You have professional experience, you know your target market, and you live and breathe your brand. You’re ready to start your own interior design business. One thing you don’t have? A clue as to which legal structure you should choose to establish your company. This article will define the main types of legal entities that best suit interior design businesses, explain the advantages and disadvantages of each, and help illustrate the way each option functions in different scenarios.
"You absolutely should not make a decision on legal structure without speaking to your accountant and attorney. A good accountant will not only help you decide how to structure your business, but will also review the tax benefits and any additional costs associated with each option."
If you have reached this point in planning your business launch, you should already have a strong bench of experts to consult, including a lawyer and accountant who are familiar with the interior design business model. In the words of Peter Lang, the Designer CPA, “You absolutely should not make a decision on legal structure without speaking to your accountant and attorney. A good accountant will not only help you decide how to structure your business, but will also review the tax benefits and any additional costs associated with each option.” This article will educate you on the basics, enabling you to have an informed conversation with your team and greater agency in your ultimate decision.
Overview of the Main Types of Business Structures
Sole proprietorship is the most common type of small business and the easiest type of entity to form. It gives the business owner complete control over their company but leaves them with full personal liability for the company’s debts. While a sole proprietorship can register for a trade name and benefit from other helpful aspects of formally registering a business, the government does not regard it as a separate entity from the owner’s personal assets and liabilities. It still must apply for any relevant licenses and permits in order to be compliant with the law. Because many interior designers begin as solopreneurs, this is the first entity type for most design businesses.
Partnerships are the simplest way for two or more people to own a business together. There are three main types of partnerships. A general partnership (GP) is an entity where two or more people share full controlling rights, assets, and liabilities for the company. A limited partnership (LP) is a structure where one person is the GP with full control over daily operations, and at least one other person owns a percentage of the company as an investor but has limited operational rights and limited personal liability for any of the company’s debts. A limited liability partnership (LLP) has no GP; all partners share operational control as well as the same legal protection of personal assets.
Corporation is another common legal structure. The term “corporation” usually refers specifically to the structure type C corporation (C corp), but there are actually five different types of corporation structures. The two that are most relevant to an interior design business are C corp, which is a legal entity that is completely separate from its owner, and S corp, which is similar to a C corp, but is designed to avoid the double tax on income, personal and corporate, that occurs for owners of a C corp. This will be explained in more detail, below.
A Limited Liability Company (LLC) is the last entity type on this list and is a hybrid of a corporation and the partnership structures. An LLC protects owners’ personal assets against the company’s liabilities and like an S Corp, allows owners to file the company’s profits and losses as personal income, avoiding the double taxation of a C corp. There are downsides to LLC ownership, however, explained in more detail below.
Liability, Taxation & Administration: A Deeper Dive
As stated, sole proprietorships are the most simple entities to form and to maintain from an administrative point of view. Business income and expenses are included in the owner’s Form 1040, the U.S. Individual Income Tax Return, while profit and losses are filed at the same time as a “Schedule C”. A business’s losses can offset income earned from other sources, which is one of the tax benefits of this legal structure. Because they are considered self-employed, sole proprietors have to preemptively calculate self-employment tax and make quarterly payments to the IRS based on that estimate. With a good CPA on call and an organized accounting system, correctly estimating taxes owed should not be a large burden for a business with a single owner and few employees. The most dramatic downside of the legal structure is the owner’s personal liability; however, a sole proprietor can purchase liability insurance to largely mitigate personal risk. As a professional practice with a wide range of liability, interior design businesses need robust liability insurance regardless of legal structure.
Taxation for partnerships is similar to sole proprietors. The legal entity does not pay tax on its income and profits and losses are passed through to the individual partners. In addition to a Form 1040, each partner annually files a Schedule K-1 (Form 1065), which indicates his or her share of partnership income, deductions, and tax credits. Liability differs across the various types of partnerships, as does the administrative burden and overall cost. In fact, they have an inverse relationship, whereas personal liability is reduced, the amount of paperwork required to register and maintain the entity grows. For example, LPs and LLPs necessitate formal partnership agreements between shareholders, which are complicated legal documents that require an experienced lawyer to execute. While general partnerships aren’t legally required to have a partnership agreement, it’s strongly recommended that you put a contract in place between all partners that clearly stipulates, at the very least, ownership amounts, controlling rights, and the order of operations that will take place in the event of company dissolution.
