Room To Grow
Your idea is panning out, you've snagged office space and maybe even a customer or two. With so much going on, it's tempting to make quick and dirty work of incorporating your new venture. But how you set up your business, or restructure a company on a growth jag, can make a big difference. The wrong structure can cost you money and leave you with just the type of legal and administrative hassles you want to avoid.
Entrepreneurs have many choices of ownership structures, from the most simple (sole proprietorships) to the most complex (corporations). Between them are limited liability companies, as well as less common permutations particular to certain industries. Real estate investors often favor limited partnerships, while limited liability partnerships are common in medicine, law, and accounting. Many companies migrate as they grow, starting as sole proprietorships, becoming LLCs when concerns about liability arise, and transforming into corporations when profits are steadily growing.
When choosing the right structure, your company's stage of development is important. But so are taxes, administrative tasks, plans for raising capital, and, crucially, the risks in your particular business. "This is not the fun part—identifying what can go wrong," says Judy Gedge, a small business attorney in West Hartford, Conn. You'll want to choose a structure that gives you the protection you need, but with as few rules as possible. Entrepreneurs should move up the complexity chain only if and when it is necessary. Each step up means more requirements and more paperwork, and although adopting a more complex form is easy, you may get hit with a tax bill if you change back to a simpler structure. "You should not adopt a form unless you have a specific need," says Anthony Mancuso, author of LLC or Corporation? How to Choose the Right Form for Your Business. "It's best to start simple and adopt more complicated structures for specific legal or tax reasons."
Sole proprietorships and general partnerships are the easiest way to go. There are no legal filings or fees, and no restrictions. And they're a breeze at tax time. All profits and losses pass through the business to the owners, who report them as income or losses on Schedule C of their personal income taxes. On the downside, you're not going to get much protection if your business gets slapped with a lawsuit or goes belly-up. Creditors can come after your personal assets to satisfy business-related claims.
But if you have little chance of being sued because you don't have employees, you have little contact with the public, or your business doesn't need to take on debt, a simple structure may be all that you need. "Many, many businesses start as a sole proprietorship or partnership, and in general, that's fine for most," says Mancuso.
LIMITED LIABILITY CORPORATION
Entrepreneurs with substantial personal assets should consider a limited liability corporation. LLCs combine the protection of a corporation with a sole proprietorship's pass-through taxation, with the business' gains and losses reflected on the owners' tax returns. Owners draw up the LLC's operating agreement themselves, deciding such things as how to divide profits and who will manage the firm. "The nice thing about LLCs is that they are like clay. They're very flexible," says Ken Gaebler, president of Gaebler Ventures, a small business incubator and private equity firm in Chicago.
But the LLC itself is not a taxable entity, so its owners bear the full burden of employment or payroll taxes, which total about 15% for each individual. (Recent tax law changes, however, allow LLCs to choose to be taxed as either S or C corporations). And because LLCs became popular only in the last decade or so, there isn't as much case law concerning liability issues. That doesn't worry Michael Pritz and his business partner Bruce Harrison, who in 2006 set up their telecommunications consulting and advisory services company, JRP Partners, as an LLC. "We wanted protection and simplicity of structure given the size of the firm," says Pritz, who is general partner of the Chicago company, which works with independent contractors and does not have employees. "We don't want to spend time talking about inane stuff like payroll services. You want the time to be extremely focused on activities that move the business along."
Another benefit, says Christopher Hughes, is credibility. He registered Hughes Settlement Services, which sells fixed income annuities, when he started the Simsbury (Conn.) company last May. "A lot of the companies I deal with require that I have a federal tax ID number, which means my business is incorporated," he says. "Establishing credibility with corporate clients is important. I can't be just 'Chris Hughes, sole proprietor.'"
An S corporation will give you the same liability protection as an LLC. But in an S corp, only the owner's salary is subject to employment taxes. Business profits are subject only to income tax. "If you have substantial income in your business, there are significant tax savings by being an S corporation," says Alan Yates, a senior tax partner at Nussbaum Yates Berg Klein & Wolpow, an accounting firm in Melville, N.Y. "Anytime you are going to make over $100,000, you should calculate your taxes and see if you can save by electing S corp status."
Those benefits do come with more rules. S corps must have a board of directors and annual meetings, and require owners to establish salaries for themselves. And the IRS has stepped up audits of S corps to ensure that owners are not trying to sidestep employment taxes by paying themselves too low a wage. "Set a reasonable salary," says Chris O'Keeffe, a certified public accountant in Richmond, Va. "I cannot stress that enough." An S corp's profits and losses must be allocated in proportion to each shareholder's capital contribution, making it tough to award profits to shareholders who have brought in a lot of business or otherwise been valuable, notes Conrad Davis, a CPA and partner at Ueltzen & Co. in Sacramento, Calif. And some jurisdictions, including six states, don't recognize S corporations for tax purposes, treating them like regular C corporations, taxing them at both the corporate and shareholder level.
Kathy Colby, president and owner of Financial Independents, a three-employee, $500,000 registered investment adviser in Lansing, Mich., chose to become an S corp so she could control her own wages and, consequently, employment taxes. She estimates she pays about $5,000 to $6,000 less in taxes each year than she would with an LLC. But the structure has been less appealing for her other business, Advisor Tools, a retirement planning software company she co-founded with her mother. Last year, Colby could deduct only half of that business' losses on her income taxes because they have to be divided equally with her co-owner. "You have to share the losses, and you can't monkey with the ratio," she says.
If your new business needs to accumulate capital for inventory or equipment, or to finance other growth, a C corporation may be a good bet. That's because C corps have lower tax rates than LLCs for the first $50,000 to $75,000 of profits. C corps also have the upper hand on S corporations because they allow different classes of stock for passive and active investors.
Although a C corp's profits are taxed twice, its income is taxed at lower rates than individual income: 15% on the first $50,000, 25% between $50,001 and $75,000, and 34% between $75,001 and $100,000.
C corporations also are good for companies looking to attract venture capital or other equity investments. That was why Ken Gaebler spun out a division of his LLC to create Walker Sands Communications, a $1.5 million marketing consulting firm, as a C corp in April, 2007. "If you're raising money, you need to give investors what they're most comfortable with, and that's equity in a C corporation," he says. Gaebler also wants to offer equity to his 15 employees and perhaps merge the company with another company in the future. Says Gaebler: "All of those goals screamed for a different corporate format than an LLC."
The biggest downside of an C corp, aside from the double taxation, is that assets will be taxed twice if you sell the company. That's an important consideration for businesses that own real estate, copyrights, or other assets that are expected to appreciate significantly, notes CPA Davis. One way around the double whammy is to sell stock in the corporation, but buyers may balk because they will lose the ability to revalue assets based on current prices.
John Gazzola isn't too worried about taxes because he expects to reinvest most of his new company's profits in his business. But the founder of Toyopolis, which will sell toys, games, and collectibles online, is very concerned about liability. So he registered his Vernon (Conn.) venture as a C corp. Even though experts say that's probably not strictly necessary, Gazzola had found another valid way to choose a structure for his company: the one that gives him peace of mind.
By Virginia Munger Kahn