According to the U.S. Small Business Administration (SBA), in 2013, there were 28.8 million small business in the U.S., 80% of those (23 million) having no employees and the rest—20% (or 5.8 million)—staffed with them. With a survival rate of 79.9% from 2014 to 2015 and a favorable economy, small businesses (with and without employees) stand to thrive. With an increase in business growth, we can expect to see more of these small businesses changing business structures (so expect to see companies listing different entity types when conducting a New Jersey secretary of state business search). Nonetheless, how do you know when it is time to make that change? Read on to learn about 4 ways that signal it is time for a business structure change!
1. You Are Paying a Lot in Self-Employment Tax
Often heralded as the easiest and most cost-effective way to start a business, sole proprietorships are a great option to new and budding entrepreneurs. While this is a great move to give you a leg up while you are gradually growing your network, fine-tuning your business plan, and building your client/consumer base, you stand to lose a sizeable amount of revenue to self-employment tax.
Roughly 30% of your income goes to pay for social security and Medicare—both as an employee and employer. What this means is that if you bring home $50,000 in income, approximately $15,000 goes to Uncle Sam.
To decrease this amount, you may want to consider transitioning to an S. Corporation or a limited liability company (LLC) with an S Corp. status. That way, the company’s revenue can be divided between salary and distributions, with no more than 60% of its revenue marked as salary (and subjected to self-employment tax) and 40% as distributions (not subjected to self-employment tax).
As a side note, it is best to not claim more than 40% of the company revenue as distributions. This will look suspicious to the IRS, potentially leading to legal ramifications let alone a possible bad business reputation.
2. You Need Funding…From a Venture Capitalist Firm
Perhaps you are running an enterprise that needs funding from the get-go. Or your business has hit a rough patch. In any case, your business growth and well-being relies on venture capitalist funding.
Angel investors may be a good funding route, especially if you are a sole proprietor. Unlike venture capitalists, angel funders invest—whether one-time or ongoing— in the business out of passion; they do not look to future profit gain as an incentive. Angel investors could be your family, friends, or simply an individual who believes in what you are doing and wants to help you out financially. This may have been the route you had gone before, especially if you are a sole proprietor. However, for whatever reason, the funds have dried up.
Unlike LLC and corporation owners, sole proprietors may not be able to receive funding from traditional banking institutions and venture capital firms. Both are very wary of taking unnecessary business risks, handing over funds to sole proprietorships, who they often see as being too much of a wild card.
If you need funding from a venture capitalist firm, it may be in your best interest to file as a corporation or LLC so you stand a better chance of being approved. While common knowledge points to a C Corporation because it has the ability to go public, according to Inc., an LLC can pull in as much as 30% more in after-tax proceeds from an asset sale.
While the C Corp offers the possibility of a future initial public offering (IPO), the double taxation—especially from an unexpected asset sale—as mentioned, could leave you walking away with less cash in your pockets. If an asset sale is a part of your exit strategy, it may be best to play it safe and transition to an LLC. Worst case, if you decide on going public, you can always incorporate later.
3. Little Risk and Foreseeable Income—You Plan on Going Public
According to Fortune, the time to go public depends on how much risk is involved and how much profit your company is expected to gain down the road. If it is reaping in large profits already with a foreseeable future of expected—if not set in stone—gradual profit increase, an IPO may be a viable option.
Combine this with the fact that your company has little to no vulnerabilities—it does not depend on 1-2 clients, investors or shareholders or has a large (increasing) pool of debt with no way to recover—you have a greater shot. If you are considering to go public, transition to a C Corp, which is the only business entity in the U.S. that has this benefit.
4. You Are Uncomfortable Using Your Personal Assets as Collateral
In order to receive a loan, you put up your personal assets as collateral. Or your business receives a cease and desist letter from another company. Or how about should your business go into bankruptcy, creditors can come after your personal assets. No matter what the situation is, whether you have suffered a close legal call or are disturbed with the idea of handing over personal assets, you may want to consider a business entity with limited liability protection—such as an LLC, S Corp, or C Corp. Either way, continuing as a sole proprietor, especially if you are in a litigious-friendly industry, may be risky for your business…and livelihood.
Transitioning from one business structure to another comes down to the specific situation and personal choice. Overall, we recommend that you seek a financial advisor and/or attorney to help you choose the right business structure for you company and to ensure the transition goes smoothly.
Should you decide to transition to an S Corp, know that the IRS requires that you fill out Form 2553 no later than 75 days from the incorporate date or from the start of the tax year. Speak with your financial advisor and attorney more about this as well as other entity-related specifications. Have you changed business structures? What was your experience like? Leave a comment!