Many business owners occasionally think about whether they should change entity structures. Trying to decide between the more popular entity structures, such as LLCs, C corporations, S corporations, partnerships or the simple sole proprietorship can get confusing.
Here are some common reasons why you may want to change the entity structure of your business and what you should keep in mind as you make your decision.
- Limiting personal legal liability. If you’re currently a sole proprietorship, becoming a corporation or limited liability company will create a separate legal entity that provides legal protection. If your business receives a legal summons for a claim, for example, having limited liability may protect your personal assets like your home and car from the claim.
- Hiring your first employee. You should incorporate your business if you anticipate hiring your first employee in the near future becausebusinesses are generally liable for their employees’ actions taken on behalf of the company. If an employee performs an act that causes an outside party to sue your business, the outside party can come after your personal assets to satisfy the lawsuit if you don’t have limited liability.
- Establishing credibility. Having LLC or Inc. after your business’s name conveys maturity in your business to customers and vendors.
- Accessing credit and/or capital. Incorporating can also make it easier for your business to obtain financing through banks or investors. Banks want to see that your business is legitimate and not simply a hobby. Bringing in investors also requires a business form that allows you to do this. Individuals often co-mingle personal funds with business activity, making it hard to consider lending money.
- Taking advantage of tax planning opportunities. As your business grows and evolves, you may be able to cut your tax bill by changing your entity structure. For example, if you’re a sole proprietorship with more than $100,000 in net income, switching to an S corporation could potentially decrease your self-employment tax bill. But that’s not all. You often must have basis to take losses and there is more flexibility in use of debt to create basis in some entities versus others.
- Avoiding double taxation. C corporations initially pay taxes on profits at the business-entity level. These profits are also taxed a second time if they are distributed to shareholders as dividends. Other business entities like sole proprietorships, partnerships and S corporations have profits taxed once on the individual owner’s tax returns. Because of this, most small businesses stay away from the C corporation as an entity choice. But with changing tax rates and tax treatment by states, the right entity choice is being blurred.
Deciding whether to switch entity structures can get complicated. And changing an entity can potentially create a taxable event. The best advice is to ask for help in working through the possible scenarios before taking action.