Laying Foundations - the Business Entity Rundown
If there’s anything that we know how to preach about here at The Freelance CFO, it’s preaching empowerment and intentionality in your financial decisions.
“We firmly believe that every single one of you is capable of becoming the architect of your own financial future. And there’s no better example of this than when the moment comes for you to lay your small business’s foundations and make it legit.”
Registering your business is an enormous, exciting and crucial step towards financial independence. But…
“What should I be looking for?”
“Does my product or service determine which entity is best for my business?”
“What type of entity should I be registering as?”
“On the legal side of things, am I in charge or should someone else handle that?”
“How much paperwork is involved in this thing anyway?”
“If I’m the only person involved in my business, what should I do?”
“What if I have employees? Or contractors? Aren’t they kinda the same?”
“If I have contractors and not employees, does that make a difference?”
“And fuck - payroll. What do I even do with that?!”
… it can be a bit, ya know. Overwhelming.
For sure, there are a lot of things to consider. And, to be honest, this blog may not have all of the answers you’re looking for. That’s why professionals - like The Freelance CFO, and other trusted professionals - exist. If you have any specific questions or concerns regarding your unique financial circumstances, we always recommend seeking such advice and expertise.
“Laying Foundations - the Business Entity Rundown” is not a bad place to start. Let's get into it.
Business Entity Types
There are, unsurprisingly, a lot of different ways to structure your business. The Mom and Pop down the road definitely had different considerations when forming compared to that of Amazon or Tesla. For the sake of simplicity, however, we’re going to focus on the entities that you - as a small business owner - are most likely to encounter. Which also happen to be the entities that we are experts in (wink wink). These include:
Sole Proprietorships;
Limited Liability Corporations (LLCs)
General Partnerships;
S Corporations; and
C Corporations
Sole Proprietorship
A sole proprietorship is, basically, what it sounds like. You are in charge of and own the business, and you’re probably its only employee/worker. The exception here would be a legally recognized partner (i.e. a spouse), though there’s more legal considerations with this arrangement. This business structure has no separation from the owner, who undertakes all of the risks associated with the business to the extent of their own personal assets - and that includes what is personally owned (i.e. homes, cars, etc).
Sole proprietorships are also the easiest business entity to form. And while they are not recognized as a separate legal entity from their owners, sole proprietorships are recognized as separate for accounting purposes.
(They’re also a popular option for our clients, though not our favorite choice for a baddie riding solo. But, more on that later.)
Limited Liability Corporation (LLC)
Now to our hybrid option, limited liability corporations, more popularly known as LLCs. These entities are incredibly popular for a variety of reasons, not least of all the ability for the LLC’s owner to decide how the LLC can be taxed - either as a corporation, as an individual, or through the owner’s individual taxes. These entities can combine characteristics of sole proprietorships, S-Corporations and partnerships.
General Partnership
General partnerships are kind of like sole proprietorships in terms of liability - but that liability is spread amongst two or more owners, or “partners.” Each partner contributes capital, property, labor or expertise based on the business’s operating agreement. Each partner shares in the profit of the company. And each partner shares in any liability within the company; aka: debts and losses.
General partnerships can also be LLCs (see above).
S-Corporation
S Corporations (S-Corps)/S-Corp elections preserve the separation between business owners and business in terms of liability, but are pass-through entities for tax purposes.
(*record scratch*
“Wait, wait, what?! What’s a pass-through entity?!”
It’s super simple, babes. Essentially, in a pass-through entity, profits and losses are “passed through” the business to the owners, and are therefore taxed at the owners’ personal rate. This is super nifty when you’re trying not to get “double taxed” by the government, and could potentially reduce overall taxes owed.
Okay, back to our regularly scheduled programming.
*record scratch*).
This is another entity you’re likely to encounter when working with The Freelance CFO, and it’s one of our favorites (for lots of reasons - again, more on that later).
C Corporation
Finally, we enter the Big Leagues with C Corporations (C-Corps). These entities can have one or more owners, but they exist entirely separate from their company. Within this structure, there are often a board of directors, shareholders (owners in their own way), and company executives and officers are the ones ultimately in control of the entire operation.
