If you have the ingenuity to come up with a stellar idea, develop it into a business, and generate profits with it, you will likely have the foresight to protect that valuable entity. Here, we talk about how you can protect your small business ideas by keeping them behind the business castle wall: your business structure.
Business structures, or entities, are generally classified into one of these categories:
- sole proprietorship
- limited liability company
Each type has pros and cons. Here, we will consider some of those.
The sole proprietorship is an unincorporated business run by one person, and is by far the simplest form of business to operate. The reasons are straightforward:
- It doesn’t require much, if any, registering or paperwork
- It is very easy to start, change, or close down
- The value of the business (viewed by both buyers and the IRS) is based upon the skills and assets of the owner, not stock
The sole proprietorship may be a simple form, and is often best when there is limited capital and personnel, but there are distinct disadvantages:
- The capital is limited to the owner’s capital or what he/she can generate
- The owner cannot be an employee of the business for tax purposes
- There is unlimited liability for the actions and debts of the business
Liability is an issue in running any business, and increasingly so with the litigious society in which we operate. Liability is the ever-present dinosaur in the cave, ready to break out at anytime. You can’t know when or why or how it may burst upon the scene of your business, but history has proven (as recent as yesterday, or any day) that IT DOES HAPPEN.
Simple can be good, but it can also be dangerous. When a sole proprietor operates, his capital, assets, and skills are what make up the business, and these assets become his payment in the event of a lawsuit. A court can freeze assets, force the sale of a residence, attach bank accounts and many other financial nightmares that you can imagine.
Fortunately, there are other business entity structures more geared to protecting your small business ideas and your thriving business.
Another of business is the partnership. It is a relationship between 2 or more persons who join together to carry on a trade or business. There are some advantages:
- It involves more than one member, so it has greater potential for capital than a sole proprietorship
- It combines the management skills of multiple people
- It has pass through taxation
The partnership also has some disadvantages:
- The authority for decision making is divided
- Partners cannot be employees for tax purposes
- Unlimited, joint and several liability among members
Like the sole proprietor, the partnership members can be held liable for all actions and debts of the business. In addition, there is joint and several liability, which means each partner is responsible for the actions and debts of each other partner.
It doesn’t take much thought to see how this can (and frequently does) create issues. Different people have different ideals, different risk tolerances, and different methods. If one partner decides to act in a way in which another partner believes is risky, the other partners often times have no recourse but to dissolve the partnership. Because of this, many partnerships do not stay intact for long.
The limited liability company is a more flexible, and in many ways, more desirable business structure. An LLC may be treated as a sole proprietorship, partnership, or a corporation. A single member defaults to sole-proprietorship, 2 or more members defaults to partnership, and either can elect to be taxed as a corporation or a subchapter S-corporation.
- Flexibility: members can be individuals, other partnerships, other corporations or even other LLC’s.
- Management flexibility and pass through taxation
- Members have limited liability for the actions and debts of the LLC
- It is governed by the laws of the state
- It is subject to a base annual tax (in some states) which is increased after profits rise to a specified ceiling
- All members must also pay individual earning taxes
Over all, the LLC is a very clever and flexible way to set up a business, but the main advantage is the limited liability to the partners. This is an increasingly valuable quality as revenues and profits increase, because more money means higher chances of being sued. Following the old “risk and reward” equation, as the reward goes up, so does the risk.
Corporations are an advantageous way of establishing a business, but especially so when the profits and scope of operations increase. The law treats a corporation as a legal entity, similar to a person. It has perpetual life, meaning it does not pass away when the originator passes – the corporation remains a legal entity until such time it is formally dissolved.
- The transfer of ownership is relatively simple
- It is easy to raise capital and expand the business
- All shareholders can be employees of the corporation, and have limited liability
- Double taxation (C Corp), meaning the corporations profits are taxed and shareholders’ earnings are taxed
- It can be difficult and expensive to organize
- The corporate officers must follow procedures, such as board meetings, corporate minutes, and others
Again, corporations are ideal for any business that has expanding operations, substantial earnings, or defined liability. Some businesses, by their very nature, encompass more risk, and some businesses are quite complex and require a more centralized structure. For these reasons and more, the corporation can be the best form of business to operate in.
Corporations were designed to encourage business. The corporate veil is a strong one and protects people from losing their personal assets in a business catastrophe such as a lawsuit, and empowers them to grow and expand without fear. However, the veil can be pierced, but essentially only one way: fraud. Fraudulent activity among officers of a corporation can pull back the protection and expose them.
Understanding the different types of business structures is an important part of protecting your small business ideas. Talking to your CPA or tax attorney is the best initial step to take, for they know your business and will know the most effective form for your situation.