Starting a new business is exciting, but it requires many important decisions. One of the earliest and most crucial decisions is what type of business entity to form. Your choice of business entity provides structure and a framework for your company. It also influences your company’s relationship and interaction with outside parties. For example, the type of business entity affects its tax treatment with the IRS.
The four main types of business entities to choose from are sole proprietorship, partnership, limited liability company, and corporation. You should consult with a professional to determine which business entity is right for you.
What do you need to consider when choosing a business entity?
Different businesses tend to have different levels of potential liability. This means the owners might take personal financial and legal risks to operate the company. Personal assets could be seized if legal action is brought against a business. Operating a business through a legal entity will protect personal assets from business-related claims and lawsuits.
Federal and State Taxes
Each business entity has its own unique tax ramifications, and the different entities can each provide different tax savings depending on the type of business involved.
Cost of Formation
There are costs associated with forming and maintaining a business entity. So while each type of entity provides certain benefits, some entities can be expensive to create. If operating a business through an entity provides no protection or benefit in your situation, there is no sense in making the financial investment.
Each business is different, so it is important to consider the current and future personal and business needs of the owners of a business. Creating a business plan that includes short-term and long-term goals can make it easier to determine the best organization for a business today and into the future.
Forming Your Business Entity
Now that you know what to consider when choosing an entity, what are your choices?
A sole proprietorship is a business with a single owner operated without forming a separate legal entity. It is the most common and easiest to create. The downside is the single owner is held personally liable for all financial obligations of the business.
Partnerships allow two or more people to share the profits and losses of a business. The benefit of this organization is that the entity itself does not pay tax and it can provide liability protection for certain partners. The disadvantage is that at least one partner must be personally liable for the financial obligations of the business.
Corporations are legal entities separate from their owners, so none of the owners are personally liable for the financial obligations of the business. Forming a corporation can be expensive, and during the life of the corporation extensive record keeping is required. Certain types of corporations are subject to tax in addition to their owners, so it is important to discuss with an attorney the different types of corporations that are appropriate for your specific situation.
Limited liability companies (LLC) allow owners to take advantage of the benefits of both corporations and partnerships. This means that all of the owners are protected from personal liability, and the entity itself does not pay tax.
Ultimately, you need to think carefully about which business entity is right for you and your situation. Seek expert advice, consider the unique needs of your business and its owners, and make the most educated decision possible that will benefit the business now and in the future.
Business succession – what happens to your business once you no longer choose to or are able to run it – is one of the most important and often overlooked issues small business owners face. As you launch your business and get it up and running, your focus is on maintaining and growing that business. Like many issues that involve planning for later in life, it can be unpleasant to think about what will happen when you are no longer able to do what you are doing now.
Unfortunately, a failure to plan can result in the unnecessary end to your business, cost you money and impact the security of future income. Creating your “exit strategy” by establishing a strong plan for succession ensures your business is protected and is one of the most important things you can do as a business owner. A strong exit strategy ensures:
- Business partners are not left dealing with complicated issues if your exit comes suddenly or prematurely.
- Insurance benefits are immediately available to pay for your share of the business, so there is no risk of external takeover or a need to force the sale of the business.
- A timely settlement of your estate, saving your family inconvenience, cost, and further emotional trauma.
Creating Your Business Succession Plan
According to the Family Business Institute, despite the assumption of nearly 90% of current business owners that their family will take over the business, only about 30% of these businesses survive into the second generation. Creating a succession plan ensures your family has the option of taking over the business, but it also allows them the freedom to choose not do so without losing money or forcing the business to fail. How can you create a realistic succession plan?
First, choose a successor. If you want your business to continue on in the hands of a family member, employee, or someone else, put a plan in place now. This gives you an opportunity to discuss succession with the appropriate people and determine if what you envision is also what your successor wants.
Next, choose the legal arrangement for succession. Your options include cross-purchase agreements or entity-purchase agreements. The former is structured so that all of the owners buy and own separate life insurance policies on each of the other owners. Each owner is a policy holder and beneficiary. Should one die, the life insurance proceeds are used to purchase the share of the business that belonged to the deceased. This arrangement only makes sense in businesses where there are few owners.
An entity-purchase agreement is less complicated because it usually involves the purchase of fewer life insurance policies. Such an agreement is structured so that only the business purchases separate life insurance policies on each of the owners. The business acts as both policy holder and beneficiary. If any owner dies, the business uses the proceeds of that owner’s insurance policy to purchase the share of the business that belonged to the deceased.
Your business does not need to end with you, but careful planning on your part is required while you are still here. The sooner you put a plan in place, the better for everyone involved.