Why does a company's business structure matter so much? And what is it startup entrepreneurs may not know about business organization that influences so many other important business decisions?
The fast answer to these questions is a company's legal structure determines income tax rates, the "ownership" of company debts, and the ease in which owners can invite partners and investors into a business.
The leading business structure options that are available to startup entrepreneurs in most states are a sole proprietorship, Limited Liability Company or one of several types of partnerships and corporations.
The most popular form of business organization is the sole proprietorship. The great advantage of a sole proprietor structure is that it is simple and inexpensive to organize. This means startup entrepreneurs get to spend more time pursuing customers than doing paper work.
Another benefit of a sole proprietorship business organization is the ease of tax reporting. All startup entrepreneurs have to do is add up all relevant business income and expenses and report them on Schedule C of a personal income tax return. It's that easy.
In contrast, organizers of C corporations have to prepare a personal income tax return plus a more complex corporate tax return. In addition, in order for entrepreneurs to keep their corporations in "good standing" they have to prepare formal financial statements and keep accounting books and records that are separate from personal income tax information. All of this adds to the administrative costs of running a business.
Sole proprietorships also make it easy for entrepreneurs to start and stop business activities at will. This benefit can be cost-effective for sole proprietors who work part-time or unemployed workers who hope to rejoin the workforce in the near future.
Avoiding Double Taxation
A key tax saving benefit of a sole proprietorship is the opportunity to bypass traditional higher rate corporate taxes and just report business related income on a personal income tax return. Equally, entrepreneurs are allowed to apply most business losses on a personal income tax return, thereby reducing personal tax obligations too.
Despite all the tax and time-saving advantages of a sole proprietorship organization, it still may not be the best business structure for every startup entrepreneur. Here are some considerations:
- High risk business operation. Do you produce or sell toys, food or medical products or work within an industry that is known to be litigious? Do you offer professional advice as part of your service to customers? If your startup business doesn't have the financial resources to pay the costs of the wrongful acts of employees, bank debts, or liability claims, then you may be personally responsible for these obligations. Business structures that can shield owners' assets from business debts and liabilities include corporations and Limited Liability Companies.
- Appealing to investors. Startup entrepreneurs who expect to raise money from foreign investors, corporations, venture capital funds, or "angel" investment clubs should consider a C corporation. Professional investors mostly prefer to invest in C corporations for flexibility in issuing shares of different classes of stock to an unlimited number of shareholders and ability to easily carve out portions of a business for sale or joint venture activities. Ambitious startup entrepreneurs who are working toward the day they can take their companies public on a U.S. stock exchange or sell to a large corporation should organize as a C corporation too.
- Employee incentive plans. Creative, yet cash-poor entrepreneurs have long offered first employees and even professional service providers the opportunity to earn equity in a business in exchange for their business building assistance. The administration of most types of equity grants, particularly stock option plans, is best suited to C corporations.
- Separation of assets. Entrepreneurs who want to keep business assets separate from spouses who share bank accounts should consider a liability-limiting structure that doesn't mix business income and losses on personal tax returns. While it may seem a little sneaky or deceitful to separate business interests from spouses, I believe it can be an act of love. Think about this. It's better to take steps to keep potential business losses within a business, than for two people to potentially lose everything they have ever owned as individuals or as a married couple.
So, is a sole proprietorship the right business organization for your new business idea? The great thing about entrepreneurship is you get to decide what's best for you without the nagging oversight of a grumpy boss!
Susan Schreter is a 20-year veteran of the venture finance community, MBA-level educator and policy advocate for small business owners. Her work is dedicated to improving startup operating performance with reduced personal risk to entrepreneurs. She is the founder of www.takecommand.org, which offers the largest centralized database of regional and national small business funding sources in the U.S., including angel clubs, micro-finance lenders, venture capital funds and more. Follow Susan on Twitter @TakeCommand