Determining the right structure for your startup

March 28th, 2014 Shawn Lisk
startup

Starting your own business is exciting, but also has many challenges. Making the right decisions during the startup phase can have a significant impact on the success of your business over the long term. One of the most important decisions is choosing the right structure for your company regarding finances, taxes and organization.

There are several different small business structures available, and this information will help you analyze them and determine which one most effectively fits your business.

Sole Proprietorship

If you are the only person who owns your business, sole proprietorship is an option. Many one-person home businesses set themselves up as a sole proprietorship.

The biggest advantages of this approach are low startup legal costs and that it allows you to solely obtain all profits. The biggest disadvantages are that you are also fully responsible for your company’s liabilities and debts, and the business is dissolved upon your death or bankruptcy.

Sole proprietorship is the most common structure for launching a business. However, down the road, most businesses change to a partnership or corporation.

Sole proprietorship is one of the quickest ways to start a company. It allows you to start without having to file any legal documents except a “fictitious business name statement,” which means you’ll be operating your business under a fictitious name and “doing business as” termed as DBA.

General Partnerships

Another way to structure your business is a general partnership. In this arrangement you join together with one or more persons to own the business.

You can set your business up fairly quickly with your partners because you generally do not have to formally file any paperwork with the state government. However, it is critical to create a written agreement with your partners that establishes the terms and conditions of the partnership – including profit sharing, ownership percentage and individual responsibilities.

Because it can be a complex situation, the best approach is to discuss the agreement with your legal and tax advisors. In addition, it’s important to understand that, while you can start the business quickly and with little legal paperwork, general partnerships do not protect you or any of your partners from personal liability.

Limited Partnerships

You can also structure your company as a limited partnership, which is formed with one or more general partners and one or more limited partners.

The difference between “general partners” and “limited partners” is that the general partners have unlimited liability and are generally more active in the company, while limited partners have limited liability and are not as invested in the company.

The advantage of this approach is that it allows you to set up the company with more power and control allocated to the general partners, but still allow limited partners to join the company as limited owners.  The biggest disadvantage of a limited partnership is that it does not legally incorporate your business, which may be a critical change you’ll need to make as your company grows.

While you don’t have to file a lot of legal documents, it’s important – as in general partnerships – to create a detailed partner agreement.

Subchapter C Corporation (C-Corp)

Subchapter C is an option you can choose when you want to legally incorporate your company. You will be required to file “articles of incorporation” with a specific department of your state government. The “articles of incorporation” are legal documents that include detailed corporate information, including name, purpose, shares authorized, name and address of initial registered corporate agent and principal location of business.

Most states require you to hold annual meetings of your directors and shareholders, which help protect you from personal liability.

The biggest advantage of a C-Corp is it can be easier to obtain loans from banks and other lenders, since you’re incorporated. The biggest disadvantage is that, as a C-Corp you must pay taxes on the corporate level when making distributions to shareholders, plus the shareholders must pay personal taxes on the distributions – the result is income being taxed twice.

Subchapter S Corporation (S-Corp)

One of the most common choices for incorporating a startup company is the S-Corp structure. It offers you all the advantages of the C-Corp, but also has a significant tax advantage. By incorporating as an S-Corp company, you avoid the double taxation on shareholder distributions, and company profits are taxed to individual shareholders based on their percentage of ownership, and their personal tax rates.

In order to launch as an S-Corp, you will need to meet specific Internal Revenue Service regulations, and file additional forms with your state government. Most S-Corps are also required to have the number of shareholders restricted to 75 or less.

However, even though there are more legal requirements, S-Corps do offer excellent tax advantages. Shareholders are not required to pay Social Security payments on their profit distributions, and as mentioned before, the corporation is not taxed on the distributions, only the shareholders are, so there are no double tax payments.

Limited Liability Company (LLC)

Many small companies choose to incorporate themselves as a Limited Liability Company (LLC).   Setting up your company as an LLC is very flexible for small and medium sized companies, and has several advantages that Sole Proprietaries, Partnerships, C-Corps and S-Corps don’t have.  In addition, you can set up an LLC as a single owner.

To set up an LLC, you need to create and file “articles of organization” and an Operating Agreement. Incorporated as an LLC, you’re not restricted to issuing only one class of stock, and you’re not limited to the number of shareholders. In addition, all members of an LLC are generally protected from liability.

Another advantage is that many states allow flexibility for LLCs by allowing the Operating Agreement to set aside default provisions that would otherwise govern and restrict the company.  The main disadvantages are that in some states, there are businesses that don’t qualify to become LLCs, and the Operating Agreement can be complex and a challenge to create.

When you’re at the point in your new business to choose the structure, we recommend you meet with and discuss the options with financial experts. They can help you plan for the best tax situation, give you legal details on setting up your business, and help you choose the structure that best fits your goals for your company.

About the author

Shawn Lisk is a Commercial/Ag Banker at MidWestOne Bank.

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