Lesson 5: Business Structures
What You’ll Learn: Choosing the right business structure is one of the most important decisions you can make as you start a business, since it affects your tax liabilities, legal exposure, and potentially, your personal assets. Don’t worry, it’s not as complex as it seems and we’ll take you through the options along with the advantages and disadvantages of each.
Business Structures (continued)
Corporations
A corporation is a more complex structure, and more expensive to form and administer than a sole proprietorship or partnership. That said, a corporate structure does offer you more protections, in part because a corporation is considered to be an independent entity that is separate from its owners.
The biggest benefit of incorporating as an S, C, LLC or Social Purpose Corporation is liability protection. First, the debt of the corporation is not considered that of its owners. So you aren’t putting your personal assets at risk, except in rare instances, such as malfeasance. A corporation can also retain profits so you don’t have to pay taxes on them. You are able to raise money more easily since you can sell stock.
The downside is increased regulation. You’ll probably want to consult with an attorney to guide you through the incorporation process as there are specific filings that need to be made with the Secretary of State and with the IRS. You will need to make sure that you file the required forms annually to demonstrate that your corporation is active and conducting business.
Corporations need some additional paperwork. This includes your articles of incorporation and bylaws that outline things like when your annual meeting will be held, how officers are elected and terms, etc.
Following are the different corporate structures a new business would use:
Limited Liability Corporation (LLC)
Think of an LLC as a hybrid of some of the best features of partnerships and corporations. Earnings and losses are passed through to the owners on their personal tax returns, much like an S Corporation. Every member or owner of the LLC can participate in the operations of the company, in contrast to a partnership where investors may not be active in the decision-making of the company. LLCs can have an unlimited number of shareholders; an S Corporation can’t have more than 75.
LLCs offer owners limited liability, including protecting personal assets. Tax preparation is fairly straightforward. Profits and losses are reported on the personal returns of the individual owners. The business does not file a separate return. Like a partnership, profits and losses can be distributed according to a percentage distribution.
Stock is not an option in an LLC, so raising money from investors can be more difficult than with an S Corporation and you can’t offer stock options to a new hire in lieu of salary. Also, you must file an operating agreement to list the members’ rights and responsibilities, similar to what you need to file with a partnership. Members of the LLC may have to pay self-employment taxes as well as Medicare/Social Security taxes.
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S Corporation
Many small businesses prefer an S Corporation, in part because it offers the additional tax benefits and liability protections larger C Corporations enjoy. Income and losses are passed through to the shareholders and reported on their individual tax returns. Personal assets are protected as an S Corp is considered a separate entity. Owners can also receive paychecks, which makes it a little easier to get financing for a new car or home, assuming your credit is good. If you don’t maintain inventory, you can use the cash method for accounting, which means income is taxable when it’s received and expenses are deductible when they are paid.
Because they have to follow the same rules as larger C Corporations, there are more filing requirements, including holding an annual meeting, maintaining minutes and voting on major corporate decisions.
Social Purpose Corporation
We covered this particular business structure in Lesson 2. If you recall, Washington State is one of only 10 states that allow the formation of a social purpose corporation (SPC). This is a corporation that is organized to support a social purpose that involves:
- The corporation’s employees, suppliers or customers.
- A local, state, national or world community.
- The environment.
It allows the organization’s directors to weigh and consider social purposes before making decisions, even if it results in a lower shareholder return. Directors are legally protected if they decide to choose environmental or social impact over economic gain. The Secretary of State handles SPC applications.
Nonprofit Corporation
A nonprofit corporation is a legal entity that is usually tied to some larger ideal or goal rather than the interests of making a profit. If the nonprofit is formed to raise funds from the public, it may need to be registered as a charity with Washington’s Secretary of State. The state has a great guide that covers everything you need to know about starting a nonprofit in Washington State.