When forming a new business, selecting the business structure is one of the most important decisions you will have to make.
Business structures, including the sole proprietorship, partnership (general or limited), corporation and limited liability company (LLC) each have distinct advantages and disadvantages. Determining which structure will best suit the needs of your business and the owner(s) can depend on several different factors, the most important of which are generally liability considerations and tax consequences. When deciding on which business organization to use, an attorney at SODEN & STEINBERGER, APLC in SAN DIEGO, CA can provide you with information about the different structures and help evaluate your goals and objectives.
Liability considerations
The first factor to consider is how important liability will be to your business. If there is the possibility that it could be sued or accrue debt, then it is probably best to avoid being a sole proprietor or a general partner. Both forms do not provide any personal liability protection from business creditors. In addition, if you have personal debt or are at risk of having personal creditors, then these two business structures will not protect your business assets from your personal creditors.
If personal liability is not a major concern, you can avoid the double taxation of a corporation and formalities of many of the business structures, and opt for a sole proprietorship or general partnership. Legally, they are simplest business structures to form and operate. Keep in mind that even though an owner is only responsible for his or her own personal income tax, it is still best to keep the business finances separate from one’s own personal assets. Allowing business and personal finances to merge may make it difficult to calculate business profits and manage finances efficiently.
Tax consequences
The next major factor in choosing a business type is how the business will be taxed. A drawback of the traditional C Corporation is that it is taxed at both the corporate level and when distributions are made to the owners. This is known as “double taxation.” Sometimes this is desirable because it keeps the owners out of a higher tax bracket, but generally, if a company wishes to minimize taxes, a “pass through” business type is usually the model of choice. This means that the business itself is not taxed. All business profits or losses are passed through to the owners to report on their own personal tax returns.
The most popular “pass through” business structure currently is the limited liability company (LLC). The LLC also provides limited liability to its business owners. This coupled with the relative freedom that LLCs have from government rules and regulations for business operations, makes it a viable option for emerging businesses.
Another option that has pass through taxation is the S Corporation. It is taxed similarly to the LLC, but it does have more restrictions. To qualify as an S Corporation, the corporation must be a domestic corporation with no more than 100 shareholders, all of whom are U.S. residents and citizens. The shareholders must also all be individuals, estates or certain qualifying trusts, and the corporation must only issue one class of stock. Partnerships also enjoy pass through taxation so that the partnership itself is not taxed.
Changing the form of a business
If the nature of your business has fundamentally changed from the time you initially selected a business form or if the owners’ needs have substantially altered, it may be necessary to consider changing the structure of the business. For example, a growing sole proprietorship may wish to switch to a partnership to allow for additional owners. General or limited partnerships may opt to become LLCs to take advantage of the limited liability available to all members. Another scenario in which a conversion to a different business organizational structure is advisable is if the tax laws and other regulations to which the business is subject have substantially changed.
When deciding whether to convert to a different business structure, there are a number of issues that you and your attorney should discuss, including:
- Whether shareholders’ personal liability will be affected by the conversion
- If it is necessary to change registration information for copyrights, patents or trademarks
- How the business’s banking and loan agreements will be affected
- Whether the conversion will affect compliance with governmental regulations for permits and licenses
- Providing creditors with notice of any name change or change in state of organization
- Filing a record of conversion with the clerk or recorder’s office in each county where the business has title to real property
- How the change will affect the internal management of the business and the rights and responsibilities of officers and principals
See Gutterman, Alan S., Business Transactions Solution, “Conversion and Other Changes in Form of Business Entity,” 2007. Careful thought should be given to each of the above issues, as well as to the potential tax consequences of converting to a different organizational structure.
Speak to a business law attorney
It is important to have a firm understanding of the various business types and government regulations prior to starting a business. For more advice on selecting a business organization, you should consult with a lawyer. An attorney at SODEN & STEINBERGER, APLC in SAN DIEGO, CA, can explain the various business organizations to you and help you choose the one that best meets your needs.
