How Do I Choose a Business Structure?

By: Michael Gallagher, District Director
North Dakota District Office

Congratulations! You’ve decided to start your own business. One of the questions you’ll be asked early in the process is: “What type of business structure will you use?” Many current or past business owners may be biased for one type over another and suggest that you follow their lead, even though individual elements vary from case to case.

This article is the first in a series of six that will discuss the factors you need to consider in making an informed decision. The next five articles will highlight specific business structures – sole proprietorship, general partnership, C corporation, S corporation, and the hybrids: limited liability company (LLC) and limited liability partnership (LLP) - and evaluate each structure based on the factors discussed in this article.

In choosing which form of business is best for your business, you need to look at several factors, including: complexity, liability, number of owners, capital, taxation and survivorship. There will be additional personal factors that impact your decision as well, such as business goals, control, skills, cost and family commitment.

Complexity
Complexity is evaluated from two points of view. First, how complex is the product or service you are providing and second, how complex is the business structure you’re considering?

If you are a maker or crafter working from your basement, you most likely don’t need a complex business structure; a sole proprietorship may be ideal. However, if you want to manufacture airplanes, a more complex structure may be appropriate.

Liability
Liability is the factor most mentioned when discussing business structures. What personal liability do I have for the operation of the business and how can I minimize it? There are several issues to evaluate.

First, how much risk is inherent in the product or service you are offering? If you manufacture jewelry, the risk of injury from your product is significantly less than if you manufacture chainsaws. Evaluate the product and service by how the consumer uses it and the possibility of injury.

Second, do you have people on your business premises? People can be customers, employees or salespeople. Having others on your premises creates a greater potential for accidents and injuries.

Third, do you have employees? Employees are one of the biggest risk factors for a business. Legally, as the employer, you are responsible for the actions of your employees. Now instead of simply having a responsibility for only your actions, you are now equally responsible for the actions of someone else.

Finally, can you avoid personal liability for the debts of the business? Some of the business structures create a “person” with the ability to contract separate from the owner. This means that this new “person” can create obligations that the owner is not legally responsible for personally. Sounds great in theory! Most new businesses will not have this opportunity, because new accounts, loans or contracts will not only be signed by the business, but will also require a personal guarantee by the owner. That personal guarantee obligates the owner for the business debts.

Of course there are several areas where you cannot avoid personal liability.
You are always responsible for your own actions. If you’re the one driving the car for work and are involved in an accident, you are responsible. On the other hand, if your business is set up as a corporation and an employee is driving the car, the corporation and the employee are responsible, not you personally.

Second, the IRS will hold any responsible individual (usually owners and officers) liable for withholding taxes if they have been withheld from the employees’ pay checks but not paid to the IRS.

Third, you must continue to maintain the structural integrity of the form of business. For instance, you cannot use the business checking account as a personal account and all required annual reports must be filed.

Number of Owners
The next factor to consider is the number of owners. Certain business structures will allow only one person while others require a minimum of two people. Plus, some structures are not ideal for a large number of owners.

Capital
Capital is the amount of money needed to start and operate the business. The structure selected will determine your ability to raise capital. Certain structures are limited to what the owners personally have to put into their business.

Taxation
The second most frequently mentioned factor is taxation. How will the profits be taxed or the losses carried? This factor has an impact not only on the business tax return, but on your personal tax return as well. The decision must be made by evaluating the potential growth of the business and the income potential for the family unit over an extended period of time. What may initially appear as a tax advantage the first few years may be a tax nightmare five years later. Also, some structures may experience the potential for double taxation of profits.

Survivorship
The final factor is survivorship. What do you want to happen to the business if something happens to you? Imagine how difficult it would be to manage IBM if every time a shareholder died, IBM had to restructure the business. It would be impossible to maintain a successful business. Each business structure handles survivorship differently.

The next five articles will evaluate each stucture based on the factors discussed above.

 


Mike GallagherMike Gallagher joined the U.S. Small Business Administration in 1984 as a Business Development Specialist.  He was chosen as the Deputy District Director in 2005 and the District Director in November 2013.  A graduate of the University of North Dakota, Mike is a Certified Public Accountant and a former business owner. He can be reached at michael.gallagher@sba.gov.

 

Other Business Structure Articles from the North Dakota District Office

Pros and Cons of Sole Proprietorships

The Ins and Outs of Business Partnerships