Many small businesses start out as sole proprietorships or unregistered partnerships, with only one or two owners and no employees. Over time, as your business grows and evolves, a different business structure may become beneficial. There are several issues to consider when 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 a properly formed and functioning LLC, for example, members are personally shielded from liability and are generally not liable for business debts or obligations.
#2. Change 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 company agreement that clearly spells out everyone’s rights and obligations. These agreements provide owners with clear roadmaps for decision-making and may minimize management disputes.
#3. Obtaining financing through a bank or funding from investors
Banks often prefer to give loans to businesses that have opted for a registered 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. Apart from banks, investors also often prefer business structures that minimize their risk.
#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, as well as whether you must pay self-employment taxes, should be considered in determining the most advantageous structure for your particular business.
How to make the change
The appropriate way to change from one type of business structure to another depends on how your business is currently organized and the type of business you want to form. The following are a few examples of typical scenarios.
For sole proprietorships or unregistered partnerships, which are not separate legal business entities (that is, business assets and liabilities are not considered to be 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. It is best practice to then review your partnership or company agreements to determine if changes need to be made.
Converting to a corporation has additional requirements. For example, the owner or director must prepare corporate bylaws, appoint directors, and issue stock. If your business is a C corporation, you may be able to 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 existing registered entity into a different registered entity (such as converting corporation into an LLC 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. Texas law permits 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.
For any type of change, it is also important to make sure that you complete all of the notifications and registrations required by federal, state, and local 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.
Give us a call.
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.
By: Daniel Taylor, business attorney