Choosing a business structure is by no means an easy task. It requires special planning and deliberation, and deciphering the complicated legalese can make choosing a business structure all the more difficult for those who are just getting started on the journey toward entrepreneurship. However, there are steps that future business owners can take to make the process less overwhelming.
Part I of this two-part series provided a breakdown of three common business structures: limited liability companies (LLCs), corporations, and sole proprietorships. In this article, you will receive a more detailed analysis of the pros and cons of each business structure that can assist you in fully evaluating all of your options.
#1 Limited Liability Companies (LLCs)
Pros: Asset protection, taxation, credibility, and flexibility
One of the major advantages of an LLC is that the owner’s personal assets are protected from business liabilities. This means that if the LLC is sued in court, the owner’s personally-owned money and assets will not be used to fulfill a judgment against the LLC. An exception to this is if the owner engaged in fraudulent activity. Another advantage is that LLCs benefit from pass through taxation, meaning that members are only taxed once at the personal level, not the business level, and owners can report profits and losses on their personal tax returns.
In addition to asset protection and pass-through taxation, LLCs also have the added benefits of credibility and flexibility. Having the “LLC” tag at the end of your company’s name alone lends credibility to your business and its services, and potential customers may be more willing to do business with LLCs because the owner has taken formal steps to be registered with the State. In regard to flexibility, members of an LLC have broad discretion when it comes to deciding how the LLC will be organized and how the business will operate. For example, unlike corporations, LLCs are not required by law to establish officers or a separate board of directors.
Cons: The “good standing” requirement and transferable ownership
Because LLCs are formed and registered at the state level, the process and fees will vary depending on the laws of your state. In Maryland, however, part of the process for forming and sustaining an LLC involves maintaining “good standing” status with the State Department of Assessments and Taxation (SDAT) each year. In order to stay in “good standing” with SDAT, LLCs must comply with a set of legal requirements, including filing a report by April 15th of each calendar year at a cost of $300. If the LLC loses its “good standing” status, it can be fined, lose its limited liability protection, or be turned over to the State.
Another con is that ownership in an LLC can be more difficult to transfer than with corporations. Unlike corporations, where ownership can be increased by selling shares of stock, LLCs cannot add members or adjust ownership percentages of existing members unless all members agree.
Pros: Protection from legal liability, business security, and attracting investors and employees
A major advantage of a corporation is that it operates separately from its owners – it is treated as an independent legal entity. So, if the corporation is sued, the shareholders are not held personally liable. Additionally, an added perk of being treated as a separate entity is business security. For example, if a shareholder wants to leave the company or sell their shares, the corporation can continue doing business as usual without any sort of major disruption. Another plus is that corporations are often attractive to investors and employees due to their ability to issue stock. Corporations can easily raise funds by selling stock, and offering stock benefits and options to employees is a great way to attract top-level personnel.
Cons: Time and cost, double taxation, and strict formalities
In order to form a corporation, one must undergo a lengthy – and often costly – application process. Owners must file extensive paperwork documenting the details of the business and its ownership, as well as appoint a board of directors and draft bylaws and other processes. Further, like LLCs, corporations must maintain “good standing” status with SDAT, which adds to the already heavy load of paperwork.
In addition, unlike LLCs and sole proprietorships, corporations pay income tax on their profits. In the case of C-corps, profits are taxed twice – once when the company makes a profit and again at the shareholder level. Finally, one of the biggest disadvantages of corporations is that they are legally required to adhere to rigid corporate formalities in order to maintain their status. This means that the corporation must follow strict procedures, such as maintaining a board of directors, holding annual meetings, keeping extensive records, and issuing annual reports. Certain corporation types even have additional restrictions. For example, S-corps can only have up to 100 shareholders, and they all must be U.S. citizens.
#3 Sole Proprietorships
Pros: Easy to form, complete control, and minimal business formalities
The functional advantage of a sole proprietorship is that it is the easiest structure to set up compared to other business entities. A business is automatically considered a sole proprietorship if a single owner conducts business activities without registering as any other kind of entity. In addition, because a sole proprietorship can only have one owner, that owner maintains complete control and ownership of the business and is entitled to all of the profits. An added plus of sole proprietorships is also the lack of formal business requirements. Unlike shareholders in a corporation, sole proprietors have the freedom to make all business decisions and create their own policies without consent or approval from partners or officers.
Cons: Risk of personal liability
Although sole proprietorships are generally the least complex business structure, they come with a huge disadvantage: personal liability for business actions. In a sole proprietorship, personal assets and debts are legally tied to those of the company, making the owner personally responsible for debts incurred by the business. This means that the owner’s personal accounts, assets, and property can be used to pay off the debts of the business.
To recap, this article covered the major pros and cons of three types of business structures: (1) limited liability companies (LLCs), (2) corporations, and (3) sole proprietorships. Remember, if you are a budding entrepreneur who is trying to find the right structure for your business, you don’t need to go through the process alone. Consulting with a professional can help guarantee that you are making informed decisions that will put your business on the path toward success.