Costly mistakes to avoid when choosing your company structure
Starting a Colorado business is an exciting prospect, but it also brings many decisions
Starting a Colorado business is an exciting prospect, but it also brings many decisions.
Whether it’s the fulfillment of a lifelong dream or a recent opportunity that suddenly presented itself, you’ll want to ensure that you are setting yourself and your business up for success.
Choosing your company’s structure or type of business entity is one of the biggest and most important decisions you will make.
It’s crucial to consider more than just the short-term picture—think about your long-term business plan and what financial implications it might have for you personally and for your business.
Here are some costly mistakes all entrepreneurs should avoid when deciding on a company structure.
Keeping Business Too Casual
Maybe you’re going into business with your childhood friend, a best friend, or a close family member. No matter how close and casual your relationship with them might be, don’t make your business agreements relaxed. Keeping things too casual with other owners or partners can, among other things, ultimately cause the demise of your business.
Instead, formally document any agreements so everyone is on the same page and there are no questions down the line about what was agreed upon. Whatever business structure you agree to and any other agreements you reach, be sure to have them review by a skilled attorney and put on paper.
Failing to Form a Legal Entity
You can start a business without forming a legal entity. However, doing so could significantly affect your business’s financial future. It’s common for sole proprietors to start a business without filing a structure, but it’s something that should be considered. Forming a legal business entity offers entrepreneurs many advantages, while forgoing a legal structure comes with many risks, including:
Putting personal assets on the line: A legal business entity protects your assets that would otherwise be jeopardized in the case of a business financial hardship or litigation. You can protect your assets and keep things simple with a limited liability company (LLC).
Decreased business credibility: Consumers, vendors, and investors all usually prefer to do business with reputable, established companies. However, it’s hard to prove if you haven’t set up a legal business entity. Setting up a business as an LLC or corporation makes it easier to obtain a business bank account, business credit, EIN, and more to establish that your company is trustworthy.
Failing to Consider Tax Implications
Business taxes can vary widely depending on the business structure. Carefully weigh your options. Understanding precisely what you will be required to pay before determining what type of entity you want to form can help you avoid negative tax implications. Failing to plan and research tax consequences for a business entity can be a costly error. Consider the following:
- Sole Proprietors, Partnerships, and S Corps are allowed pass-through taxation. LLCs are not a tax type but are taxed as a Sole Proprietor or Partnership by default. As a result, LLCs aren’t liable for corporate tax; but owners will very likely need to pay self-employment taxes, typically around 15 percent of their profits.
- Owners of LLCs taxes as sole proprietors or partnerships can potentially decrease their self-employment tax burden by filing as an S Corp using form 2553. By paying a portion of the profits to the owners as salary/wages and withholding taxes one might be able to lower the total taxes paid.
- Although owners are also subject to double taxation, a C-Corp may be attractive depending on the applicable tax rates and write-offs. For example, with investment heavy businesses, passthrough owners are taxed on ALL of the profits at ordinary tax rates before reinvestment. In comparison, the corporate tax rate for a C-Corp on profits could be much lower so that more profits can be reinvested. As a result, later on, the reinvested amounts not only grow the business profits, when the owner receives the funds, they are capital gains and taxed at generally lower capital gains rate instead of as ordinary income.
Circumventing Future Growth
You might be on your own now, but do you expect or want your business to grow, possibly taking on partners or shareholders later? If you hope to find investors to back your business goals in the future, the entity you choose could have a substantial role in the future growth of your business. It could also impact your bottom line. It’s essential to understand the following about business structure and development:
- S Corp ownership limitations: S-Corps aren’t allowed to have more than 100 shareholders and foreign owners aren’t permitted.
- Multiple LLC members: Business owners have the right to add members to their LLC. However, they need to think about their role and percentage ownership. If the company folds or disagreements about operating the business, there could be significant financial implications.
- C-Corp Ownership: In general, the structure of C-corps allows for more significant long-term growth. Yet, they also have more intricacies and fall under stricter regulatory and compliance standards.
Not Enlisting the Help of a Business Attorney
The best step a budding business owner can take is to enlist the help of an experienced business attorney. A well-versed attorney can help them understand each business structure option as well as the pros, cons, and potential long-term costs of each.