There are 27.9 million small businesses in the United States according to the Bureau of Labor Statistics. Moreover, small businesses make up: 99.7 percent of U.S. employer firms, 64 percent of net new private-sector jobs, 49.2 percent of private-sector employment, 42.9 percent of private-sector payroll, 46 percent of private-sector output, 43 percent of high-tech employment, 98 percent of firms exporting goods, and 33 percent of exporting value.
I think it’s safe to say that our country’s economy relies heavily on the success of small businesses like yours and mine. Yet, when it comes to forming your small business or evolving it as it grows, how do you know which business structure is the right one for you? Well, the type of legal structure you choose for your small business depends on several key factors that likely change over time.
Here is a quick guide to help you understand the different types of legal business structures and how to assess which one may be right for your small enterprise.
The overwhelming vast majority of small businesses are sole proprietorships, constituting 94 percent of nonemployers in 2010.
This form of business is characterized by the fact that it is not treated separately from its owner from a tax and liability standpoint. Meaning, the business is the owner and vice versa. It is the simplest form of business and is not considered a legal entity.
While a sole proprietorship is simple, easy to create, and inexpensive to form, its one big disadvantage is that the owner is personally liable for all the business’s debts. The unlimited personal liability a sole proprietorship holds can be alarming but business liability insurance offers protections that all sole proprietorships should secure.
When does it make the most sense to be a sole proprietorship?
- When you are new and just starting out
- If your business revenue is less than $100,000 annually
- If you have no employees
- You run your business from your home
As of 2007, there were more 3 million partnerships in the United States, growing at an annual rate of 5.6 percent.
If you run a business with someone else, then you may consider a Partnership business structure. Partnerships are businesses owned and operated by two or more individuals. You can have a general partnership where everyone is equal or a limited liability partnership (LLP) where partners hold different statuses and liability depending on how it is structured.
Partnerships have characteristics of both sole proprietorships and limited liability corporations. Like a sole proprietorship, they are easy and inexpensive to set-up and each partner is taxed individually. Also like a sole proprietorship, each partner can be held personally liable.
When does it make the most sense to be a partnership?
- When you are a new partnership just starting out
- When you want to go into business with a family member, friend, or business colleague
- If you don’t have a lot of initial funding to get your business off the ground
- You want to maintain control between you and the partners rather than answering to outside entities
Limited Liability Company
Limited liability companies are one of the fastest growing business structures in the United States with over 2 million LLCs filing tax returns in 2012.
A limited liability company (LLC) is a separate and distinct legal entity from its owner. One of the most attractive reasons people form LLCs is because, in most cases, it protects its owners from personal liability.
While LLCs are flexible and relatively easy to create, it is often best to hire an attorney to help you form an LLC. If you do business across multiple states, you need to create LLCs for each state you operate a business in. Forming an LLC is more expensive to create than a sole proprietorship and partnership, but does offer inherent protections to owners like a corporation, even though an LLC is not a corporation.
When does it make the most sense to be a limited liability company?
- When your need to be insulated against personal liability is significant
- Your business revenue is in excess of $100,000 and you can minimize taxation by filing as a corporation (which LLCs can do)
- If you are growing your business to sell it one day, or you want it to continue after you die
Corporation (S or C)
Forming a corporation is the most formal legal entity you can create for your business. It is, in essence, its own entity completely separate from its owner or owners. It functions as an individual. It can sue, be sued, and own and sell property just a few examples.
Most small businesses are not corporations. Just 19.5 percent of small business operate as corporations (versus 73.2 that operate as sole proprietorships).
Like an LLC, owners are protected against personal liability under the corporate business model. It is, however, substantially more expensive and complex.
If a small business opts for this legal structure for their business, they tend to go the S Corporation route because it offers greater tax benefits. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay.
When does it make the most sense to be a corporation?
- When your small business is no longer “small”
- You have over 500 employees
- When your business is positioned for explosive growth and continued growth (think Apple, Facebook, Amazon)
As a small business owner, you essentially have to weight the risks vs rewards when it comes to determining your business structure. I think one of the biggest takeaways to remember is that you can evolve your business structure as your business grows. That means, if you start out as a sole proprietorship, nothing precludes you becoming a partnership with others or graduating to an LLC level.
At any given moment, you can update your business structure to what makes sense for your changing needs and financial well-being. Therefore, think big and know that as your business grows, there is a business structure out there designed to help you continue the growth while limiting the increased liability that comes with owning a self-made enterprise.
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NEXT FRANKLY SPEAKING POST…
Our next FRANKly Speaking article offers insights on what the recent government shutdown can teach all of us about what to do when there is a sudden loss of income.
As always, I invite you to reach out to me – in real life – with any comments, feedback, or questions! [email protected]. Are you ready to take the first step towards securing your financial future? If so, schedule your free 45-minute no-obligation consultation with me today! Schedule Your Consultation with Frank.