Choosing The Optimal Business Structure

How do business owners protect their personal assets when things go wrong with the company? This question has worried many an entrepreneur. Until they figure this out, it must be hard for business owners to focus on running their businesses. This is especially so if they're concerned about possible lawsuits.

One of the simplest ways to protect yourself is to form a separate business entity. That way, the entity (not you, personally) takes the "hit" from any lawsuit that might occur in the course of your business. That's also why they are called "limited liability entities," because they limit your personal liability. Limited liability entities come in many forms including the C-corporation, S-corporation, limited liability company, limited partnership, professional corporation (or, in some states, professional association), limited liability partnership, and professional limited liability company. Like the dessert tray at a buffet, all will meet a particular need, but are slightly different in their form and composition, and some aren't right for everyone.

For the most part, small business owners tend to choose the S-Corp ("S," for Subchapter S of the Internal Revenue Code, which permits its special tax treatment) and the limited liability company. How do you know which choice is right for you? Let's look at just a few of the significant factors:

1. Who will own the business? Some forms have restrictions on who, or how many, people can own it. For example, in many states, professional corporations can be owned only by people who are licensed members of the company's profession (e.g., only architects can own an architecture firm). Also, an S-Corp cannot be owned by foreign nationals who are not resident aliens in the U.S., so you could not use that form with overseas investors. An S-Corp can have as few as one, but no more than 100 owners (called "shareholders"). By contrast, a limited liability company (LLC) does not have these limitations, although in a few states, there need to be at least two owners. So ask yourself: Can I own the company by myself? Will others own it with me? Will I have investors (even family or friends) who are not U.S. residents? Am I a licensed professional? Your answer may rule out the choice of certain business forms.

2. How much flexibility do you require in distributing profits? If there are two parties, each investing different amounts of money, but with one pouring in sweat equity, how do you plan to divide profits and management control? In such a case, a limited liability company is the better business structure -- it affords flexibility in dividing profits which does not have to directly link to how management control or ownership is divided. For example, if there are two of you, you can set up an LLC in such a way that you can control 60% of the company for the sweat equity you are investing, but are apportioned only 30% of the profits. The other shareholder, as the major financial investor, could receive the remaining 70%. In an S-Corp, there is only permitted class of shareholders, and share of profits are directly linked to the percentage of ownership. This will not work for business owners who need some flexibility in divvying up profit and management control.

3. Most small business owners prefer the S-Corp and the limited liability company for the pass-through treatment of profits to personal income. The business entity is not taxed, unlike the C-Corp whose main drawback is double taxation. Note that in some states, the S-Corp is subject to state and local taxes even though it has no federal tax liability. The LLC is taxed like a partnership and all profits flow completely through to personal income. Before finalizing your decision, ask your accountant to compare tax treatments for different business structures. You may see marked differences from one to another.

4. How much does it cost to form and maintain the businesses structure? Costs of formation vary, depending on the state in which you live. In some states, like New York, the costs of forming an LLC far exceed that of an S-Corp. However, these initial costs need to be weighed against the ongoing accounting costs of corporate tax returns (which may be higher than the returns for an LLC), and the legal costs of keeping up with corporate formalities like meeting minutes. LLCs do not generally have the same documentation requirements (although it's a good idea and good practice to do so anyway).

The choice of business structure is a significant one that can be difficult (and costly) to change. So be sure you're making the right decision for you and your business by consulting with an attorney and an accountant before taking this important step.


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