Risk Management for Business Owners
Owning a business comes with a certain amount of risk. Some risks can be mitigated, some can be transferred to insurance companies through liability policies, but others are unavoidable. To protect their personal assets, business owners must carefully consider which business structure best fits their needs.
When starting a business, sole proprietorships are the easiest to get up and running. No state filings are required (although there may be other licensing requirements), and they are easy to maintain administratively. Basically, as soon as your enterprise has revenue it’s considered a business. Profits are then taxed on a pass through basis, meaning that no separate business tax filing is due, and all profits and losses are reported on the sole proprietor’s personal tax return.
The downside of a sole proprietorship is that there is no legal separation between the business’s assets and the business owner’s assets. This puts business owners’ personal assets at significant risk if the business gets sued. According to the IRS, the estimated cost for a liability case is $54,000, and $91,000 for a contract dispute. And while some litigation risk can be mitigated through effective business management, others are unavoidable.
Limited liability companies are a popular alternative to sole proprietorships. Legally, an LLC is a separate entity from the business owner, which shields the business owner’s personal assets from potential lawsuits. There are exceptions though, including for personally guaranteed debts to the LLC or fraudulent business activities taking place. LLCs are considered a more flexible business structure, as an unlimited number of owners may be added to the business. LLCs also allow members the freedom to allocate profits and losses amongst the owners as they see fit, as opposed to a mandated pro-rata allocation. Additionally, LLCs offer pass-through taxation just as a sole proprietorship does.
Administratively, LLCs are somewhat more onerous than sole proprietorships in that they have various state requirements that differ throughout the country. Mostly, this includes filing annual reports and paying annual fees and/or franchise taxes.
Corporations also offer asset protection similar to an LLC, but are the most time consuming and expensive to administer. S corporations and C corporations are the two main types, and have differing tax treatments. S corporations have pass through taxation just like sole proprietorships and LLCs, and require articles of incorporation and fees to be filed in its respective state. In addition, S corporations must enact bylaws, hold ownership meetings, and keep minutes. There may also be no more than 100 owners at any one time, and all profits must be distributed pro-rata. Owners of S corporations cannot be a C corporation, LLC, partnership, or certain types of trusts, and must be U.S. citizens. That said, S corporations are generally at lower risk of audit (when compared to sole proprietorships) by the IRS given their stricter operating requirements.
C corporations are similar S corporations in terms of liability protection and ongoing administrative requirements. The chief difference is in tax treatment. C corporations are taxed at the business level, and unlike pass through entities, are not automatically taxed on business earnings. Business earnings are only taxed when distributed as dividends, providing strategic planning options for business owners. Transfer of ownership is easy, and owners have more flexibility in deducting expenses since the company is taxed at the business level.
There are other forms of business ownership, such as professional corporations, limited partnerships, and non-profit corporations. For business owners, it’s important to assess whether their current form of ownership is still the best fit. This will change as their company progresses through various life cycle stages. Given our increasingly litigious society, it’s important for business owners to strongly consider separating their personal assets from their business assets if they haven’t done so already.