For a college entrepreneur, choosing the right corporate structure is a significant decision, and it should not be taken lightly. While choosing the wrong structure is not the end of the world, keep in mind that some structures are better than others for certain businesses. This article is part of the college startup series, which provides relevant information to college startup entrepreneurs.
First things first. The bottom line is that you actually need to talk to an accountant about this. There are no two ways around it: you need professional advice. You could also talk to an attorney, but I have found that CPAs are a better source of information in the matter of choosing corporate structure.
This article provides some basic concepts so that you can speak to your CPA and ask intelligent questions. However, it cannot replace their advice.
There are three reasons why you should consider incorporation:
Protection: Using a corporate entity to operate your business provides some protection of your personal assets for any liabilities that arise from the business. Note that I said “some protection.” This is important to remember since the protection is not absolute, as there are ways around it. Some college students laugh at this concept because they have no personal assets to protect. Although this may be true initially, it will be no laughing matter if your business is successful.
Taxation and benefits: Using the right corporate entity has some tax advantages because you can separate business gains from personal gains, which are taxed differently. This separation becomes important later on as your revenues grow and as you hire employees to help you run the business.
Getting funded: Most investors and lending institutions will only consider offering financing to your college startup if the startup is incorporated. Period. They won’t fund an individual owner (also known as a sole proprietor).
The four ways to structure a business
There are a number of corporate structures that can be used to organize a business, and the choices can sometimes be confusing. Let’s focus on the four corporate structures most commonly used by entrepreneurs:
Sole proprietorship: This is the most basic business structure and is used by a single individual. You can register the company easily by going go to your local municipal office (varies by state). You should establish a business bank account and run your business separately from your personal finances. Keep in mind, however, that legally and financially you and your business are one. You are 100% liable for anything that happens with your business.
Partnership: This structure is similar to a sole proprietorship, but it involves more than one person. Each person is called a partner. The business interests, revenues, and expenses are divided among the partners based on their respective shares of the business. However – and this point is very important – the liability is usually not divided among partners. Each partner remains 100% and fully liable for all of the business liabilities.
Limited Liability Company: A Limited Liability Company (LLC) is a step above a partnership and a sole proprietorship. An LLC puts a corporate structure around a business which separates corporate liabilities from the owners. An LLC operates like a partnership, in which each member is awarded a percentage of the business; however, LLCs can also be operated by a single person in most states. Generally, LLCs have less formal requirements than corporations, which makes running an LLC fairly easy.
Corporation: Like an LLC, a corporation separates corporate liabilities from the owners. The company issues shares, which represent an ownership interest in the company. A corporation often shields shareholders from corporate liabilities. As is the case with an LLC, this protection is good but far from perfect. As opposed to operating LLCs, running a corporation requires more formalities and paperwork.
Subchapter S and Subchapter C
To make matters more complicated, corporations and LLCs can be treated for tax purposes in different ways. These designations are known as Subchapter S and Subchapter C options. The subchapters refer to chapters of the tax code that define these tax treatments.
Basically, if the company has a Subchapter S designation, the taxes flow through the tax returns of the shareholders. If it has a Subchapter C designation, the taxes do not flow through the shareholders’ tax returns. These designations affect how much money you get to keep and how much you pay in taxes. There are other tax issues as well, and this can get very complex quickly.
A word about LLCs
I like the Limited Liability Company concept because it can provide as much liability protection as a regular corporation without the required formalities of a corporation. Furthermore, an LLC gives you more flexibility in choosing taxation methods. You can elect to be taxed as a sole proprietorship, as a partner, as an S corporation, or as a C corporation. You can switch taxation methods, within reason, as your business matures and your needs change.
How I did it
I cannot give you legal or financial advice, but I can tell you how I did things when I started Commercial Capital. I was unsure of how to structure the business, in part because there were too many options. After a long discussion with my CPA, we opted to start with one structure and upgrade the structures as it became necessary.
This approach worked very well for me:
Concept phase: During the concept phase of the company, I operated the business as a sole proprietorship. During this time, revenues were minimal. This structure allowed me to take deductions for business expenses while keeping the business fairly easy to operate. Also, if things did not go as expected, closing the sole proprietorship would have been a relatively straightforward process.
Startup phase: Once I knew that this business would have traction, I formed an LLC that operated as a sole proprietorship. This structure provided the liability protection of an LLC while keeping the taxation part of the business fairly simple.
Ongoing operations: After my first year of operations, it was clear that the company would grow faster than expected. At that time, I chose to upgrade the tax structure to a Subchapter S designation, which allowed me to run the company more efficiently. Although the tax structure changed, the LLC remained.
By the way, just because I did things one way does not mean that it’s the right solution for you. This is simply an example of how things can be done in real life.
There is no one-size-fits-all solution. Ultimately, the right business structure depends on your business idea, the state in which you operate, and your financial prospects. My only advice is to spend a little money ($150 – $300) to get advice from a CPA or a corporate attorney. OK, I know it sounds lame that my advice is that you should get professional advice, but it’s important to establish the right structure early on. I hope this article showed you how complex this can be.
Here are some great resources that go into great detail on this subject.
- Choose your business structure (Entrepreneur Magazine)
- SBA business structure guide
- Niel Patel’s Guide to Selecting a Corporate Entity
Who is Marco Terry? About the College Startup Series
Over the years, I have noticed two things. First, there are very few resources to help college students start their own businesses (though this is improving). Second, the little advice there is usually focuses on conventional wisdom, which often has shortcomings or is plain wrong. So I did something about it: I wrote this series.
Now, go out there and build a great company.
Disclaimer: This guide does not provide legal or financial advice. It only provides information – which could be wrong. If you need legal or financial advice, get a good advisor.
Copyright: This guide is copyrighted. Please do not steal it. Actually, it’s updated regularly so you are better off simply linking to it.