Starting your own business can be rewarding and energizing. And yes, it can be a bit stressful. You have numerous essential decisions to make during the critical start-up phase. One of the most significant decisions is choosing a business structure.
It’s best to seek counsel from an accountant, business counselor, and business lawyer when deciding. Your business structure impacts day-to-day operations, taxes, personal liabilities, how you raise money, and more. So when choosing a business structure, do so wisely.
Factors That Determine Your Business Structure
You can choose several options when setting up your business, including a sole proprietorship, partnership, Limited Liability Company (LLC), or corporation.
The one you select depends on several factors:
- Flexibility: Determine your expectations for business growth and ensure your structure provides ample flexibility to accommodate that growth. Generally, an LLC offers the most flexibility for growth potential.
- Liability: You’ll need to examine the risks and your potential personal liability. You’ll also need to consider insurance, credit, and assets. For example, corporations offer the most significant liability protection.
- Taxes: Sole proprietors, partnership owners, and S corporations classify income as personal income, while a C corporation separates business income from personal. Your structure impacts tax burdens because business income is taxed differently than personal income.
- Operating Costs: Keeping updated records and paperwork can be costly, so you will also want to factor in these expenses. Sole proprietorships are usually the business type requiring the least amount of time and money invested in recordkeeping.
- Fundraising: Your structure dictates how you raise funds. For example, sole proprietorships typically can’t offer stock, whereas corporations can.
- Control: A sole proprietorship is typically the best route if you want complete control over the business. However, you also assume total liability for potential lawsuits, taxes, and losses.
If you need more information and guidance on the factors impacting choosing your business structure, talk to a business formation attorney in our Bucks County or Montgomery County law offices.
After Choosing Your Business Structure, Can You Change It?
The answer is yes. Actually, it happens quite often. For example, many businesses change from a simple structure like a sole proprietorship or partnership to a more complex structure like an LLC or corporation.
A business structure change can happen for any number of reasons:
- Personal Liability: As businesses grow, so do the risks. Consequently, the owner of a sole proprietorship may want to remove their liability by moving to an LLC or corporation.
- Taxes: Generally, tax considerations are the prime motivator for a business structure change. For example, the IRS views businesses as partnerships or corporations. The latter pays taxes on profits before distributing those profits to shareholders. However, the former is a pass-through entity where profits and losses go through the individual partners and require reporting on tax returns.
- Attracting Investors: Venture capitalists and angel investors prefer investing in C Corporations for tax purposes. In addition, a more formal structure like a corporation or LLC establishes the business arrangement upfront and what the options are.
- More Employees: As your employee numbers increase, liabilities attached to them do as well. So moving from a sole proprietorship to an LLC or C Corporation protects you.
- Financing: Many banks want to see a more formal business structure before providing funding.
Changing your business structure differs based on your initial business setup. For example, moving from a sole proprietorship to an LLC, partnership, or corporation requires registration with the state where you conduct business.
You’ll want to create an LLC operating agreement when moving to an LLC. Moving to a corporation requires selecting officers, a board of directors, and shareholder agreements.
You’ll want to involve a business lawyer to help you sort through the details and ensure you manage all the requirements for the business structure change.
What are the Types of Business Structures?
How to form your business legally is controlled by the law of the state where you create your business. Your decision must consider liability, taxation, and recordkeeping.
The most common forms of business structures are:
- Sole Proprietorships
- Partnerships
- Limited Liability Companies (LLC)
- Corporations
So, let’s take a closer look at which to select when choosing a business structure.
Sole Proprietorship
Generally, this option is the most simple and most common. With a sole proprietorship, your business is unincorporated and run entirely by one person – you as the owner. Although this structure entitles you to all the profits, you are also individually responsible for all debts and liabilities.
You obtain the necessary licenses and permits for your business when operating as a sole proprietorship. However, they vary by state and industry. Also, if you operate under a business name, you may legally have to file for a fictitious name.
In many states, such as Pennsylvania, registering a fictitious name does not protect the name or give you any right to block others from registering the same fictitious name. Instead, it serves only as a notice to the public that you are trading under that name. In addition, you must file with the IRS for an Employer Identification Number (EIN) if you hire employees.
Because you are the sole owner, your business entity is not taxed. Instead, you report the income and losses on Schedule C to Form 1040.
Partnerships
A business is legally structured as a partnership when two or more people share ownership. As a result, each partner contributes to aspects of the company, and both share liability and income.
In choosing this business structure, developing a legal partnership agreement is essential to document how you will make future decisions. In addition, the contract should include terms for dissolving the partnership if necessary. Although a legal agreement is not mandatory, it’s strongly encouraged since operating a business without one is risky.
If you choose a partnership structure, you can form a general partnership. Consequently, everything is divided equally among the partners. On the contrary, a limited partnership allows a partner to have limited responsibility.
You can register partnerships with the state with an established business name and all licenses and permits. The business must also register with the IRS and file an “annual information return” to report its income and losses.
The company itself does not pay income tax. Instead, profits and losses are “passed through” to the partners.
Limited Liability Companies
An LLC, or Limited Liability Company, is a legally recognized business structure combining corporate and partnership aspects.
To form an LLC, you must first choose a name that complies with state rules. The next step is filing articles of organization with your state’s business filing office, typically with the Secretary of State. These are generally short and simple documents that take only a few minutes to fill out.
After filing with the state, it’s imperative to work with a business lawyer to create an LLC Operating Agreement that sets legal rules for the ownership and operation of the company.
Finally, make sure to obtain all licenses and permits required. Also, some states may ask you to publish notice that you intend to form an LLC in a local publication.
Corporations
Becoming a legally recognized corporation is more complex. First, states determine the formation of corporations. In addition, corporations pay corporate income tax at the federal and state levels.
Certain small corporations can elect Subchapter S status and be taxed like a partnership, avoiding corporate taxes. In that case, profits flow to the shareholders as ordinary income.
In a corporation, the business becomes a corporate entity, and the corporation is taxed and held legally liable for all business responsibilities.
The business first needs to choose a corporate name not used by another corporation or limited liability company and prepare and file articles of incorporation to become a corporation in the Commonwealth of Pennsylvania.
Pennsylvania corporations also need an agent for service of process in the state that agrees to accept legal papers on the corporation’s behalf. However, a corporation with a Pennsylvania address need not have a separate agent to service the process.
To complete the legal requirements of forming a corporation, you must publish legal advertising, create corporate bylaws and hold an organizational, board of directors-style meeting.
You can learn more by reviewing A Guide to Business Registration in Pennsylvania.
Which Business Structure Do I Choose?
This answer depends on your business, current ownership structure, and goals. You should assess your individual needs and choose the proper business structure.
It’s best to talk with business experts and a business lawyer near you to guide your selection. They can also ensure you complete any required paperwork and file it appropriately.
U.S. News cited our law firm as a “Best Law Firm.” So, you can depend on our attorneys to provide the best advice, particularly as a Pennsylvania Business. Our firm can also support you with various legal services, including business litigation, intellectual property, restrictive covenants, and workers’ compensation.
The information above is general: we recommend you consult an attorney regarding your circumstances. This information does not represent legal advice or a substitute for legal representation.