The greatest benefit of the corporation structures, C corp and S corp, is that owners are in no way personally liable for the debts of the company unless an owner personally guarantees the loan or other credit arrangements. However, the time and cost of forming and maintaining a corporation is greater than the aforementioned, and can be overwhelming for a small business owner with a small number of employees. It also requires the ongoing help of a lawyer, due to the complicated and ever-changing nature of regulations that govern corporations. Corporations are legally required to adhere to strict record-keeping, operational, and reporting practices, including forming a board of directors. Also, C corps must pay corporate tax on income, which can greatly impact the take-home pay for owners, who must also pay tax on the personal income they receive from the company. S corps fare slightly better in the taxation and administration departments since they avoid double taxation, and if the business does not have inventory, can use the cash method of accounting, where income is taxable when received and expenses are deductible when paid.
The taxation for an LLC is fairly simple compared to a corporation. The LLC designation is not recognized by the IRS, which treats an LLC as either a sole proprietorship or a partnership, depending on the number of members named in a company’s registered documents. While an LLC has similar qualities to an S corp in terms of liability and taxation, one difference is that income generated by an LLC is all personally taxable, while business expenses can be deducted from the income of an S corp. The laws surrounding establishing and maintaining an LLC vary by state, as do the costs and overall administration required. Therefore, an LLC may not be the best choice for a company that operates across multiple states.
“If you are reading this and realize you may not be structured correctly for your business, you don’t have to wait till the first of the following year to do anything about it. Once you have good, solid advice from your trusted advisors, you can restructure your business at any time.”
Other Factors To Consider
Another important factor to consider when selecting the right legal entity for your business is whether or not you want to raise money to operate or expand your business. Some entity structures, like LP, LLP, and corporations, are specifically designed for taking in passive investor capital. It’s best practice to treat all loans or investments, even from close family and friends, as a formal agreement with written, legally binding terms. Also, banks and other financial institutions are less likely to give a sole proprietor a business loan or line of credit.
Also consider what will happen to a business if an owner passes away, declares bankruptcy, or leaves the business for some other reason. Corporations are best structured to handle the above scenarios, as ownership shares are easily transferred. However, many other entity types, like sole proprietorship and LLC, would be forced to dissolve in the event of an owner leaving the company. This makes succession planning difficult and requires additional forethought and legal agreements to address such issues.
Selecting the Business Structure For Your Interior Design Business: Scenarios
To better illustrate the factors that help determine which entity type is best for a particular business, we will look at three scenarios.
Scenario A: Robert is an interior designer with a concentrated client base in the same state in which he lives. He doesn’t have any full-time employees and has no need for financing. Robert has purchased business insurance, including liability insurance, that covers his professional practice of helping clients select furnishings and other decor. He has no plans to expand his service offering. Sole proprietorship is likely the most suitable legal structure for Robert’s business.
Scenario B: Kate is an interior designer with a small staff that she intends to grow. She would like to partner with an architect to be able to offer a full suite of design/build services, as well as raise money from passive investors. Most likely, a limited partnership best suits Kate’s plans, where she and her partner will be the GPs, and the passive investors will be LPs. She should also consider the LLC and S. corp structures with the help of her lawyer and tax professionals.
Scenario C: Alex is an interior designer and furniture maker who needs a large staff to support her wide range of operations. She would like to offer her employees benefits and possibly partial ownership. She’d also like to expand her merchandise into multiple product lines. Long term, Alex would like to operate offices across multiple states and envisions her company outlasting her professional career. A C corp is a good option for Alex’s business.
While choosing the right legal structure for your interior design business shouldn’t be taken lightly, it’s also not a permanent decision. The focus of your business, your personal finances, and the law will change over time, all of which can affect how well your legal structure serves your professional and personal needs. As Peter Lang shares, “If you are reading this and realize you may not be structured correctly for your business, you don’t have to wait till the first of the following year to do anything about it. Once you have good, solid advice from your trusted advisors, you can restructure your business at any time.” However, educating yourself on the different legal structures and keeping up with changes to business regulations and tax laws is always a good idea for any business owner.