One of the most important early steps for starting your own mortgage brokerage is filing for a company entity and figuring the structure that’s best for your business. This will determine the tax qualifications that your business will be eligible for and influence the way your business operates. 

Since there are discrepancies for tax filing and business structures from state to state, it is important to consult with an accountant or attorney before filing for a business entity. Our Brokers Are Better Network partner, Strategic Compliance Partners, are a great resource for legal advice and work solely to help independent mortgage brokers. 

We’ve provided some examples of business structures along with their advantages and disadvantages you can take into consideration.

Also Read: Capital and Liquid Asset Requirements for Mortgage Brokers

Sole Proprietorship

A sole proprietorship is the simplest, most common form of organizing a business. This is not classified as a separate legal entity, but it is a business owned and run by one person. For legal purposes, there usually isn’t a distinction between the business and the sole proprietor.

What are the advantages?

• Ease of Formation – A sole proprietor does not have to file any formation documents through governmental agencies. However, if you’re naming your business something not related to your actual name, you’ll need to file for a DBA — which stands for any registered name your business operates under that isn’t your legal business name. 
• Inexpensive – Since there are no legal organizational documents, there won’t be legal fees for drafting the documents and no filing fees (unless you’re under a DBA). 
• No double taxation – The business and owner do not pay income taxes separately, all income taxes are handled on the owner’s personal tax returns.

What are the disadvantages?

• Unlimited Personal Liability – This tends to be the biggest problem with sole proprietorship. The owner will be held personally liable for all business activities, including debts and liabilities. 
• No Equity Insurance – Since this type of business is solely owned by one individual, they cannot issue equity (ex. stock options) to a key employee or an investor. 
• No Continuity Existence – If a tragic event were to happen to the owner/proprietor, the business would cease to exist.

With all of this information, a sole proprietorship fits best with someone who is interested in starting a one-person business quickly and inexpensively.

General Partnership

A general partnership is an association of two or more individuals (or entities) to conduct business as co-owners.

What are the advantages?

• Easy Formation – Similar to a sole proprietorship, there are no formalities required to form a general partnership. Although, few states require a simple filing at the county level and a DBA certificate may be required. In some cases, a general partnership can be formed without a written agreement, but strongly advised to have one. 
• Inexpensive – Since there aren’t any formalities, this can be less expensive than other entities both initially and ongoing. However, there are legal fees associated with the drafting of a partnership agreement. 
• Separate Legal Entity – In most states, a general partnership is a separate legal entity with partnership interests that can be issued and transferred. You are eligible to own real estate and property under the company partnership name.

What are the disadvantages?

• Outside Investors – The business will not be able to raise capital from outside investors due to their unwillingness to be a general partner and subject to unlimited liability. 
• Unlimited Liability – Each partner assumes unlimited liability for the partnership’s debts and liabilities, including anything done by the co-partner during business operation. 
• Fiduciary Obligations – Both partners have this obligation to one another, with respect to all matters affecting the business. It’s an extremely high standard requiring undivided communication, loyalty and fair dealings.

As stated above, a general partnership is mostly ideal for two or more individuals who want to start a business quickly and inexpensively. Also, if you’re not seeking any outside investors, and have limited liability exposure. Legal advice is strongly advised when going through this process.

Limited Partnership

Much like a general partnership, a limited partnership is a business conducted by two or more people. However, a limited partnership’s liability is limited to the amount of his/her investment within the business.

What are the advantages?

• Outside Investors – A limited partnership is a good outlet for raising capital due to the investors becoming limited partners and thus having limited liability. Also, a limited partnership’s interests/units are easily transferable. 
• Pass-Through Tax Treatment – Assuming all required formalities have been complied with, a limited partnership’s profits and losses flow directly to the individual limited partners. This can be a desirable aspect in some cases.

What are the disadvantages?

• State Law Agreements – A limited partnership is a creature of state law. A certificate of limited partnership must be filed with the applicable Secretary of State, and in some states, a written limited partnership agreement must be executed. 
• No Management Participation – If a limited partner is participating in any control of the business they could be deemed as a general partner and be held accountable for unlimited personal liabilities. In some states, the activity that constitutes this can be unclear therefore it’s best to enlist in legal advice within your state.

C Corporation

To begin, a corporation is a separate legal entity created under state law, with legal existence distinct from the owner. A C Corporation is the most common form of corporation, and subject to double taxation. Basically, meaning the corporation is taxed on its profits and, secondly, each of the shareholders are taxed on the dividends distributed to them.

What are some advantages?

