The Daily MBA

Tips, Tools, and Techniques to be a Better Entrepreneur

Topic #2: Business Structures

Talking Points

  • Non-Profit vs For Profit has tax and ownership implications
  • Sole-Proprietors (including a partnership) controls their own destiny including any liability.
  • Limited Liability Companies (LLC) vary state by state. They provide liability protection to owners.
  • S Corporations are limited to US citizens and a limited number of stock holders.
  • Limited Liability Partnerships are usually reserved for professionals like lawyers, doctors, venture capitalists or architects
  • Corporations issue stock and have a board of directors that provide oversight.

Discussion

Selecting a proper business structure can be daunting. There are so many tax, liability and investor consequences that sorting through it all can make your head spin. Before you settle on a specific structure, you should seek advice of a lawyer or business professional just to make sure you have not missed anything. This topic will go over the different structures and what they do. Things to consider when choosing a structure include:

  1. Is it for Profit or Not? This will determine your tax status, ownership and how your governance is setup
  2. What is the Liability Profile: Liability is anything that you could get sued over. Protection against liability can either be the entity has limited liability or you have insurance to cover any issues.
  3. Will you have Partners? If you plan on having partners, then you need to consider who owns what, the management structure and responsibilities.
  4. Do you need Investment? Outside investors will want some control over their investment. If it’s a company that requires venture capital, then they most certainly will want a Delaware corporation and a board seat. Other investors may just want to be “silent investors” which means they want periodic updates but don’t worry too much about the day to day operations.
  5. Will you Operate and Grow or Just Hold Assets? Some structures are ideal for holding assets (like real estate or an investment pool) while others make it possible to operate and grow a business. The tradeoff usually has to do with taxes (losses due to depreciation) and investors (taking investment to build a product).

Keeping those questions in mind, lets take a look at the structures you have to choose from. They are:

Sole-Proprietor

Is a single person business. You don’t need to file anything with the state or federal government to start.. You just start doing business. There are local permits or licensing depending on your city, county or state. In this structure, the business and the person are one. That means that all losses, profits and liability are the owners.

Partnership

One or more persons that agree to engage in a common business activity is called a partnership. Traditionally, these are professional people (lawyers, doctors, architects, etc.) that form a firm to practice their craft. It’s similar to a sole proprietor except there are multiple people. The same losses, profits and liability rules apply. There are Limited Liability Partnerships (laws vary from state to state). The LLP is similar to an LLC (see below) except the limited partners don’t run the day to day operations of the LLP. They are complicated to setup and usually reserved for investment funds and the professionals listed above.

Cooperatives

These entities are groups of people who come together and run the business like a democracy. All decisions are made as a group of equals. Most states have specific laws on how to form a co-op. Check with your state for specifics. This type is not that common, so consult a lawyer for specific questions.

Limited Liability Company (LLC)

As the name implies, the LLC protects the owners from liability. If your business may have liability issues, then an LLC or Corporation is your best bet. These entities are created state by state, so check your state LLC laws. Each state has different tax laws as well as reporting requirements. This structure has mostly replaced the S-corporation since it’s easier to setup and manage. From a tax perspective, LLC’s are treated like partnerships (or sole-proprretors) where the loss and profit are passed through to the owners. Usually, an LLC is managed by an appointed manager that takes care of the day to day operations. Other owners can be involved in the business but typically play an advisory role or no role at all.

C-Corporation

C-corporations are the most formal of the structures. They require a board of directors, annual meetings and stockholder reports. A corporation is basically a separate legal entity that stands on it’s own. Which means it can sign contracts and own assets. It can go on forever as long as it meets reporting requirements. Corporations are also taxed separately from the owners which is referred to as “double taxation”. Corporations issue stock and can have a wide variety of different stock types including common and preferred. These entities are the preferred structure for raising money via venture capital or the public markets.

S-Corporation

Like the C-Corporation, it has to elect a board of directors and have annual shareholder meetings. There is a limit to the number of owners and who can own stock. For example, a company cannot own stock in an S-Corp. The profits and losses pass through to the owners like an LLC, so there is no double taxation like a corporation. The S-Corp is not used as much since the LLC provides the same benefits with less overhead and restrictions.

Non-Profits

As the name implies, this structure does not make a profit. More specifically, any profit is put back into the organization. There are many different types of non-profits. They are governed by the IRS code 501(c). The most common is 501(c) 3. Another thing about a non-profit is that the assets are owned by the non-profit. There are no stockholders. Everything is done for the beneficiaries of the non-profit. Therefore, if the non-profit stops operations, the assets must be donated to another non-profit.

Now that you understand the specific types of entities, go ask yourself the questions about and see which one fits your business. Remember that setting up the right structure is important. If you have any questions, seek advice from a lawyer.

Things To Ponder

  1. Write a paragraph on your businesses most likely liability. How big a deal is it? What structure might protect you the best?
  2. List three for profit and three non-profit businesses. Write a sentence or two as to why they choose that structure.
  3. Look up your states LLC laws. How do they compare to the rest of the US? What state would be the best place to start an LLC from a tax view, operating view or liability view?

Exploring Further

Also published on Medium.

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