Thinking to start your own business? Or maybe your business is growing and some form of reorganization is necessary to manage it all? If you are engaged in the sale of a product or service commercial law pretty much governs your options for setting up and administering your business. These entities include corporations, cooperatives, partnerships, sole proprietors, limited liability companies and others.
So, which type of business structure is right for you? The answer depends on the type of business you run, how many owners it has, and the overarching financial situation. Some of the most important factors to consider, include:
- the potential risks and liabilities of your business
- the formalities and expenses involved in the various business
- the motivation behind the venture (profit, social, or charitable)
- your income tax situation
- your investment needs, and
- the sources of revenue.
In large part, the best ownership structure for your business depends on the type of service or product it provides and the sources of revenue. Often the ownership structure is ruled only by tax and risk questions but there are many other reasons. I will highlight legal, tax and motivational reasons that are associated with specific business structures and in particular provide information on two new entities.
If your business engages in what most people would consider “risky activities” you ought to consider a business entity that provides some personal liability protection (such as a limited liability company, or LLC), which shields, to a certain degree, your personal assets from business debts. Note that I said it offers some personal liability protection.
Under a traditional corporate structure, corporate directors have a fiduciary duty to exercise business judgment with the goal of maximizing profits. In fact, corporate officers and directors can be held legally liable to shareholders if they do not maximize profits to the exclusion of other goals.
New to the mix are benefit corporations (sometimes informally called a “B Corp,” not to be confused with a certified “B Corp”). Benefit corporations don’t follow the traditional profits-only model. Instead, these have a dual purpose, to generate some type of public benefit while creating value for their stakeholders. For example, if the charter of a benefit corporation makes it clear that it is organized to build affordable housing, officers and directors are therefore held accountable to achieve both this objective and a profit. Legally this means benefit corporations are shielded from lawsuits by shareholders who argue that the corporation has diluted their stock by putting social objectives over profit.
Of course there is also the full non-profit corporation where the social mandate is the only mandate and large profits are not permitted. Most nonprofits are known by their 501 tax-exempt status. Owners of sole proprietorships, partnerships, and LLCs (LLC for tax purposes) all pay taxes on business profits in the same way. These three business types are “pass-through” tax entities, which means that all of the profits and losses pass through the business to the owners, who report profits (or deduct their share of losses) on their personal income tax returns. Therefore, sole proprietors, partners, and LLC owners can count on similar tax complexity, paperwork, and costs. Owners of these unincorporated businesses must pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. That said, LLCs do have the option to file as a corporation for tax and benefit purposes.
In contrast, the owners of a corporation do not report their share of corporate profits on personal tax returns. Owners pay taxes only on profits they actually receive in the form of salaries, bonuses, and dividends. The corporation itself pays taxes, at special corporate tax rates on any profits that are left in the company from year-to-year (called “retained earnings”). Corporations also have to pay taxes on dividends paid out to shareholders, but this rarely affects small corporations, which seldom pay dividends. A double taxation occurs when the corporation pays taxes on its profits AND the owners pay taxes on the dividends. Subchapter corporations (S Corp) are popular with professional services businesses primarily for tax reasons.
Unlike other business forms, corporations can sell ownership shares in the company through stock offerings. This makes it easier to attract investment capital and to hire and retain key employees. But for businesses that don’t need to issue stock options and will never “go public,” forming a corporation may not warrant the added administration and expense. If it’s limited liability that you want, an LLC provides the same protection as a corporation. If it is ease of use, then sole proprietorship or partnership may be the most appropriate. Moreover, the simplicity and flexibility of LLCs and sole proprietorships can offer a clear advantage over corporations.
An L3C is a new variation on the LLC. What sets it apart from regular LLCs and other for-profit entities is its ability to pursue charitable, educational or socially beneficial objectives. Although the L3C can also pursue profit oriented objectives, they are secondary to its social goals. The L3C is a hybrid entity taking on the flexible characteristics of an LLC in combination with a low-profit socially beneficial objective. The verdict is still out on their usefulness and whether or not these business entities will endure, but they are currently an option in some states, including Hawaii and California. For social and community conscious business ventures to succeed, they need a flexible, lightly regulated business structure that allows access to investment capital.
The L3C format was designed to satisfy this need. Before you can decide how you want to structure your business, you’ll need to review your vision for the business against all the available structures. Here’s a brief rundown on the most common ways to organize a business:
- sole proprietorship
- limited partnership
- limited liability company (LLC – profit mandate)
- low profit limited liability company (L3C- profit & social/community mandate)
- corporation — usually C or S Corp (for-profit mandate)
- benefit corporation (profit & social/community mandate)
- nonprofit corporation (not-for-profit or 501 firms), and
If you are contemplating a new business or thinking to restructure an existing one, you should seek both legal and tax professional advice. Aikapa can help integrate this advice with your vision.
Edi Alvarez, CFP®
BS, BEd, MS