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How To Pick A Small Business Type

When it comes time to pick a small business type, will you base your decision on a well thought out plan or will you just wing it? As you pick a small business type, you will make important decisions about liability, taxation and ownership.

If you're lucky enough to have a market for your products or services, you've got the foundation for growing a successful business. We'll discuss why the small business type you choose should take into account the nature of your business, where your business stands today and where you want it to be in the future. In addition…

As you read on, you'll also find a quick outline of the small business types, with a definition and the advantages and disadvantages of each. Plus a case study in stupidity, *my own of course.* The information we've gathered here comes from readily available facts, personal experience and some common sense.

As with any information gathering project, your goal is to become more familiar with your choices and possibilities, then consult a professional like your CPA, lawyer or financial advisor before making a final decision.

Try to keep it simple if you can

In the rush and excitement of starting a business, many people pick a business type that is more suited for an established successful company and opt for a corporation or an LLC instead of the simpler sole proprietorship or the partnership. With some common sense and a liability insurance policy, the sole proprietorship or the partnership should suit the needs of a wide range of business ventures.

They are easy and inexpensive to start, operate and dissolve. They have minimal paperwork requirements and income tax requirements that make it as easy as adding another form to your individual income tax return. Here are some criteria for weighing your business as a sole proprietorship or partnership.

  • Home based
  • No employees
  • Little or no liability exposure
  • Self funded/Self managed

Depending on the nature of your business, you should consider establishing an LLC or a corporation even at start up if one or more of the following criteria exists for your business.

  • The business has major liability exposures from your employees, the public or consumers of your products and services.
  • Your business uses a trade secret, special processes or methods.
  • You need to raise capital.
  • You need an organizational structure to manage ongoing day to day operations.
  • You are exposed to large monetary outlays to your suppliers and subsequently a large unsecured debt exposure.

Descriptions of small business types

Corporations - Corporations operate as a separate and distinct legal entity. This means they can conduct business activities independent of its shareholders. The fact that a corporation acts as its own entity is the main advantage of incorporating. A corporation frees shareholders from liabilities incurred by the corporation.

Advantages:

  • Company shareholders enjoy limited liability for debts and lawsuits incurred by the corporation and its activities.
  • Ownership is easily transferable through the transfer of stock.
  • It can be easier to raise capital through stock and bond offerings.
  • A corporation is the only business entity that can deduct expenses for employee benefit premiums.

Disadvantages:

  • Double taxation can incur when taxes are paid on net income to the corporation and then again on income distributed to shareholders as dividends.
  • Corporations are more costly to set up and they require extensive record keeping and tax filings.
  • Corporations often have to qualify to do business across state lines.

Sub Chapter S-Corporations -Basically, an S-Corporation starts out as a regular corporation and then elects a special tax status with the IRS to become an S-corp. using IRS form 2553.

Advantages:

  • Like a regular corporation there is liability protection.
  • They do not pay federal taxes. Profits and losses pass directly to the shareholder's personal tax returns.
  • No double taxation.

Disadvantages:

  • The main disadvantage in electing Sub Chapter S status is the treatment of its stock. It may not have more than 75 shareholders, it may only have one class of stock and shareholders must be US citizens.
  • As with regular corporations, they require extensive record keeping and more complicated tax filings.
  • They also must qualify to do business across state lines.



LLC - Limited Liability Company - An LLC combines the limited liability protection of a corporation with the tax advantages of a partnership or an S-Corporation, but trumps the S-corporation in that there is no limit to the number of partners.

Advantages:

  • The LLC owners have limited liability much the same as corporate shareholders. Liability is limited to each owner's personal investment.
  • No double taxation. Profits and losses pass through to the owners' tax returns like the sole proprietor and the sub-chapter S corporation. In addition, profits and losses can be allocated. Corporations distribute profits and losses evenly.
  • Management is flexible in that unlike corporations, a LLC can establish its own organizational structure.
  • Fairly easy to form and dissolve.

