How often do you think about the entity formation of your small business and whether you need to change your business entity?
Some entrepreneurs might feel completely satisfied with their legal formation. They know that they chose an entity from the outset that was the perfect fit for their company and its needs.
However, other business owners may be viewing their entities through a new lens thanks to COVID-19. Perhaps choosing to initially incorporate as a sole proprietorship isn’t the best decision for the startup’s long-term future. Or, amid unprecedented times, they might feel compelled to switch to a Certified B Corporation and combine making a profit with holding their business accountable to higher performance standards.
During this unprecedented time, it’s entirely possible that some business owners may decide their initial entity formation is not going to be their “forever” formation. If you feel like this applies to you and it’s time to make the switch to another business entity, this is what you need to know.
Disclaimer: This content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Weigh your business entity formation options before making a change
For consistency’s sake, let’s use the example that your small business initially incorporated as a sole proprietorship. A sole proprietorship is an inexpensive structure that requires little paperwork to file and incorporate the business.
Why choose a sole proprietorship? This is one of the few entity formations where the owner is allowed to fully be the boss. The upside as a sole proprietor is that only the owner — aka you — may call the shots for the business.
Sole proprietors must be able to assume responsibility for their actions because this entity does not provide them with limited liability protection.
What is limited liability protection? Limited liability protection helps create a separation between personal and professional assets. If a sole proprietor was served lawsuit paperwork, for example, their personal assets could be at risk.
Unfortunately, sole proprietorship structures do not provide their owners with limited liability protection. However, the good news is that there are several entities that do offer limited liability protection. Here are a few highly common formations for you to consider:
Limited Liability Company (LLC)
In addition to offering limited liability protection, LLCs are fairly flexible entities. You may choose how you’d like the entity to be taxed, with a partnership and S Corporation as two popular options.
Owners within LLCs are also referred to as members. Depending on the number of members your LLC has and its structure, you may incorporate it under various LLC structure types. These include a single-member LLC, member-managed LLC and manager-managed LLC.
This entity formation is ideal for entrepreneurs who would like to go into business alongside a partner. This individual may be a family member, friend or close mentor.
There are several types of partnerships entrepreneurs may incorporate, including joint venture, silent and limited liability partnerships (LLPs).
Generally, however, most business owners will choose a general partnership. This partnership allows partners to equally divide all profits, liabilities and management duties between themselves. A written partnership agreement may be created that outlines each partner’s role and responsibilities. Partners can refer back to it as a reference, much like they do with a business plan.
This entity is one of the few that begins as a different business structure. S Corporations are initially an LLC or C Corporation that files for S Corporation status under the provisions of Chapter 1, Subchapter S of the IRS.
The company will not pay income taxes, deductions, credits or losses of the organization. Rather, those items will “pass through” to the owners. This makes the owners responsible for reporting taxable activity of the company on their personal income tax returns.
This entity differs slightly from a typical nonprofit in that it is a corporation founded for a charitable purpose.
Nonprofit corporations are formed to benefit the general public and pursue a social mission.
Once a nonprofit corporation has been incorporated, bylaws must be established that state how the corporation operates. You must also create a mission statement for the nonprofit corporation and file for the appropriate tax-exempt status with the state and federal governments.
Related: How to write a mission statement
Certified B Corporation
A B corporation isn’t a type of entity in the traditional sense, as companies still have to be incorporated under traditional structures before applying for the certification.
B Corporations are a hybrid made up of a standard corporation and nonprofit. They may earn a profit in business while holding their entity accountable to higher social and environmental performance standards.
B Corporations earn their B Corp Certification with nonprofit group B Lab. In order to become a Certified B Corp, you must take and pass the B Impact Assessment (BIA) test, complete a virtual assessment review, and meet certain legal requirements contingent on your entity formation.
Consult a lawyer for additional guidance and support.
As a quick disclaimer, I help entrepreneurs incorporate their businesses and can provide information about relevant entity formations. However, I cannot offer legal advice. Each small business is unique. If you find you have additional questions about converting to a new entity formation, you may consult with a legal professional. They may provide further guidance as it specifically relates to the needs of your small business.
File necessary paperwork for conversion
Once you have determined which entity you would like to incorporate as, begin filing the necessary paperwork with your state of incorporation’s Secretary of State to make the switch.
Remember that you will also need to file for additional documents due to changes in your organization type. In the event that you switch from a sole proprietorship to an LLC, for instance, you will need to file articles of organization. Obtain a new employer identification number (EIN) and reapply for business licenses and permits necessary to operate under your new structure.