But, what’s weird about C Corporations? A single person could technically fulfill all of the roles required for the company to exist and function. So, hypothetically, you could create a C-Corporation all for yourself!
(Though, we do not recommend this at all, mostly because of taxation considerations. Yeesh.)
Pros and Cons
Sole Proprietorship
Pros:
It’s the easiest type of business entity to set up;
There are no fees required in creating a sole proprietorship;
Taxes are insanely easy to file and only need to be filed once; and
If your business encounters a net loss, you can deduct that loss from your personal returns.
Cons:
You are exposed to unlimited liability - if you’re sued, you could lose your house, your car… all the things;
You can’t accept capital or investments from outside sources - even banks are reluctant to give business loans to sole proprietors; and
About those profits only being taxed once? Yeah, that comes from your bank account.
Limited Liability Corporation (LLC)
Pros:
Exactly as it sounds - you have limited liability in regards to business debts, judgements and other liabilities, even if you’re a significant controller of the business itself;
You can choose how your business pays taxes - either as a corporation, a partnership or a proprietorship.
The number of shareholders is unlimited.
Cons:
LLCs are more expensive to set up than a sole proprietorship or a general partnership;
The legal fees can also add up, depending on where you live; and
Speaking of, you have to register your LLC with your state of domicile (i.e. the state where your business primarily operates out of); and
General Partnership
Pros:
They’re relatively easy and straightforward to form;
There are no fees required in creating a general partnership;
A partnership allows for a group of like minded individuals to come together, share expertise and share in profit; and
If a partner passes or decides to leave the company, the partnership can continue onwards (with the right paperwork in place).
Cons:
Partners are each exposed to unlimited liabilities, including debts or judgements;
Owners must pay personal income taxes from any business profit made; and
Having a group of awesome, like minded professionals in a room can also lead to conflict - this can include compensation.
S Corporation (S-Corp)
Pros:
Similar to an LLC, you have limited liability in regards to business debts, judgements and other liabilities;
Remember pass-through entities? This helps you avoid double taxation (taxation at both the corporate and personal level);
Lenders really like S-Corps, so say hello to loaned capital to help your business hit the next level; and
Owners can not only share in the net profit from the business, and also any net losses. Both can be reported on personal income tax returns.
Cons:
They’re more expensive to form and maintain than a sole proprietorship or general partnership;
Articles of incorporation have to be filed with the business’s state of domicile;
S-Corps are limited to 100 total shareholders, and they can only be offered one type of stock; and
Fringe benefits offered to employees or shareholders may be taxable as compensation.
C Corporation (C-Corp)
Pros:
Owners are not personally liable for any debts of the company, and shareholders only risk what they have invested;
C-Corps have much more access to financial resources. They can sell stock, obtain bank loans easily or even issue long-term bonds for consistent and reliable financing; and
Some benefits may be deducted as business expenses
Cons:
This is by far the most complicated and complex type of business entity to set up and maintain, and requires practiced and experience legal counsel;
C-Corps are also very expensive to set up;
Earnings could be subject to double taxation.
Okay, So… How Do I Choose?
Now that we’ve gotten you through the basics, it’s time to figure out the Big Question: What’s best for me and my business? Easier said than done, yes. But… let’s step back. Put aside the Big Question for a second, and look ahead in order to ask yourself the Tough Questions: Do you need a partnership? Why do you think you need to become an S-Corp? Are you planning on hiring employees or contractors at some point in the near future?
Reading a few blog posts and comparing your options is helpful and informative (at least we hope so). But the type of entity that you end up choosing for your small business directly impacts:
the size of your business
how you are taxed
how profit is shared amongst yourself and others
your degree of ownership; and
your degree of liability
And that’s not even taking in consideration the broad variation between states concerning business entity registration! Registration requirements in California and Massachusetts, for example, can be cost prohibitive for those seeking to register their business as an LLC.
Put simply… this isn’t a decision to be made lightly, or on a whim.
