Contrary to popular belief, your business entity is not set in stone. It’s common to change from a simple structure, like a sole proprietorship or partnership, to an LLC or corporation. Some business owners make a change for tax purposes or because they are acquiring or merging with another company. Here are some instances where changing your business entity might be a good move.
[Read more: How to Choose the Best Business Entity for Your Small Business]
To lower your liability
Many business owners start their business as a sole proprietorship. This type of business entity is the simplest to set up and run, but it also comes with a lot of risk. The owner of a sole proprietorship is personally liable for the debts and obligations of the business. If the company were to go bankrupt, for instance, the founder/owner would have to pay all outstanding debts out of their personal savings.
As a business grows, the risks associated with running the business do too. And, at some point, a business owner may not want to be personally responsible for the obligations of the company. In this scenario, a sole proprietor may convert to an LLC or corporation — two structures that offer personal protection from business activities.
To improve your tax burden
Taxes are probably the most common reason why businesses change entities. Stephanie Sims, founder of Finance-Ability, explained to CO— that the IRS views business entities in one of two broad categories: partnerships or corporations.
“Corporations are taxed on their profits before distributing profits to their shareholders. That means the shareholders in corporations don’t always have personal income from their business that is taxable,” said Sims.
“A partnership, on the other hand, is what’s known as a pass-through entity. That means that the profits or losses in that partnership pass through to the individual partners and must be reported on their tax returns in that year,” she said.
For example, imagine you and two friends run a software development business as an LLC, which is usually considered a partnership under IRS tax law. Your business ends the year with a $100,000 profit. You and your two partners are each responsible for paying taxes on your share of that profit. Assuming an equal partnership where each person owns one-third of the business, that means each partner has to report $33,333.33 of income from the business on their taxes. “There’s no way you can avoid recognizing all of the profits earned in the business that year as personal income. This can be an unpleasant surprise if you have a great business year but didn’t plan for the additional taxes you’ll owe,” said Sims.
When their personal tax rate is higher than the corporate rate, many business owners prefer a C corporation to avoid paying higher personal income tax. The big distinction with a C corporation is that the business bears the tax burden and the shareholders are only taxed on what they receive in the form of dividends or other distributions.
Alternately, some companies choose the S corp election. An S corp is an election that a qualified company makes with the IRS by completing Form 2335. This election requests that the business earnings “pass through” to the owners’ personal taxes - even if the business is established as a corporation.
“For a lot of entrepreneurs, this can be an interesting way to set their business up. In the company’s early days, when there isn’t a lot of profit, it may simplify things to consolidate any business income (or losses) on yours and your co-founders’ personal returns. When the business starts to grow and it’s time to retain earnings inside the company to fund that growth, the S-corp election can be withdrawn,” said Sims.
Remember, you will pay taxes no matter which type of entity you choose. No one entity will allow you to avoid your debt to the IRS; but choosing the right structure for your personal financial situation can help alleviate some of the burden. Speak to a legal advisor or CPA to find out which structure is right for you.
[Read more: Tax Reform Update: The Tax Cuts and Jobs Act]
When the business starts to grow and it’s time to retain earnings inside the company to fund that growth, the S-corp election can be withdrawn.
Stephanie Sims, founder, Finance-Ability
To attract investors
Whether you’re seeking a loan or looking for a partner to buy an ownership stake in your company, you may need to change business entities to sweeten the deal. “Anyone that wants to buy a portion of your business or become a partner is going to want a formal structure (and if they don’t, they may not be the kind of investor you want),” wrote the experts at Accion. “A formal structure like a corporation, LLC, or partnership involves setting out clear rights and responsibilities upfront so everyone knows how the arrangement will work and what their options are.”
Banks also look for companies that have a more formal business structure before approving a loan request. In the event of a catastrophe, banks are more secure in recouping their debt from a formal business rather than a sole proprietor who may not have the savings to repair the financial damage.
Sims added that venture capitalists and angel investors tend to prefer investing in C Corporations. “Those investors want you to be a C Corp because they don’t want to be taxed on all the profits for every business in which they invest,” she explained. “As a practical matter, you probably won’t be distributing those profits to your investors each year, because investors want you to use those profits to grow your business. So, a partnership structure would require them to pay taxes on profits that they didn’t even receive. As a result, it’s very important for most investors – if not all – that you be structured as a C corp.”
Sims recommends for new businesses worried about attracting investors and their tax burden to start as a C corp and file an S corp election. Then, when you start to raise capital, you can withdraw the S corp election. It’s a much simpler process than converting your company from an LLC or other partnership structure to a C corp before taking investor funding.
To achieve environmental or social impact
One increasingly popular business entity is known as a B corporation. “B Corporations are a hybrid made up of a standard corporation and nonprofit. They may earn a profit in business while holding their entity accountable to higher social and environmental performance standards,” explains domain provider GoDaddy.
Beyond being the right thing to do, research shows that consumers globally seek out companies that care about environmental issues. Achieving your B corporation certification is one way to signal to customers that you’re serious about going green. It also can be achieved by pursuing a social mission — which in turn helps with employee retention and customer loyalty.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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