Did you know there are things you can do in the structuring and setting it your business that can pay huge dividends in terms of making it more efficient, less frustrating and putting more money in your pocket in a tax efficient manner?
And, one of those things is how you set up your new venture. Starting a business is exciting, but don’t overlook the details. It’s important to think through which type of business entity makes the most sense for your company today and down the road.
As you make your decision, you’ll also want to steer clear of five common mistakes that entrepreneurs make when selecting a business entity.
Not forming an entity
There’s an old saying that not making a decision is a decision in itself. Similarly, not choosing an entity structure leads to the default of operating as a sole proprietorship.
This is the single biggest mistake I see. I consult with business owners who may have a few businesses and are looking for some help. And, my most important piece of advice is you should always have an entity in place. And, by that I mean a legal entity.
Here’s why. Having a legal entity provides you with asset protection to ensure any future claims from creditors can only be satisfied with the assets in the legal entity. And, in the most industries this is super important. Plus, there are personal benefits to having your business under a legal entity, And oh by the way, in a lot of states your professional license (think attorneys, CPAs and physicians) needs to be held by a legal entity.
Now, I’m not a lawyer, but I am a CPA and have seen this in a ton of cases, where someone just starts into business without a legal entity. And, this is a huge mistake!
The business structure you choose can significantly impact some important issues in your business life. These issues include exposure to liability and at what rate and manner you and your business are taxed. It can also impact your financing and your ability to grow the business, the number of shareholders the business has, and the general way the business is operated.
Let’s pause for a minute and talk about the major types of legal structures. You’ll hear a lot about an LLC, and often what’s called an S corporation (an “S Corp”) or a C corporation.
Each of them have benefits but also requirements. For example, an LLC is generally easier to set up and to run, but has some restrictions.
Now, while LLCs and S Corps are two terms often discussed side-by-side, they actually refer to different aspects of a business. An LLC is a type of business entity, while an S corporation is a tax classification. An S corp election lets the IRS know that your business should be taxed as a partnership.
To become an S corporation, your business first must register as a C corporation or an LLC and meet specific guidelines by the IRS in order to qualify.
Which, brings us to the second huge mistake you want to avoid.
Failing to research your options
Not researching all your options at the start could put you and your business on a path that doesn’t match your goals.
For example, if you do think you’ll decide to have shareholders down the road, do not make your company an LLC.
LLCs are owned by members (think, partners) who share the profits. Partners are more involved in the business plan and operations, whereas shareholders are simply investors. Often shareholders have a voice, but they usually only make up 49% of the shares.
► Pro Tip: If you’re looking to add investors down the road, it’s much easier to do with a C corporation.
Focusing on short-term over long-term plans
The mistake here is structuring your business for the short-term and not considering the future, such as the potential for investors or new owners.
And, this is super important if you’ve decided that you would need to raise funds for growth in the early years of the business. If so, you need an investor-friendly structure. And as we talked about, that might be a C corporation.
Forming a C corporation also allows you to issue multiple classes of shares, which is often a requirement for investors who usually request a separate share class be issued for each investment.
Only considering taxes
It’s a huge mistake to select your filing type solely because it offers certain tax advantages. For instance, you’ll see some niche organizations in their early days avoiding C corporation status at all costs. And, that’s even when it’s clearly the most functional entity for their business model, growth goals, and future capital requirements.
These tax considerations must be balanced with liability concerns, government requirements, and, ultimately, your vision for the business’ future.
And, oh by the way. Depending on the type of structure you settle on, you’re going to have members or partners or shareholders. How one of these is taxed is the same for all of them, so if you’ve got a passive investor who just wants to invest in your business, you’ve got to consider their requirements.
Casual relationships your partners
Now, we’re not talking about personal relationships here. We are talking about the consideration that when forming a partnership or an LLC with people you know well, you may be inclined to skip the official paperwork.
After all, you’re friends, right? Everything is unicorns and lollipops. But, what happens when the shine wears off? What happens if you and the other owners have a falling out? And believe me, It happens all the time.
So in long-term ownership situations, or in case of a separation, all of this needs to be considered. And, the more specific the agreements and terms, the better.
I tell folks, hope for the best when setting up your company, but plan for the worst. And that includes protecting you and your business in the event of a messy divorce.
So, there’s five common mistakes you can avoid in setting up your business. And, while it may be a lot to think about, the good news is that it’s fairly easy to avoid these common mistakes. Simply explore all your options, think about where you see your business going—and growing—in the years to come, and be sure to formalize any business relationships.
Want to learn more? Speak with us about how we can help you select the right entity type for a new venture or possible change your entity type if it doesn’t serve you anymore.