Now, that’s not to say that entity types can’t change. Enterprises evolve, adapt, grow and retract. Much like change, expansion and contraction are realities of the economy’s lifecycle, so too are the stages of creating, growing and nurturing your own business. So, starting off as a sole proprietorship and switching to an LLC at the right time isn’t uncommon. It happens, like, a lot.
But doing the research with your business entity decision directly relates to one of The Freelance CFO’s foundational principles - intentionality.
“Don’t just leap into something because you “think” it’s appropriate, or because others in your industry are structured in such a way, or because you heard something about an S-Corp on a podcast somewhere and went, “That sounds good.” ”
Even if the entity can be readjusted later down the road to better suit your needs, why wouldn’t you just make the best decision that you can, with the information and expertise you’ve gathered specifically for your business, and yourself?
You and your business deserve better.
Our Recommendations
… that’s not to say that we don’t have our own thoughts on the matter. We help individuals like yourselves register their businesses literally all of the time, so it’s pretty likely that we’ve got some opinions. Here are some common questions that we’ve gotten from entrepreneurial spirits over our many years of business registration experience:.
Keep in mind that most of the businesses we work with are pretty small - either a one Majesty show, or a company with approx. 10 employees (including contractors and freelancers). Our recommendations, therefore, are often going to be skewed towards the direction of entity types that best suit those business structures.
When should I take my business and go legit? We’d like to think that if you’ve been at this thing for a year or more, or if it’s going to be your only source of income (getting furloughed, fired, etc), it's time to make it official.
It’s just me right now, and I’m just starting out - what’s my best option? Sole proprietorships are the easiest, least expensive and most straightforward way to legally register your business, and they’re popular for a lot of reasons… but we prefer single-member LLCs.
Why single-member LLCs? In order to get the full liability protection for your business that LLCs can provide, you need to treat your business like a business (separate bank accounts for your business transactions, etc.)
What’s the point of an S-Corp Election? We recommend electing to be taxed as an S-Corp election for your single-member LLC after your business grows and begins to make a profit. Normally this is after the $50,000/year mark, or greater.
What’s, generally, your favored business entity? We really love LLCs because of their flexibility. You can be a single-member LLC or a multi-member LLC; your business can be taxed as an individual, as a corporation or be taxed through you at your personal tax rate. Honestly, it’s the best qualities of different business entities, combined into a dope foundational package.
Again, that’s not to say that an LLC is the best fit for you and your business now or in the future… but, damn, we recommend this a lot and it’s consistently a big hit
One Last Thing, Your Majesties
So… you have your business. You have your product or service. And now you have the knowledge, and you’re ready to take this thing to the next level.
What do you want out of your small business?
Registering your business is probably - at this point - the next, natural step in its progression. But it’s also not a babystep. You have to see not only where this business lives currently, but where you see it headed in the future.
Maybe you’re just dipping your toe in and doing this as a hustle while working that corporate life. Maybe you’ve been doing this for a few years now, and you’re ready to quit that 9-5 and transform this side hustle into a bona fide full-time venture. Or maybe you’re just fucking going for it because you love it and why the fuck not. All of these statements are completely valid. And they are also the exact type of questions you should ask yourself before making any big moves with paperwork and all the other legal shit - is this something that you legitimately want to take to the next level?
“There’s no right or wrong answer, babes. It’s all up to you. And while that may seem like a pretty scary statement? It’s also pretty fucking empowering.”
You, after all, are the architect of your own financial future.
And there’s no better time than the present to lay the foundation, and start to build.
This blog was just the beginning. If you want to “Get Your Finance Sh*t Together”, we have a course that covers all of this and more (yes, we’re serious - more), including:
How to manage legit books with professional practices;
Knowing - not guessing - what you owe in taxes, based on your business entity type;
Understanding quarterly and estimated annual taxes for your small business;
Learning about accounting software, why you need it, and how to use it;
Organizing with professional systems that let you focus on growing your business instead of endless spreadsheets;
Budgeting without feeling like your living on one; and
Knowing how and when to build your team
Disclaimer: The information provided in this blog is for educational purposes only and does not constitute financial or tax advice. Reach out to The Freelance CFO team with any questions regarding specific financial concerns, or seek the services of a fiduciary.
