Today’s blog continues The Business Plan discussion of How to Start a Box by taking a look at the various ways to hold ownership of your business. There are benefits and drawbacks to each form of legal entity, and you’ll want to make the choice that’s right for you.
Limited Liability Company
The legal ownership format that is rapidly becoming the most popular is the Limited Liability Company, or LLC. The limited liability company is a state-registered entity that combines the legal protections of a corporation, with the ease of operational flexibility and tax benefits of a sole proprietorship or partnership. Generally speaking, the LLC format offers a good level of protection from personal liability for company debts, which could include real estate and business purchases made in the name of the LLC. The limited liability company format also operates similar to a partnership or sole proprietorship in that profits are treated as “pass through” to the personal partners. This means that the company does not have to pay taxes on income, and, with some exceptions, income and tax benefits like depreciation, pass through to the business partners on a personal level.
Advantages of the LLC format include liability protection for the partners, so if you take a lease in the name of the LLC, or purchase equipment on loan in the name of the LLC, you’ll have no personal liability in the event of default. Managers of the LLC also have a great deal of flexibility in making operational decisions and profit sharing. Managers can elect how to take income from the company to best fit their tax situation. For example, active members such as owner-operator coaches may take a salary, while passive investors may elect to receive their income in the form of distributions, and avoid paying some of the payroll taxes that an active member may have to pay. The LLC also has no restrictions on the owners, such as requirements to be US citizens or the number of potential owners in the business.
Disadvantages, while few compared to other forms of ownership, do exist. First, the LLC is more expensive to form than a simple sole proprietorship. You’ll need to file with your states secretary of state office, and maintain your entity each year. In California, it costs about $800 per year just to maintain the LLC. Also, some partners may not be comfortable with the LLC format which, depending on the state, may provide less protections for them. Also, while the LLC does not have to pay any federal taxes on income, as it is passed through to the individuals, it may have to pay taxes on gross income to the state. Generally, there is a minimum threshold of gross income the business has to reach before a tax kicks in, but once you hit it the tax is on everything. It’s also on gross income, so while your taxes may even show a loss, if your gross income was above the threshold, the tax has to be paid. Finally, most landlords and lenders are smart enough to require personal guarantees on leases and loans, wiping out the liability protection benefits. After a few years of good operations, though, you bank may be willing to provide you with lines of credit or credit cards in the business name, but you’ll have to earn the privilege. Protections from lawsuits are also limited, as they would be in other forms of ownership. If a member gets injured and decides to sue, he or she will likely sue the LLC and the partners personally, especially if you’re an owner-operator who is actively involved in the day to day operations and training,
The sole proprietorship is the simplest form of business ownership. It’s not even technically a legal entity. The minute you start to operate and sell memberships, goods, and services, you’re a sole proprietorship. The sole proprietorship means there is no separation between the business and individual – you are your business and your business is you. There is no special paperwork to file for a sole proprietorship, other than getting a local business license and maybe filing for a DBA so you can operate under a business name.
The advantages of the sole proprietorship are the ease of setting up and the minimal costs to get local licenses and DBA filings. As a sole proprietorship, there’s no paperwork or Articles required, and all management control and decision making is in the hands of one person.
The major disadvantage of the sole proprietorship is the unlimited liability aspect. Eveything is on your shoulders, as the owner. All debts and potential risk are at your feet, and you’re responsible to make sure they’re covered.
The subchapter S-Corporation, or S-Corp, is a state registered entity that has decided to be treated as a pass-through operation, where all profits and losses pass through to the individual owner or partners. The S-Corp is a dying format for a variety of reasons.
While the advantages of the S-Corp are similar to the LLC, the disadvantages are the reason why this form of ownership has lost popularity except in states that have weak laws regulating LLCs. The S-Corp is more expensive to form and operate than a sole proprietorship, but is on par with an LLC, so that’s generally a wash. The major drawback of an S-Corp, in my opinion, compared to an LLC is that the S-Corp only allows for one class of stock shares to be issued. Without getting technical, this means that all shareholders have the same rights and privileges as the others. In an LLC (or C-Corporation) the company can issue various classes of stocks to various partners, so some partners may only have a financial interest in the company and no voting rights or ability to tell you how to run the business. In an S-Class, everyone has a vote and a say. Another drawback of an S-Corp is that all of the investors must be US citizens and legal residents, so if you’re raising capital from family or friends that are foreigners and don’t have legal residency in the US, they can’t hold shares in the company.
Honestly, unless you’re looking for a massive headache or you think you’re going to become as big as Microsoft overnight, it’s not even worth wasting time writing about the C-Corp, so I won’t.
Just so I am clear and have made full disclosure: I am not a lawyer and the advice I’ve provided in this blog is just my opinion and something you should use in furthering your own research. A great place to do a little research for free is legalzoom.com. They have a help desk that can answer your questions, and unless you’ve got bunch of partners and investors, they can probably get your business filings done in the same amount of time and for half the price of an attorney. I used legalzoom.com in opening two gyms with 2-3 partners each, and am happy with how my stuff came out. You can also take care of your DBA and get your federal Tax ID number through the site as well, and for a few bucks each year, they’ll file the BS paperwork to keep your business in check with your state.