Disclaimer: This article covers general financial and accounting concepts for different legal business structures. Remember, I am not a legal expert and this is not legal advice. Always consult a qualified attorney before making any legal decisions for your company. Getting your business’ legal affairs in order is not a place to scrimp on spending.
Polly Pica started a Sole Proprietorship advertising agency, Pixels & Pica, out of her spare bedroom in 2012. Within three years, she hired five designers, landed a massive retainer, and officially registered as an LLC. Everything was going so well — campaigns were going viral and client retention was nearly 100% — and Penny was loving the fast-moving business owner lifestyle.
Earlier this year, Polly decided it’s time to sell. A private equity firm is interested in buying Pixels & Pica for a cool $9 million. When the buyers started asking for her legal records and documents, her stomach dropped. She’s been moving so fast, she never stopped to think about the legal maintenance that her company needed to prepare for a sale. Now everything is pixelated and chaotic. To stay on track, she now has to spend $15,000 in rush legal fees and weeks of hair-pulling stress to salvage what she has and change her legal structure to save the sale.
As a Fractional CFO, I pay attention to every pixel of your business, from clean books to exit goals. I’d love to help you look at the financial implications of your legal business structure today so you aren’t caught off guard tomorrow. Doing your due diligence now will save you thousands — not to mention gray hair and worry lines! — down the road. Schedule a meeting with me today to chat about the financial possibilities.
What are the main types of business structures?
The legal structure you choose has dramatic effects on the life of your business, especially during large transitions. It dictates how you’re taxed, what your personal liability looks like, and—as Polly found out the hard way—what your options are when you decide to sell.
While there are many considerations, for-profit companies generally fall into one of these four main categories:
Sole Proprietorship
This is the “default” structure if you start a business by yourself and don’t file any paperwork with your state. You and the business are legally one and the same. It’s simple, it’s cheap, and for Polly Pica who started her agency from her bedroom, it’s often the beginning of the journey.
Limited Liability Company (LLC)
An LLC can be owned by one or more owners, with each person owning a specific percentage of the company. Many small businesses choose this structure because it creates a protective legal barrier between your personal assets and your business.
Partnership
A partnership is owned by two or more partners. It can scale up to include hundreds of partners, usually divided by agreed-upon ownership percentages. It provides no legal barrier between your personal assets and business, although another variation — limited partnership — can.
Corporation (C-Corp)
Corporations play by a different set of rules. Instead of tracking “percentages” of ownership, a corporation splits the company into shares of stock and sells them for a specific price per share. For example, anyone over 18 can buy a single share of Disney stock (which is traded on the New York Stock Exchange), which legally makes them a partial owner of The Walt Disney Company. However, you don’t have to “go public” to be a corporation — you can be a privately-owned corporation without selling shares to the public.
A great example is SpaceX. For years, the company kept its stock entirely private among a select group of investors. When the owners decided to open up and sell shares to the public, they filed with the SEC and launched an Initial Public Offering (IPO). At that point, basic supply and demand for the stock took over, dictating the company’s total value, also known as its Market Capitalization (Market Cap).
PRO TIP: Why isn’t the S-Corp on this list? Contrary to popular vernacular, an S-Corp is not a legal structure but rather a tax election created by the IRS. Both Corporations and LLCs can file paperwork to elect to be taxed as an S-Corp if they meet certain criteria. In the accounting world, we tend to use the term C-Corporation (or C-Corp for short) so we can clearly differentiate it from a corporation which elected to file its tax return as an S-Corporation.
What are the financial and tax implications of different business structures?
If you don’t actively make a specific tax election with the IRS, your business will default to a standard taxation method based on its structure.
For example, Partnerships and LLC’s default to being taxed as pass-through entities, meaning the business itself doesn’t pay income tax. Instead, the profits “pass through” to the owners’ personal tax returns. Structuring the business as an LLC and electing S-Corp tax status allows you to operate as a pass-through entity too, and it opens up a world of advanced options for deducting expenses and deferring income taxes. For a Sole Proprietorship, you default to being taxed as a sole proprietor on your Schedule C and cannot deduct certain business expenses that corporations can.
Want to see exactly how these taxes flow? Check out The Cure for Financial Color Blindness: How To Avoid Double Taxation to learn more about the taxation of pass-through entities!
Beyond your annual tax return, your legal structure completely dictates how we set up your accounting books. For instance, a corporation requires us to meticulously track transactions in a complex Equity Section of your balance sheet rather than simple owner draws. (Keep an eye out for next month’s article, where we’ll dive deep into managing your equity accounts!)
What’s the best business structure to protect myself and my business?
The government actually wants you to grow the economy, so they created entity structures like LLCs and Corporations to act like separate legal “people.” Because the company is its own legal entity, it carries its own baseline protection.
However, Sole Proprietorships and Partnerships have zero baseline protection. If the company makes a mistake and a client sues the business, they are suing the owner (you) directly. If business liability insurance falls short of the judgment, the owner’s personal assets (house, bank accounts, etc.) could be on the line to cover the difference.
With an LLC or a Corporation, owners gain a legal shield (often called the corporate veil). If someone sues the company, they can go after the company’s assets, but they generally can’t touch the owners’ personal assets.
However, there are things you must do as a business owner to protect yourself:
- Keep Clean, Separate Books: If you constantly mix your personal expenses with company money (called commingling), opposing lawyers will argue that the line between you and your business is completely blurred. A clean, separate set of books proves the business is its own entity. (If an accidental mix-up happens once in a while, it’s okay as long as your accountant cleans it up immediately. But regular commingling will destroy your safety net.)
- Keep Up with the Paperwork: LLCs and Corporations require ongoing maintenance. In some states, you need to hold an annual meeting of the Members, Shareholders, and/or Board (even if the only member/shareholder is you!) and sign the Meeting Minutes to keep your corporate veil intact. Consult your state’s specific business rules and regulations to ensure you are in compliance.
Are you ready to choose your business structure?
If you are looking to attract venture capital, bring on private equity, or cleanly hand over the keys to a buyer in a $9 million sale like Polly, you have to do your due diligence now to set yourself up for success.
Choosing the right structure requires a coordinated strategy between a great legal mind and a sharp financial eye. If you don’t have a trusted attorney in your network, give me a call — I have trustworthy references and would love to connect you with the right professionals.
I’d love to help you turn your long-term business plans into a clear, crisp financial picture that considers every detail. Let’s get your financial pixels lined up — schedule a call with me today!
