Building a Firm Structure: Starting Your Small Business, Part 5

This is the fifth part of a multi-part series that will help prospective entrepreneurs to develop the tools they need for a successful business venture. 

Congratulations, your dream business is a step closer to becoming a reality! Now that you have a location selected, it’s time for a critical next step: selecting your business structure. 

The kind of business entity you choose determines how much you’ll pay in taxes, how you’ll raise money, and how much personal financial liability you’ll have as a business owner. 

Because you have to register for your state business license under a specific business structure, careful homework now can save you a lot of pain later–as anyone who’s dealt with the IRS and other governmental organizations knows, making changes after the fact can be a very frustrating experience. 

While it is possible to convert to a different business structure in the future, there may be restrictions based on your location which could result in negative tax consequences or even the dissolution of your business. Therefore, it is best to make a carefully informed decision as you move forward. 

Although business structures vary somewhat by state, the five general categories listed by the IRS are sole proprietorships, partnerships, corporations, S Corporations, and Limited Liability Companies (LLCs). 

Alabama’s Business Entity Division operates as a depository for records of domestic and foreign entities that have qualified to do business in Alabama. The types of entities it serves include for-profit and nonprofit corporations, LLCs, General Partnerships, Limited Partnerships (LPs), Registered Limited Liability Partnerships (LLPs), and Limited Liability Limited Partnerships (LLLPs). 

If you’re starting a business on your own, a sole proprietorship is the simplest form and will provide you with complete control over your business. While this sounds like an attractive option, it’s important to be aware that it comes with significant financial risk because sole proprietors are individually liable for the debts of their business–if disaster strikes, you’ll be held personally and financially accountable for damages. 

While there are financial drawbacks to having a sole proprietorship, they can be a good choice for low-risk businesses and owners who want to give their business a trial run before establishing a more formal business. 

Forming a partnership is another option. This is an unincorporated business owned by multiple parties, whether they be people or other businesses. Partnerships can take several forms with varying amounts of financial risk to their members. A general partnership is essentially a multi-owner version of a sole proprietorship, with financial risks split between two or more people rather than just one.

While it may seem less risky to split the financial burden, it’s critical that you have full trust in your partner or partners–if your partner decides to take the money and run or enters into a binding deal with a third party without your knowledge, you’ll be left to bear the financial consequences. 

A limited partnership, on the other hand, includes a general partner who runs the business, making business decisions and taking personal responsibility for its debts and lawsuits and a limited partner, who simply invests in the business. Limited partners don’t have control of day-to-day operations and are only liable for what they invest in the company. Rather than a standard business structure, LPs are used primarily for raising investments. 

An LLP operates much like a general partnership but offers the benefit of insulating your personal assets from others’ actions and the actions of the partnership’s employees. Even so, limited liability is limited in that each partner remains personally liable for his or her own professional activities. 

A Limited Liability Limited Partnership, or LLLP, is a new hybrid of various business entities in which both general and limited partners are shielded from personal liability in the case of debt or legal action. While it does provide more protection for partners, it doesn’t offer as much or as comprehensive protection as LLCs and corporations such as S-corps. It’s most commonly used in the real estate industry but can also be found with asset management companies, car dealerships, and occasionally scientific research labs. 

LLCs and corporations provide more protection for the personal assets and liabilities of their owners. An LLC can have any number of “members,” the official term for its owners. Members can be individuals or other businesses. With an LLC structure, members’ personal assets are protected from the business’s creditors. 

While it’s fairly simple to start and offers flexibility in management. The IRS considers LLCs to be partnerships for tax purposes unless members opt to be taxed as a corporation. If it’s taxed as a partnership, the government considers members who work for the business to be self-employed. Therefore, those members will be responsible for paying their own Social Security and Medicare taxes based on the business’s total net earnings. 

If the LLC forms as an S corporation, on the other hand, members pay Social Security and Medicare taxes based on their actual compensation rather than all of the company’s pretax profits. 

The S corporation provides the advantage of lower taxes and limited liability, but it also has some drawbacks: you’ll face constraints on who can own your business and you’ll be responsible for paying Medicare and Social Security taxes on wages you pay, not only to your employees but to yourself.

The IRS has fairly strict rules regarding who can hold ownership stakes in an S corporation, so it’s important to do research beforehand. In addition, restrictions on shareholders can put limits on how quickly you can grow your business, and limitations on the type and number of shareholders can bring challenges with regard to raising capital. 

There’s a lot to consider when starting a business, especially more complex forms of business. Even if you’re starting a sole proprietorship, it’s important to remember that you don’t have to go it alone. The Catalyst Center for Entrepreneurship and the UAH Small Business Development Center/Procurement Technical Assistance Center (UAH SBDC/PTAC) can step in here, providing guidance and walking you through the process of selecting and organizing your business structure at no charge. 

Now that you’ve made it through this step, it’s time for the next milestone: choosing the right name for your business. We’ll discuss this in part six of our guide to starting a successful small business.