The legal structure of your business is not a once-and-done proposition. As businesses grow, evolve, and change, it may make sense to change the legal structure of your business. The good news is that in most cases changing your business structure is more simple than you might imagine.
In the vast majority of cases, small businesses change from a simple business structure (sole proprietor or simple partnership) to a more complex one (LLC or Corporation). Occasionally, corporations will decide to change to simpler structures to reflect changes in their company, but that’s not common.
For most small business owners, a structure change will come because they’re taking on new owners or investors. Another common reason small businesses change structures is because they are seeking financing and their prospective lender requests to review a formal business plan. And many change their structure to take advantage of the legal protections and potential tax options available to some of the more complex structures.
So, when is it time to take the plunge and make a change? And how do you get it done? First, remember that you should always consult your attorney and accountant before you make any decisions regarding the structure of your business – that choice can have serious long-term consequences and you can’t always switch back. That said, we can give you some general tips for what you should be looking out for and what you need to do when you’re ready to make changes.
When Is It Time To Change Business Structure?
When you first started your business, you chose the business structure which was right for you and your new company at the time. For most small business owners, many found that a sole proprietorship or a simple partnership was sufficient for their start-up business needs. In fact, you may not have considered your structure at all and just started doing business (that makes you a sole proprietor). Sole proprietorships and simple partnerships are considered default business structures, since you don’t have to register.
Those simple structures are really easy to manage, but they do have some limitations. They’re really only cut out for businesses owned by one or two people, ideally without employees. They also don’t offer much by way of legal protection for the owners. As your business grows, it may make sense to consider changing your structure.
According to the SBA, “Businesses typically change their legal structure because of a change in business need. That might mean a need for more or different business liability, growth in your business, etc. Sole proprietorships and partnerships enjoy simple management and operations. LLCs and corporations enjoy limited liability to their personal assets.”
Why are the main reasons small businesses consider changing their business structure? The top reasons include:
- Increasing the number of employees: Employees come with liability and you’re going to want the protection offered by an LLC or Corporation, rather than being on the hook for everything yourself.
- Protection from liability (LLC or Corporation): In addition to the liability that comes with employees, your business may be liable for injuries to your customers, for loans, and for other issues. By switching to a more formal business structure, you can protect your personal assets from that liability.
- Allowing outside investment: Anyone that wants to buy a portion of your business or become a partner is going to want a formal structure (and if they don’t, they may not be the kind of investor you want). And you’ll want it too! A formal structure like a corporation, LLC, or partnership involves setting out clear rights and responsibilities up front so everyone knows how the arrangement will work and what their options are.
- Need for greater bank financing: If you’re looking for a loan to grow your business, the bank may want to see a formal business structure. That indicates that you’re serious about your business and have put work into setting it up the right way. It lends a sense of legitimacy.
Note that you don’t have to wait for one of these reasons to pop up. It’s a good idea to plan ahead for your business needs and make any structural changes before you need them. That way, you’re ready to take advantage of opportunities that come up. And it’s always a good idea to consider a structure that protects you from personal liability!
What Structure Should You Choose?
Before changing your business structure, the SBA recommends that you look at these five characteristics of the proposed new business structure:
- Fees and Forms
- Investment Needs
- Operational Continuity
Legal professionals, accountants, and your financial team can help you review these components and determine whether a change in business structure would benefit your company. Both tax and legal issues arise when you change business structure, so you want to make sure you’re not missing any crucial details.
How Do You Change Business Structures?
Changing business structure depends on what the current structure of your business is. The easiest change to make is from a sole proprietorship or simple partnership to a more complex business structure. If you haven’t registered a specific structure with the government, then you’re automatically a sole proprietorship (or a simple partnership, if you have a partner).
Whether you want to change your sole proprietorship to an LLC, a partnership, or a corporation, the first step is to register with the state where you conduct business. Try a Google search for “[your state] incorporation.” You’ll need to fill out a couple of forms and send them in. After a few weeks, the paperwork will be approved and you’ll get notice through the mail or online.
But the paperwork you file with the state isn’t enough. If you’re changing to an LLC or a partnership, you’ll need to create a formal operating agreement or partnership agreement. That’s a legal document that sets out the ownership, rights, and responsibilities of the owners. You can find boilerplate agreements online but you should consult an attorney to make sure you have all your bases covered.
If you’re changing your business structure to a corporation, you’ll need to act like a corporation. That means choosing officers (a president and secretary, for example), a board of directors (you can be the sole board member, although having other board members is good business practice), and creating a shareholders agreement. Like an operating or partnership agreement, that document should cover the rights and responsibilities of the owners. And you’re going to want to run it by your attorney.
Note that you may not be required to file these extra documents with the state, but that doesn’t mean you can skip them. If you run into a legal issue or if the IRS asks, you need to be able to show that you have those documents in place, especially in the case of a corporation. It’s called “following the corporate form” and if you can’t show that you’ve done it, they may treat you as a sole proprietorship (which means you’re on the line for any liability.
In almost every case, you’ll be changing from a very simple structure to a more complicated one. But there may be reasons to go from a more complex structure to a simple one. Unfortunately, that process can be really complicated. You’ll need to work with an attorney to get it done.
And Don’t Forget
A business structure only works if you’ve handled all the details. To make sure your change is recognized, the SBA recommends that you:
- File a DBA (Doing Business As) form (you can do this online on your state’s website and with the IRS)
- Register with the IRS to apply for an updated Employer Identification Number (EIN) (you’ll need that to file your taxes and pay your employees)
- Register your new business structure with the state
- Reapply for state licensure
- Update your bank accounts and records to reflect your new business
- Update your insurance records to reflect your changed business structure
- Create (or update) partnership/stock agreement
- Contact your vendors and suppliers to update them on the change
- Double check with your tax and legal professionals that all paperwork is filed and complete
Finally, stay in touch with your financial and legal advisors. Filing the forms and making the change official is the first step, but your obligations are going to change from then on. For example, you may need to deal with corporate taxes and you’ll have to handle payroll once you start hiring employees. Take advantage of their expertise to make sure you’re doing it by the book.