As your small business expands and evolves, it may make sense to consider changing its structure. Many small businesses start as sole proprietorships or partnerships, with only one or two owners and no employees. Over time, as your business grows and changes, a more complex business structure may become beneficial. There are several key considerations in deciding whether a change in your business structure may be right for you and your company.
1. Protection from personal liability.
If your small business has hired employees, taken out loans, or provided products or services to customers, you, as the owner of the business, may be exposed to extensive personal liability for business-related damages in lawsuits against the business unless you have selected a business entity that limits potential liability to business assets. In an LLC, for example, members can only lose the amount they have invested in the LLC, and they are generally not liable for business debts or obligations.
2. Changes in ownership.
If you have been a sole proprietor, but now want to add one or more business partners, it is beneficial to formalize the arrangement by entering into a partnership or limited liability company (LLC), with a partnership or operating agreement that clearly spells out everyone’s rights and obligations.
3. Obtaining financing through a bank or funding from investors.
Banks often prefer to give loans to businesses that have chosen a more complex business structure, seeing them as less risky. If you are planning on seeking a loan, it may be advantageous to invest in the effort required to adopt a more formal structure. Investors also often prefer business structures that minimize their risk. For example, in a limited partnership, limited partners, who have invested money in the business but have a minimal role in its day-to-day operations, are not liable for business debts or obligations.
4. Different tax treatment.
Some business structures, such as sole proprietorships, partnerships, certain LLCs, and S corporations are pass-through entities, which may be eligible for the 199A deduction under the new tax law. However, the corporate tax rate also was reduced to 21 percent under the new law. These factors, and whether you must pay self-employment taxes, should be considered in determining the most advantageous structure for your particular business.
How to Make the Business Structure Change
The appropriate way to change from one type of business structure to another depends on how your business is organized and the business you want to form. The following are a few examples of typical scenarios.
For sole proprietorships or partnerships, which are not separate legal business entities (that is, business assets and liabilities are not considered separate from the owners’ personal assets and liabilities), changing to an LLC or corporation simply entails filing the required paperwork with the Secretary of State. LLCs usually must file articles of incorporation and pay a filing fee.
NOTE: In all but five states—New York, California, Delaware, Missouri, and Maine–having an operating agreement is not required, however, creating one is considered a best practice and allows you as a business owner to customize how your LLC functions.
Corporate statutes typically impose additional requirements, for example, preparing corporate bylaws, appointing directors, and issuing stock. If your business is a C corporation, you may elect to have it treated as an S corporation by filing a timely IRS Form 2553 with the Internal Revenue Service. This avoids the “double taxation” that exists for C corporations, as an S corporation is a “pass through” business entity. The S corporation itself is not subject to federal income tax; rather, company shareholders pay income tax on their share of the S corporation’s profits. This option is only available for corporations with only one class of stock and 100 or fewer shareholders whose shareholders are individuals (not LLCs or partnerships) who are legal residents of the United States.
If you are converting an LLC into a corporation or vice versa, you can implement the change by dissolving the original business entity and forming the new one. However, this can be a time-consuming and expensive process. Many states now have statutes establishing a simplified conversion process that eliminates the need to start the business over from square one. Instead, the conversion can take place by filing the required forms with the office of the Secretary of State.
Note: For any change, make sure that you complete the notifications and registrations required by state law. For example, you may need to request a new Employer ID Number (EIN), file a new fictitious name statement, and notify the state tax agency of the change.
There are many factors to consider when deciding whether to change the structure of your small business. As business law attorneys, we can help you think through and implement the business structure that is the most advantageous for your individual circumstances. Please contact us today to set up a consultation.
NOTICE: The information on this website does not constitute legal advice and you should not rely on any information without seeking the advice of a competent attorney licensed to practice in your jurisdiction. This web site is both a communication and/or solicitation as defined by California Rules of Professional Conduct, rule 1-400. For further information, please click here.