Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Choosing Your Legal Status: What Kind of Business Are You?

Starting a business is both exciting and terrifying.

First, there's finding the perfect idea that fills an obvious need. Then there's the challenge of gathering enough seed capital to tide business operations over for the next year or so.

In the meantime, your wildly successful marketing plan has customers beating down the doors to buy the product.

Everything is falling into place faster than anticipated. But before taking the plunge into the rollercoaster world of gross revenues, there's one final question that must be answered...

What kind of business structure do you want to follow?

At first glance, the hassles of establishing a legal business structure can seem like a fabulous way to waste precious time in local and state government offices when there's money to be made.

However, varying business goals require separate legal structures.

A tech startup company aiming for an eventual IPO will need a different setup than a privately held business wanting nothing to do with Wall Street shareholders. Likewise, a fashion designer will want different liability protections than a freelance writer.

Understanding your business model and what it does now will help narrow the choices for where you want your business to be in five or 10 years.

Hot Startup Seeks Angel Investors for Eventual IPO (C Corporation/S Corporation)

Most technology startups dream of angel investors and a successful initial public offerings (IPOs). "What typically happens is that [these types of companies] elect to become a C corporation with an S corporation tax status," says Deborah Sweeney, CEO of MyCorporation Business Services.

C corporations are considered separate tax entities that file corporate tax returns, while S corporations are pass-through tax entities. This means all profits (or losses) earned by the business pass through to the owners' personal income tax returns and are thus taxed at the lower personal tax rate instead of the higher corporate rate.

Lower taxes are certainly helpful for new companies, but Sweeney advises to keep in mind that an S corporation tax status has restrictions a C corporation does not.

"In order to maintain an S corporation, you can only have one class of stock and you must not have more than 100 shareholders," Sweeney cautions. "These shareholders must be U.S. citizens, residents, and natural persons."

This means S corporations must generally exclude corporate shareholders or partnerships, although certain trusts and estates may be eligible.

However, once company revenues take off, Sweeney advises taking a fresh look at that S corporation tax election. "As you grow and consider whether to take on different types of shareholders, go back and drop the S status for the C status. This allows the company to issue multiple types of stock and will open the door to corporate shareholders like angel investors."

No Thanks, Shareholders Are Too Demanding. But I Still Want Protection! (LLC)

Not all businesses need or want to go public.

For some business owners, keeping the company private -- retaining the earnings in-house while still minimizing personal liability -- holds a greater appeal than facing the constant stress of meeting shareholder earnings expectations.

For those privately held companies with no intention of going public, a limited liability company (LLC) is a common business structure, notes Sweeney.

An LLC offers the same pass through taxation and limited liability protections as an S corporation, but also allows an unlimited number of members and an unrestricted number of subsidiaries -- a distinct advantage where future business expansion is concerned.

#-ad_banner_2-#Management is also more flexible. Whereas corporations have a board of directors and officers handling daily affairs, an LLC can be run either by the owners or by an elected manager.

LLCs will also open doors to loans as investors are typically more comfortable with an established legal entity than say, an individual sole proprietor.

But an LLC isn't just for big companies with multiple subsidiaries, either. "Whether you are a giant or one person, you still want to protect your personal assets," advises Peter Minton, president of Minton Law Group, P.C.

With an LLC, the owner has limited personal liability for the debts and actions of the company. "Most people want to sleep at night knowing that their creditors or liabilities won't cause them to lose their house."

The same goes for the downsized corporate manager who's thinking about starting an online t-shirt design business. "People in fashion are concerned about trademark issues and want the flexibility and protection of an LLC," says Minton. "They want that extra formality of a corporation and to have that cachet."

Really, I'm Just Not That Complicated (Sole Proprietor)

Is an LLC or S-corporation status truly necessary for every business owner?

Not really, concedes Minton. "Freelance writing is probably one of the few careers I would recommend remaining a sole proprietorship because [writers] might not face the same amount of liability of say, a home improvement company."

Nonetheless, he points out that it's far too easy for new business owners to spend countless hours figuring out which legal structure is the best fit.

"Everyone has different needs," he says. "Ultimately, you need to understand the differences between the legal entities, understand what they are, and make the decision on what is the best option for you."

The Investing Answer: Who you are, what you are selling, and whether you want to be public or private in five or 10 years can influence the most important part of your business -- the bottom line.

It's worth the time to understand which legal structure will best fit your company's future needs, and your accountant and attorney can help you sift through the available options.

Legal Resources to help you further: NOLO.com, an excellent online resource, offers valuable legal information on business structures for business owners or new entrepreneurs. The IRS's Business Structure section can also point you in the right direction before entering your attorney's office.