local laws vary, so check with the county you do business in for specifics. Along with a DBA, many business require a business license in order to operate. These licenses are usually at the city level, so check with your local chamber of commerce or city hall for specifics. A more detailed article on sole proprietors can be found here.
Typical Type of Business: Freelancer (single designer, book keeper, etc.), handyman (with proper insurance), small shop owner, arts and crafts and artist.
Limited Liability Company (LLC)
LLCs are state specific entities that can be treated as a partnership or a corporation for federal taxes. They offer the members limited liability in terms of the 3rd parties being able to sue members. Each state varies in its treatment of LLCs. Mostly, it has to do with taxes. Check out this table for a comparison by state.
LLCs are great for business who have liability because of their operations (such as construction). Forming an LLC is straightforward. There are two documents that need to be drafted and filed with the appropriate secretary of state . These are the Articles of Organization and the Operating Agreement. Both spell out how the LLC will conduct its business. All LLCs need a managing member or a manager that takes care of legal compliance.
Ownership in an LLC is based on percentage. The number of members can be as many as required (unlike an S-Corporation, which can only have up to 100). No stock is issued in an LLC. All profits and losses pass through to the members via a Schedule K-1 if the LLC is taxed as a partnership. An excellent article on LLCs is here.
Typical Types of Businesses: Rental Real Estate Holding Company, Construction, Manufacturing, Multi-person Professional Business (like photographer, design studio, etc.).
Corporations are the most governed out of three structures discussed here. They provide limited liability just like the LLC. The biggest differences between the LLC and the Corporation is the issuance of stock and the setting up of a board of directors. Corporations are formed with articles of incorporation as well as the creation of bylaws.
Most venture backed corporations are incorporated in Delaware since Delaware corporate law is the most straightforward and is studied by almost all law students. If you want to someday raise venture capital, then your best bet is to form a Delaware Corporation. Take a look at this article for more on corporations.
Some consultant’s go the corporation route since it mitigates some of the issues related to hiring contractors (see this IRS article for details). For those applications, it is usually best to form a corporation in the state you do business in but this all depends on your specific case.
Types of Businesses: Any venture capital back company, companies wanting to go public, capital intensive companies that need to raise funds, companies that want more governance and structure.
Do What Makes Sense
As you can see, there are several types of business structures to choose from. The best structure for your business depends a lot on what business you are in. If you are just a freelancer working by yourself, then a Sole Proprietor is probably the way to go. If you have partners or are in a business with potential liability (like construction, etc.), then an LLC might be for you. If you think you might raise funds from a venture capitalist, then a Delaware Corporation is your best bet. No matter the structure, if you have any doubt, talk to a lawyer or a CPA. They will be able to review your specific requirements and give you a recommendation.
- This IRS site is a good overview of how the IRS deals with the different structures
- This SBA site has a handy advantages/disadvantages list while this one gives the details of all of the structures
- Take a look at this link to appreciate the amount of effort required to keep up a corporate and what happens when you don’t.
- Orrick has a great site for form and calculators to help you start a venture backed company.
- Formswift has a great guide on when and how to use Form 1099.