When Is It Time to Change Your Business Structure?
Choosing a business structure is one of the first major decisions an entrepreneur makes.
And we want to stress “major.” Your entity type isn’t just a vanity title. It affects how you’re taxed, how much personal liability you take on and how easily your business can grow.
Thing is: Goals change. Startups are often looking for simplicity and speed. But as a company matures, a structure that once made sense might start holding it back.
The good news? Your original entity choice isn’t permanent. Indeed, it’s not just a good idea to revisit your decision as revenue increases, ownership evolves and long-term goals come into focus, it’s a common situation in the business world.
Knowing when and why to change your business structure can help you reduce taxes, lower risk and better position your company for the future. So let’s look at some reasons why you might change your business structure.
The Structure That Worked at Launch Might Not Work Forever
For many startups, the initial entity choice is driven by flexibility and ease of administration. Sole proprietorships and partnerships, for instance, are popular options for businesses just coming out of the gate because they’re relatively straightforward and have pass-through taxation.
But, as we discuss in our Startup Essentials series on choosing a business structure, these early decisions are typically based on current circumstances, not future complexity.
Your business (hopefully) will not remain static. Your goal is to eventually hire more employees, increase revenue, expand into new markets and/or add partners. They’re reasonable goals, but they can also strain a structure that’s designed for smaller operations. When that happens, the original entity choice might present more limitations than advantages.
Here are a few example considerations that might warrant a business structure:
1. Risk Exposure
As businesses grow, they often take on more risk. Entering new industries, offering additional services, signing larger contracts or expanding geographically can all increase liability exposure. And some entities have more liability protection than others.
For instance, sole proprietorships have no legal liability protection, nor do general partnerships. Limited partnerships offer limited liability to the partners, but the general partner has unlimited liability. Limited liability partnerships limit liability to all owners, protecting them from debts against the partnership. Limited liability companies (LLCs), as the name suggests, shield you from personal liability, and S corps offer limited liability protection, too.
The strongest level of protection comes from C corps. However, they’re also among the costliest to set up, the most complex, and require the most upkeep in terms of reporting and keeping records.
2. Tax Picture
While sole proprietorships and general partnerships are simple, they’re not exactly the most efficient from a tax standpoint. Specifically, the burden of self-employment taxes (Social Security and Medicare) is high, as you must pay both the employee and employer portions.
However, converting could save you on taxes.
A common for-instance: If you converted into an S corp, you could pay yourself (and other shareholder-employees) a reasonable salary, then distribute all other cash flow to yourself and shareholder-employees. While wages paid are subject to federal employment taxes, distributions are not.
3. Ownership Changes
Another signal that it might be time to switch your structure is a change in ownership. Bringing on new partners, issuing equity to key employees or planning for succession can all expose limitations in an existing entity type.
The easiest example of this is a sole proprietor who wants to take on a partner. The business structure would naturally have to change. A partnership is the most obvious change, but many other structures would suffice, too.
But what if you wanted to sell your business, or hand it down to a son or daughter? You might think a sole proprietorship would be the ideal structure given its simplicity. But remember: A sole proprietorship is the same legal entity as its owner. (Same goes for general partnerships.) It would actually be simpler, and more tax-effective, for your business to change hands as an LLC or corporation. In the case of the former, you could map out rules and situations in which the business would be handed down; in the case of the latter, you could transfer ownership through gifting or selling stock.
What to Evaluate Before Changing Your Business Structure
Before restructuring, business owners should carefully evaluate (among other things):
- Current and projected tax implications
- Liability exposure as operations expand
- Ownership flexibility and succession planning needs
- Administrative and compliance requirements
- Long-term growth, investment and exit goals
Because entity changes can have lasting tax and legal consequences, these decisions should be made with a clear understanding of both short- and long-term effects.
Is Your Business Structure Still Working for You?
Business growth is a sign of success, but it can also reveal cracks in the foundation. If your company has evolved beyond what you originally envisioned, your business structure might need to evolve as well.
McManamon & Co. is an accounting, tax, fraud, forensic and consulting firm that serves small and midsize businesses. Our experienced business consulting team can help you evaluate whether your current business structure aligns with your tax strategy, risk profile and long-term objectives, and guide you through potential changes when it makes sense to do so.
Call McManamon at 440.892.8900 or contact us online to learn how we can help you plan for your next stage of growth.
Tags: accounting, business structure, consulting, McManamon, McManamon & Co., small business bank account, small business finances, small business taxes, taxes | Posted in McManamon & Co., small business