When entrepreneurs start new companies, they typically devote a good deal of thought to what types of businesses they want to form. Potential buyers need to be just as thoughtful if they want to avoid making costly mistakes. There may be types of business structures to avoid when buying a business.
There are two basic categories of business ownership models: pass-through businesses and corporations. Within these two general categories, there are also four more specific types of business structures and seven variations on these models, each of which comes with various pros and cons.
Just as no one ownership strategy works for every budding entrepreneur, there’s no one solution that’s best for every buyer. Choosing the right form of business ownership requires deciding how buyers want to manage their personal responsibility, deal with taxes, and make decisions for the company. Read on to find out about the business structures to avoid depending on what decisions buyers have made about how to handle their new companies’ affairs.
Business Structures to Avoid When Full Control Is a Priority
Some business owners prefer to take a more active approach to management than others. Sole proprietorships and single-member limited liability companies (LLCs) are both good options for entrepreneurs who want maximum control while general partnerships and corporations involving partners that they do not know are best avoided. However, it is best to check with your business formation attorney to understand the risks of different forms of corporate ownership, especially when it comes to sole proprietorships. This section of the article mainly deals with the idea of “partners” and partnerships and whether they are best avoided, especially, if you, as the buyer, are not buying 100% control of the business.
These business models all require sharing responsibility for making essential decisions with others. In general partnerships, buyers will also share liability for their companies’ failures and potential legal issues. While S-corporations, C-corporations, and LLCs all offer some protections against liability, those who have other partners require sharing control over the company’s path forward with other business partners or shareholders. While this can seem like a good idea at first, you must think about the inevitable issues that occur in business down the road. If you get along well with others, partners might be a good way to divide responsibilities and scale the business. However, if you need full control, single-member LLC’s or corporate entities where you are the single shareholder might be a better idea.
Buyers who want to maximize the control they have over their new companies’ daily operations should be aware that they’ll also be taking on significantly more work. Given that most entrepreneurs who choose to purchase established companies do so because they don’t want to take on the risk and responsibility of starting a new business from scratch, it’s worth considering whether full control should be a top priority and whether a partnership is one of the types of business structures to avoid.
Structures to Avoid for Less Complicated Taxes
Business revenue can be taxed in one of two ways. Pass-through taxation allows business owners to claim profits and losses on their personal tax returns, simplifying the entire ordeal come tax season. Structures that offer pass-through taxation include sole proprietorships, partnerships, S-corps, and many LLCs.
While pass-through taxation may increase business owners’ liabilities, if not properly documented (i.e. ‘breaking the corporate veil’), it also simplifies their tax situations. The alternative is paying corporate taxes, though this can lead to issues with double taxation. Only C-corps and select LLCs utilize this tax structure. Though having the business taxed separately can save business owners some money, it usually requires them to hire additional tax and financial advisors to manage the more complex tax situations that often arise.
Business owners who are willing to take on the added burden of filing multiple tax returns often find that it’s easier to take advantage of tax breaks if they use C-corps or LLCs that do not utilize pass-through taxation. However, it’s relevant to note here that the tax incentives for running a corporation rather than a sole proprietorship or a general partnership only tend to be worth the trade-offs if the company is already generating a lot of profit.
Business Structures to Avoid for Liability Reasons
Some business structures require business owners to put their personal property and assets on the line for their companies. Small business structures like sole proprietorships and certain general partnerships can even leave buyers personally responsible for financial losses suffered by the business.
While some people don’t mind taking on the personal risk of using a sole proprietorship or a partnership to buy a business, it’s not a good idea for risk-averse buyers. They’re better off purchasing majority shares in S-corporations or, if they’re buying small businesses, looking for companies formed as LLCs.
Corporations and LLCs taxed as separate business entities can also take out business lines of credit and loans, just like people would, without requiring business owners to put up collateral or risk taking on negative credit implications should the company fail. They can also file for bankruptcy without requiring their owners to do the same, which can reduce the personal financial risks associated with buying a business that operates within a volatile industry. However, this protection usually occurs once businesses reach a certain size threshold. This is not usually true for small businesses.
Business Structures to Avoid When Investing in Future Generations
Some business models make it easier to pass the business on to heirs than others. Sole proprietorships, for example, are automatically terminated when the business owner dies or decides he or she no longer wants to run the company. The business’s assets can be passed on to a buyer, of course, but sole proprietorships only extend beyond the entrepreneur who started the business if he or she makes explicit legal provisions for passing it on, so if generational wealth is a consideration, a sole proprietorship might be one of the types of business structures to avoid.
In cases where LLCs are individually owned, the same situation applies. If a business owner dies or decides to stop the company’s operations without first filing paperwork to transfer it to a buyer or an heir, the LLC will automatically dissolve.
Buyers who plan to turn their newly acquired businesses into family affairs are better off looking for companies that utilize corporate business structures. Since these businesses have legal rights of their own and are treated as individuals for tax and liability purposes, they continue until all shareholders agree to dissolve them. To transfer ownership to an heir, the majority shareholder simply needs to pass on his or her shares.
It should be clear by now that no one business ownership model stands out as the gold standard. Buyers need to consider their preferences when it comes to control, taxation, liability, and ease of transferring ownership before they decide what type of business to purchase, what type of entity to use, and whether they buy the stock or assets of the company. There may be types of business structures to avoid when buying a business.
Buyers who need help investigating options, whether they’ve already narrowed them down to one business ownership model or need some extra help understanding the ins and outs of pass-through businesses and corporations, should contact reputable attorneys for help. Business brokers can usually point potential buyers in the right direction of a reputable M&A attorney. These industry experts have all the knowledge and expertise required to assist clients with finding the right businesses and negotiating sales and should be happy to help every step of the way.