• Shield Against Personal Liability – This is the most widely accepted and well-established entity for the protection against personal liabilities. If all formalities are complied with, shareholders will only be liable for the debts, obligations and liabilities of the corporation up to their respective investment, regardless of management participation. 
• Attracts VC (Venture Capital) – Venture Capitals usually only invest in C Corporations because they generally like to avoid investing in “pass-through” entities such as S Corporations or LLCs. 
• Capital Structure Flexibility – C Corporation’s offer the simplest and most flexible capital structure of any entity. They may also have different classes of stock and have the ability to issue stock options to employees and consultants. The flexibility of a C Corporation facilitates capital raising due to the accessibility of a broad range of financial vehicles, including preferred stock, warrants, subordinated debt, etc.

What are some disadvantages?

• Not a Pass-Through Entity – This means a C Corporation is subject to double taxation stating corporate profits are taxed twice and any losses do not pass through to shareholders. 
• Difficult Formalities – Corporations do require difficult formalities regarding state law, including filing for an incorporation, the adoption of bylaws, the election of a Board of Directors, annual meetings with Board of Directors and shareholders, maintaining separate books, accounting and capitalization requirements, etc. Any failure to adhere to these formalities could result in the court’s holding shareholders personally liable. 
• Expensive – Costs for maintaining and forming a corporation are relatively high. Furthermore, if your business plans to operate in other states you must qualify to do business there increasing costs. 

S Corporation

An S Corporation is another entity formation option. It is formed under applicable state law, similar to a C Corporation, an “election” is filed with the Internal Revenue Service. As stated for a C Corporation, an S Corporation is a separate legal entity with a separate existence distinct from its owners. The name “S Corporation” stems from the sub-chapter S of the Internal Revenue Code. An S Corporation is classified as a pass-through entity, and not subject to double taxation.

What are some advantages?

• Effective Against Personal Liability – This is well-established and effectively protected against personal liabilities. 
• Pass-Through Taxation – As stated previously, their profits and losses flow directly through the corporate entity and straight to individual shareholders. 
• Easily Convertible to C Corporation – As venture capitals are likely to invest in C Corporations and not eligible to invest in S Corporations, the conversion is relatively easy if you’re in need of that assistance.

What are some disadvantages?

• Shareholder Type and Number Limitations – The biggest disadvantage with S Corporations is that shareholders may only be individuals who are U.S. citizens or residents, estates and certain eligible trusts. The number of shareholders is capped at 100. 
• Limited Capital Structure – An S Corporation may not issue both common stock and preferred stock, even the issuance of certain options or convertible notes could invalidate the S Corporation election. 
• Difficult Formalities – Relating much to a C Corporation, an S Corporation requires all the same formalities and can get quite expensive. This also includes filing of a certificate of incorporation, the adoption of bylaws, the election of a Board of Directors, annual meetings of the Board of Directors and shareholders, the maintenance of separate books, records and bank accounts, capitalization requirements, etc.

Limited Liability Corporation

A Limited Liability Corporation (LLC) can best be described as a hybrid between a C-Corporation and General Partnership; it protects against liability and it has a general partnership’s flexibility with pass-through tax treatment. Owners of an LLC are referred to as members; these members can be individuals, partners, corporations, trusts or any other legal/commercial entity. 

What are the advantages?

• Flexibility – This is probably the most attractive aspect of an LLC is its flexibility options, including the distribution of cash and other assets, the allocation of income or losses, etc. An LLC also may elect to be taxed as either a C or S Corporation, and in certain states (like Delaware) it may even limit the fiduciary obligations of its managers. 
• Shields Against Personal Liability – Much like a C Corporation and S Corporation, an LLC can provide a shield to any personal liabilities associated with the business. Although, a few courts have held that a single member LLC is not protected against personal liability. This can be a tricky situation, therefore advice from a legal representative is highly recommended. 
• Pass-Through Tax Treatment – Another advantage is that profit and losses flow directly through the entity to the individual members, unless elected otherwise. This can be ideal to avoid the double taxation of profits and to permit its members from writing off certain losses associated with the business. 

What are the disadvantages?

• Complexity – This is the most significant disadvantage, particularly from a tax and accounting perspective. Generally, LLCs are governed by complex partnership tax rules which can trigger pages of tax provisions in the operating agreement and significant ongoing compliance costs. 
• Unattractive to Investors – If a business is seeking venture capital funding, this would not be a good choice of entity to file under. 
• Limitation on Capital Structure – It’s very difficult and expensive to grant options to employees and consultants, and/or issue other forms of securities. (EX. like a preferred stock in a C Corporation)

In consideration with all the information provided above, picking an entity is a very important step on the entrepreneurial journey. A bad choice could result in paying double the taxes, or a mistake that could result in personal liabilities being held on you.

We strongly recommend enlisting in legal and accounting advice especially from Strategic Compliance Partners who will ensure you understand every aspect of classifying your business correctly and lead you to success.