Disadvantages:

  • Tax considerations in that members pay self-employment tax on profits not salary.
  • Benefits paid to employees are not deductible by the LLC.
  • They cost more to start than a sole proprietorship or a partnership
  • There is no stock which means you are limited in what you can offer to potential investors, plus having no stock prevents the issuance of stock options for employees.

Partnership - A business with two or more people who share in all facets of the business.

Advantages:

  • Fairly easy to form and dissolve, but use common sense and have a partnership agreement signed by all partners outlining the terms of the partnership and the responsibilities of the partners.
  • Shared responsibilities and workload.
  • Profits flow through to the partners' individual tax returns. There is no double taxation and the profits and losses can be distributed unevenly.
  • Can be easier to raise capital than a sole proprietorship.
  • Less expensive to start and operate compared to corporations and LLC's

Disadvantages:

  • Unlimited liability for each partners personal assets as the result of company debts and lawsuits incurred by the partnership and its employees.
  • No stock, so it's harder to attract investors and you're unable to offer stock options as an incentive or a fringe benefit.
  • Employee benefit premiums are not deductible expenses.

Sole Proprietor - A business owned and operated by an individual or married couple.

Advantages:

  • Profits are reported on your personal tax return. No double taxation.
  • Easy to form, it's normally just a visit to your county clerk to fill out a simple form, pay a nominal fee and pick a name for your business. This allows you to open a business checking account. They are just as easy to dissolve.
  • You finally get your wish to be your own boss. That's what you always wanted…Right?

Disadvantages:

  • You eat all the losses.
  • You incur unlimited liability for all debts and actions by you or any of your employees. You will have to satisfy those debts and any lawsuits related to your business to the tune of your personal assets if necessary.
  • It can be difficult to raise capital. Your local SBA can provide some guidance.
  • No stock, so it's harder to attract investors and you're unable to offer stock options as an incentive or a fringe benefit.
  • Without employees or outside services, you could find yourself doing menial tasks such as bookkeeping and fixing the fax machine instead of doing what you need to do to bring in the cash.

A case study in small business type stupidity

I should know, like many before me, I was the poster child for putting the cart before the horse. Here's a quick case study in choice of small business type stupidity:

My first foray into entrepreneurship was a video arcade vending machine business. Hey these things were all over the place and they're always sucking in cash, *so I thought.* There's almost no office space required, no overhead and no hassles. Just empty the coin hoppers once or twice a week and it's off to the bank to make the deposits and you're done.

I quickly found out it wasn't the slam dunk I thought it would be. First it was next to impossible to find any venues to place my arcade games. Here in NY, the vending machine business is kind of controlled by a certain type of organization… and I assure you it's not the Boy Scouts.

To make a long story even longer, after 6 months, at the few places where I did manage to get in, I raked in a whopping $87 woo woo. BTW… that included the street value of the copper in the slugs that found they're way into the games.

After 9 months these machines found a new home in my basement where they still reside today.

I had made the hasty decision to incorporate as sub-chapter S. I saved a few bucks by doing my own corporate tax returns and doing all the bookkeeping myself, but I still incurred a $325 a year minimum tax liability even though I never experienced a day of profitability.

In hindsight, I should have opted for sole proprietorship with an insurance policy to cover my liability exposure. Obviously, I took a bath on the whole gig and incurred additional regulatory headaches when I failed to dissolve my S-corporation in a timely matter.

Conclusion: For the small business owner, the one or two man shop in a low risk business environment, the sole proprietorship or the partnership is usually the way to go. If your business involves a liability exposure even on start up, you should consider one of the corporation business types.

You can always trade up to become a bigger fish later on. Use common sense and get some form of liability insurance policy to cover your butt and seek out the advice of professionals before you make any final decisions.

Now that you've got a basic knowledge of where the dangers lie in the type of business you choose to operate and a an outline of the types of business entities available to fit your requirements, then your ready to take the next step and pick your small business type.



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Rick Contrata


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