When choosing a business entity type for their companies, general contractors must think about the legal, financial and tax implications. How can you help your clients become better informed about which business entity type might benefit them the most?
Below, I’ll share six key considerations as they explore the available options. Naturally, I encourage you to offer the expertise and guidance you’re authorized to give them on the matter. And if they’re seeking legal advice, recommend they speak with a reputable attorney who can assess their situation and give them direction.
1. Liability risks
Entrepreneurs in the construction, home improvement and renovation industries face various customer- and employee-related liability risks (e.g., injury, property damage, negligence, project delays and more). While general contractors may be drawn to the administrative simplicity of operating as a sole proprietorship or general partnership, those business structures provide no legal separation between the business owner and the company. If someone sues the company, it puts the business owner’s personal assets at risk.
So, general contractors may consider getting some peace of mind by forming a limited liability company or a C corporation instead. Both structures are their own legal entities — independent from their owners — and therefore offer entrepreneurs personal liability protection.
2. Tax matters
As you know, sole proprietorships, partnerships and LLCs are one in the same entity as their owners for income tax purposes. While pass-through entity tax treatment is convenient and relatively uncomplicated, it isn’t always ideal financially. That self-employment tax burden can hurt!
With that in mind, general contractors may want to discuss electing S corporation tax treatment. For some clients, incorporating as a C corporation (or being an LLC that elects to be taxed as a C corp) might be advantageous (depending on the business owner’s individual income tax rates vs. the corporate rates and other factors). Your clients may need your help to crunch the numbers and figure out what will be best. Doing the math can add up to an informed decision your clients can bank on!
3. Compliance formalities
Entity-related compliance. General contractors can enjoy minimal compliance responsibilities when operating as a sole proprietorship or general partnership. There is usually no state entity registration paperwork or ongoing compliance filings required other than filing (and renewing) a DBA ( if the business uses a fictitious name), filing taxes and applying for (and renewing) business licenses.
LLCs must follow more compliance rules. Still, they are not usually extensive, overly time-consuming, or costly. Several common LLC business compliance requirements include obtaining an Employer Identification Number, maintaining a registered agent, holding an annual member meeting and submitting an annual report.
C corporations have the most compliance responsibilities. Among them are holding shareholder and board of directors meetings, recording minutes of those meetings, maintaining bylaws, and filing annual reports (in most states).
Requirements vary by state, so it can be beneficial for your clients to get guidance from a legal professional to ensure they understand their obligations.
Industry-related compliance. Regardless of entity type, there are often other requirements general contractors will need to satisfy to do business legally:
- Licenses and permits. General contractors must obtain any required state and local business licenses and permits they will need to operate legally. Moreover, if they manage a team of contractors or subcontractors, they should verify that all individuals and entities working for them have the appropriate business licenses, permits and tax forms. Otherwise, they could risk incurring fines and other penalties. The client’s state business licensing board is a good resource for identifying the requirements. Your clients can find links to state licensing agencies on the SBA website. Several industry-specific licenses that a contracting company may need include lead-based paint certification, a contractor’s license, or a specialty contractor’s license.
- Business insurance and surety bonds. In many states, contractors must have general liability insurance and a surety bond to protect themselves and their customers. When pricing business insurance, your clients may find they can get more favorable rates if their company is registered as an LLC or corporation. Why? Remember that sole proprietorships and general partnerships are the same legal entity as their owners and may be considered riskier since personal assets could get tied up in resolving legal claims against the business. Something to note about surety bonds — sometimes the bond amounts required for general contractors set up as LLCs can be much higher than the bond amounts for general contractors set up as corporations.
Remind your clients that obligations may vary from local jurisdiction to local jurisdiction and state to state. It’s well worth taking the time to research the requirements thoroughly!
4. Public perception
The business structure your clients choose may also affect how they’re perceived by customers, vendors and project partners. For some stakeholders, seeing “LLC” or “Inc.” after a company name provides a measure of assurance that the general contractor is running a legitimate business.
5. Aspirations for growth
What if your clients need outside funding to grow or expand their construction businesses? Securing loans and getting approved for other financing may be easier for general contractors who operate as an LLC or corporation. Some lenders may not feel comfortable about investing in sole proprietorships and general partnerships.
6. Succession plans
Clients should also think about what they want to happen to their general contracting company if they die, retire or otherwise exit the business. With a sole proprietorship, the business dies when the owner passes away, retires or stops operating the business. That may also be the case with a general partnership — unless the partnership agreement states otherwise.
Conversely, LLCs and C corporations allow for businesses to continue beyond their owners.
In an LLC, the company’s ownership is typically transferred according to a buy-sell provision in the LLC operating agreement. For example, a member’s ownership interest might be transferred to a new member, distributed among existing members or put back into the business. Or the provision might require that the LLC be sold. In a C corporation, ownership may be changed by transferring stock from one shareholder to another.
What every client must understand
No two clients will face the exact same opportunities and challenges when setting up and maintaining their businesses. For that reason, it’s imperative for them, you and their legal advisors to consider their unique circumstances when talking about the pros and cons of business entity types. Selecting the ideal one for their immediate and long-term goals requires a lot of thought and homework. However, those efforts are well worth it as they can save time and potentially many dollars in the long run.