Determining Your Corporate Structure, Part 1

One of the most important decisions you will make as a business owner is how to legally structure your company. Your own assessment of the risks and costs involved, together with guidance from your professional advisers, should determine your corporate structure.

Many personal trainers open their studios as sole proprietorships and then find that as their businesses grow, that structure no longer fits their needs. That’s when it’s time to consider incorporating. Under this legal structure, there are a variety of choices, all of which have unique advantages and disadvantages.

Sole Proprietorship

Sole proprietorship means that a single person (i.e., you) owns your business and solely enjoys the profits. Unfortunately, it also means you are directly responsible for your studio’s liabilities and debts.

In the United States, sole proprietorship is the simplest and most common way to launch a new business. But once the business is set up and starting to be successful, many sole proprietors decide to change their corporate structure to a partnership or a corporation.

Formation. Sole proprietorships are not required to file any legal papers except what is known as a fictitious business name statement. Simply put, this means you will be operating the business under a fictitious name, or “doing business as” (DBA).

Advantages. Formation costs are low, and there is only one legal filing requirement. The sole proprietor can manage the business as he or she sees fit. Profits and losses flow freely to the individual owner.

Disadvantages. The owner runs the risk of personal liability in the event that the business is sued. The duration of the business is limited because sole proprietorships are automatically dissolved upon the death or bankruptcy of the proprietor.

Incorporating Your Business

How do you know when to incorporate? You may want to consider making the change when your business is showing a profit. Depending on the scale of your business, this could be anywhere from 3 months to 3 years. Sole proprietors typically decide to incorporate in an attempt to limit their personal liability.

Incorporating is the process of forming a separate legal entity for the purpose of running your business. Incorporating separates your assets—and more important, your personal liabilities—from those of the corporation.

You have a variety of incorporation choices, and each has advantages and disadvantages.

General Partnerships

A general partnership occurs when two or more people join together to make a profit and do not formally file any paperwork with the appropriate state government office. However, the partners do typically enter into an unrecorded but written agreement between themselves that regulates the terms and conditions of the partnership.

General partnerships can be complex, so you will want to discuss this option carefully with your legal and tax advisers. Keep in mind that a general partnership does not protect any of the partners from personal liability.

Limited Partnerships

A limited partnership consists of one or more general partners and one or more limited partners. The general partners can be individuals and/or entities; they all have unlimited liability and tend to play more active roles in the business of the partnership than the limited partners. The limited partners have limited liability and are typically more passive investors. (A variation of this method is called a limited liability/ limited partnership, which differs only in that the liability of the general partners is also limited.)

Limited partnerships are typically quite expensive to form. That’s why many have been replaced with limited liability companies (LLCs).

General Corporations

Unlike general and limited partnerships, a general corporation is a legal entity separate from its owners. The owners are called shareholders because they hold shares of stock in the corporation. The shareholders elect directors, who are responsible for managing the affairs of the corporation. The directors oversee operations and elect or appoint officers to carry out day-to-day functions. Officers typically include the president, secretary and treasurer. In many small corporations, one person assumes all these roles.

Corporations provide limited liability, provided that government rules are followed and that the corporation’s shareholders do not commingle corporate funds and assets with personal funds and assets.

General corporations can be filed as C corporations or S corporations. Both have advantages and disadvantages.

Subchapter C Corporation (C-Corp.)

A general corporation can elect Subchapter C status when it is incorporated.

Formation. Under Subchapter C, articles of incorporation must be filed with the Office of the Secretary of State or Department of Corporations. The articles are a legal document that lists information about the corporation, including name, purpose, shares authorized, name and address of initial registered corporate agent for service of process and principal place of business.

Generally, under the laws of each state, every corporation is required to conduct annual meetings of its directors and shareholders. These meetings are important and help to protect directors, officers and shareholders from personal liability.

Advantages. Obtaining funding from banks and lenders is often easier for corporations than for sole proprietorships or partnerships. C corporations can appear more professional than sole proprietorships.

Disadvantages. Government formalities must be followed, including the requirement for annual meetings and corporate formalities. Failure to follow these formalities may result in personal liability to shareholders, directors and/or officers. It also costs money to form a corporation, and in most states, corporations incur an annual filing tax (“franchise tax”), which can vary significantly. This tax is separate from any personal or corporate income tax. Corporations must pay taxes at the corporate level when making distributions to their shareholders. Plus, the shareholders must pay personal taxes on these distributions, which essentially results in being taxed twice.

Subchapter S Corporation (S-Corp.)

Using Subchapter S when incorporating creates a general corporation that is taxed in a similar manner to a partnership, thus avoiding the double taxation penalty associated with C corporations. However, in order to qualify as an S corporation, a small business must meet specific regulations set by the Internal Revenue Service (IRS). (See sidebar “IRS Regulations for S Corporation Status.”)

Formation. The person filing the articles of incorporation with the Office of the Secretary of State or Department of Corporations elects S status and files any additional forms required by the particular state. The corporation also needs to file with the IRS to elect S status on the federal level (IRS form 2553).

Advantages. An S-corp. enjoys the same advantages as a C-corp. But it also has a significant advantage in that an S-corp. avoids double taxation for shareholders, and profits are taxed at individual shareholder rates.

Disadvantages. In addition to the formalities required for a C-corp., there are a few other disadvantages for an S-corp. The IRS allocates a whole section of the tax code to deal exclusively with S-corps., so there are complex tax laws to comply with. Additionally, an S-corp is typically required to have a calendar year end (i.e., the end of its tax year must coincide with the end of the calendar year), and the number of shareholders is restricted.

Limited Liability Company (LLC)

A limited liability company (LLC) is a relatively new form of corporate structure. LLCs are very flexible for small- to medium-sized businesses and are generally more advantageous than partnerships or S corporations. LLCs are often the method that personal trainers use to incorporate, since it is lawful to have a single-member LLC.

Formation. Articles of organization must be filed with the Office of the Secretary of State or Department of Corporations. Also, the members of an LLC must execute an operating agreement.

Advantages. All members of an LLC are generally protected from liability. Also, an LLC is more flexible than an S-corp. since it does not restrict the LLC to issuing only one class of stock and does not limit the LLC to 75 shareholders. Many states allow broad flexibility for LLCs by allowing the operating agreement to overrule default provisions that would otherwise govern the entity; this makes the LLC attractive both as a passive investment and as an actively managed business.

Disadvantages. Under various state laws, certain kinds of business do not qualify and some LLCs cannot be perpetual. The operating agreement can be complex and must be written on a case-by-case basis. The state of California currently imposes a minimum annual franchise tax of $800 for LLCs, which makes it a disproportionately expensive place to form an LLC. (This is currently being challenged as unconstitutional in a class action lawsuit, but the outcome is uncertain.)

Choosing Your Structure

When it comes to deciding on a business structure, experts recommend that you get professional advice specific to your location and type of business.

“Although a number of factors should be considered when selecting the best choice of entity for your business, in many cases an LLC makes the most sense,” says Saralyn Abel Dorrill of Abel Band, Chartered, a law firm in Sarasota, Florida. “LLCs offer limited liability protection to their owners, as well as flexibility from a tax perspective. If you are contemplating owning your own property where your business will be operated, you may consider forming one entity to take title to the property and another entity to run your business; this shields the liabilities of the business from the asset of the property and vice versa.”

According to Abel Dorrill, the availability and cost of business insurance are other factors to consider. “State laws vary, and you should consult with a competent attorney before finalizing the entity choice that suits your situation.”