When choosing a business entity type for their companies, general contractors have a lot to consider. I can't over-emphasize the importance of making an informed decision. There are legal, financial, tax, and other issues to think about. Every entrepreneur's situation is unique somehow, and many variables affect which business structure will offer the most advantages. I'll share a list of them below to give you a head start exploring which business structure might benefit you the most. Keep in mind that this information is not a substitute for professional guidance from a licensed attorney, accountant, or tax advisor. I encourage you to reach out to experts in those areas to ensure you understand your options and their impact on your business.
5 Considerations When Choosing a Business Entity Type for Your General Contractor Business
1. Consider How Liability Risks Will Affect Your Personal Assets
Business owners in the construction, home improvement, and renovation industries face liability risks such as customer injury, property damage, and other potential claims. While the sole proprietorship and general partnership business structures offer administrative simplicity (there's no requirement to register those forms of business with the state), they can put a general contractor's personal assets at risk. There is no legal separation between the business owner and the company. So, if the company is sued, claimants may have access to the owner's personal assets, accounts, and property.
To minimize that personal risk, a general contractor may consider forming a limited liability company (LLC) or corporation instead. Those entity types are separate legally from the business owner. Therefore, under most circumstances, the owner's personal assets are protected from the company's debts and legal issues.
If a contractor will hire employees, the LLC or corporation structures can provide peace of mind that a sole proprietorship or partnership cannot. While workers’ compensation insurance covers an employees’ workplace injuries, it doesn’t provide protection for liability resulting from employee negligence or accidental property damage.
2. Understand How Income Taxes Will Be Treated
Sole proprietorships, partnerships, and LLCs are considered the same tax-paying entities as their business owners. As such, their business profits and losses flow through to their owners' personal tax returns and are taxed according to the appropriate individual tax rate. In addition to income tax, all profits are subject to self-employment taxes (Social Security and Medicare).
General contractors that register their business as an LLC might consider filing an S Corporation election to minimize the self-employment tax obligation. With the S Corp election, the business profits and losses flow through to the owners' tax returns, but only a business owner's wages or salaries from their company are subject to the self-employment tax. Business profits paid to owners as distributions are subject to income tax but not self-employment taxes.
When general contractors incorporate their business as a C Corporation, the company files its own tax return and pays income taxes at the corporate rates. Business owners file their own separate individual income tax returns for monies received from the business. Only the owners' salaries and wages from the business are subject to self-employment taxes. Note that taxation as a C Corporation is sometimes called "double taxation." That's because the company profits paid to owners (shareholders) are taxed as income on the owners' personal tax returns after they've already been subject to income tax on the corporation's tax return.
As you can see, there’s a lot to think about, so it is beneficial to have an accounting or tax expert’s assistance in figuring out which taxation method will deliver the best financial outcome.
3. Think About Your Target Market and Customer Perception
Some customers, vendors, and project partners may only be willing to work with general contractors that have officially registered their businesses as an LLC or corporation. That’s important to consider; how unfortunate it would be to miss out on projects simply because someone doesn’t perceive sole proprietorships or general partnerships as professionally credible.
4. Consider How Much Ongoing Compliance Formalities You’re Willing to Deal With
Sole proprietorships and general partnerships have minimal business compliance responsibilities. There may be renewing a DBA ("doing business as") if the business uses a fictitious name, filing taxes, and renewing business licenses, but likely no ongoing formalities otherwise. LLCs have more but typically not an extensive list of compliance obligations. Common LLC compliance requirements include maintaining a registered agent, holding an annual member meeting, and submitting an annual report. Corporations have even more responsibilities, such as holding board of directors meetings and shareholder meetings, maintaining bylaws, and filing annual reports.
The obligations vary from state to state, so it's essential to check your state's rules to understand what is required.
5. Think About Your Future Business Goals
If you plan to grow or expand your business, you may need funding to do so. Securing loans or other financing options may be easier for general contractors operating as an LLC or corporation. Some lenders prefer to invest in formally registered entity types rather than sole proprietorships and general partnerships.
Although it may seem a long way down the road, it’s good to think about what will happen to a company after the owner dies or decides to exit the business or retire. As an LLC or corporation, the company may survive beyond the business owner. That’s not the case in a sole proprietorship; the business departs with the owner. In an LLC, unless the company's operating agreement prohibits it, ownership can be transferred (e.g., via a buy-sell provision to move the departing member's ownership interest to a new member or put it back into the business) or sold. In a corporation, ownership can be changed by transferring stock from one individual to another.
More to Think About: Understand Other Requirements
Licenses and Permits
Regardless of the entity type contractors choose, they will need business licenses and permits to operate legally. These vary by state and locality, so it's critical to research the requirements. Contractors that manage a team of contractors or subcontractors should make sure that all of the individuals and entities working for them have the appropriate business licenses, permits, and tax forms, too. Otherwise, the contractor can get fined or suffer other penalties.
A good place to check which licenses, permits, and other requirements might apply to you is your state's business licensing board. You can find links to state licensing agencies via the SBA website. Several industry-specific licenses that a contracting company may need include:
- Contractor’s license – Many states require contractors to obtain a contractor’s license to ensure that they will be responsible if a project doesn’t go according to plan. Often, there’s a state-mandated exam that’s part of the licensing process.
- Specialty contractor's license – General contractors who want to provide services involving sanitation systems, acoustics, insulation, or another specialized area may need a specialty contractor's license.
- Lead-based paint certification – Contractors involved in renovating older buildings may need to deal with lead-based paint. Because of the toxic nature of lead and requirements for handling and disposing of lead-based paint, many states require general contractors to obtain a lead contractor license or special certification.
Business Insurance and Surety Bonds
Many states require construction contractors to have general liability insurance and a surety bond to protect themselves and their customers. When looking for business insurance, general contractors may find they can get more favorable rates if they have registered as an LLC or corporation (because they're considered less risky than insuring a sole proprietorship or partnership).
Start and Build Your General Contracting Business on Firm Ground
As you think about which business entity will be right for your company and other critical startup decisions, ask for help. Talk with trusted professionals with expertise in the legal, financial, and tax aspects of business ownership. Also, talk with a SCORE mentor for guidance about how to launch, run, and grow your business successfully.