The business structure you choose will have legal and tax implications. This summary is not intended as a substitute for working with qualified corporate counsel or a business attorney before choosing a structure for your business. But it may help you ask some of the right questions.
While this list is not exclusive, as business attorneys we receive more questions about the following:
A sole proprietorship is the most basic type of business to operate. It is in fact not separate from its owner / operator at all. You alone, or with one’s spouse, own the company and are responsible for its assets and liabilities. While there is no double taxation, it also offers its owner no limitation from liability.
While there are different forms of partnership, some of which offer limited liability to certain classes of its partners, in its simplest form it is an association of two or more persons to conduct some business activity, and, as a general partnership, it assumes that profits, liability and management duties are divided equally among partners. While it largely avoids so-called double taxation and passes profits and losses through to the partners individual income tax returns, its owners, as general partners, enjoy no limitation from liability.
An LLC is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Its owners (members) can generally achieve limited liability while avoiding corporate income tax at the entity level. That said, partnership taxation, which most LLC’s elect on a pass-through basis, is complex.
A corporation, frequently taxed as a so-called “C” corporation, has a separate legal identity from its owners (the shareholders) and requires a bit more documentation of certain ongoing acts relating to its governance. In that sense it is more complex and often best suited for companies that plan to grow, attract Angel or venture capital investors, or issue equity (stock) as options to incentivize employees.
An S corporation is a corporation with a legal identify separate legal from, and thus providing certain liability limitations to, its owners (shareholders) but whose shareholders elect to be taxed on a pass-through basis like partnership, largely avoiding so-called double taxation: at the corporate level and on distributions paid to the shareholders.
Some Advantages and Disadvantages of LLCs, C-corporations,
Like most business attorneys and corporate counsel, at DPA Law APC the large majority of clients -- from first time small business owners to serial entrepreneurs --- ultimately organize as either an LLC or as a corporation, either a so called C-corp or S-corp.
Limited Liability Company
A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Think of it as a more sophisticated, protective form of partnership than can be governed either by its members, or run more like a corporation, with managers or officers. It is ultimately flexible. With the flexibility, however, it can be more expensive to organize.
The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Advantages of an LLC
- Tax Flexibility. LLC members may chose how they’re taxed, such as flow-through taxation akin to partnerships (e.g., no taxation at the entity level, as with regular C corporations), or, they may elect to be taxed as corporation.
- Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or issued, members' personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means "limited" liability - members are not necessarily shielded from wrongful acts, including those of their employees.
- Less Recordkeeping. An LLC's operational ease can be one advantage. Compared to an S-Corporation, there can be less registration paperwork – fewer require meetings, minutes, written consents of directors and owners, etc
- Flexibility in Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Unlike a corporation, profit can, but need not, follow ownership. Members might contribute different proportions of capital and sweat equity. Consequently, it is up to the members themselves to decide who has earned what percentage of the profits or losses.
Disadvantages of an LLC
- Self-Employment Taxes. Members of an LLC are generally considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
- Potentially Greater Organizational costs. Because of the flexibility in the sharing of profits, the governing document – the operating agreement – can become quite complex, and ones business attorney or corporate counsel to take great care in drafting that agreement to align with both the applicable partnership taxation rules and the members’ intended relative business and management relationships among them. While one could pull a prepackaged “operating agreement” from online, it will generally follow default statutory rules for the state of organization, rather than capture the particular relationships the members contemplate – or should contemplate.
- Limitations on Raising Captial. If a business intends to raise investment captial through Angel or venture capital or corporate investment, generally, these investors generally prefer to tax and governing structure of a C-corporation. This does not mean that while bootstrapping the business the member/founders cannot first organize as an LLC, and then later convert to a C-corporation to attract institutional investors.
Corporation (C Corporation)
A corporation (sometimes referred to as a C corp) is an independent legal entity owned by shareholders and managed by officers appointed by a board of directors. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs. Annually, the shareholders elect the members of the board of directors.
Advantages of a Corporation
- Limited Liability. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.
- Ability to Generate Capital. Corporations have an advantage when it comes to raising capital for their business - the ability to raise funds through the sale of stock to Angel investors, VCs, and large corporations.
- Corporate Tax Treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.
- Attractive to Potential Employees. Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.
Disadvantages of a Corporation
- Time and Money. Corporations can be costly and time-consuming ventures to start and operate – particularly if its founders are raising investment capital from third-party investors.
- Double Taxation. In some cases, corporations are taxed twice - first, when the company makes a profit, and again when dividends are paid to shareholders.
- Some Additional Paperwork. Because corporations can have an increased paperwork burden associated with recordkeeping required to document its internal corporate governance structure. Frankly, burden, however, is one often exaggerated. Once one understands the role of the shareholders relative to the board, and of the board relative to officers, it is really not that difficult to document events and transactions properly.
An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.
Advantages of an S Corporation
- Tax Savings. One of the better features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a "distribution," which is taxed at a lower rate, if at all.
- Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. However if an owner / employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.
- Independent Life. An S corp designation also allows a business to have an independent existence, separate from its shareholders. Beyond affording certain limited liability protections to its shareholders, if is relatively easy to adjust ownership. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.
Disadvantages of an S Corporation
- Stricter Operational Processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.
- Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.
- Restrictions on number and type of owners / investors. To receive subchapter S treatment (pass-through taxation) there must be no more than 100 shareholders, they must generally be natural persons, and U.S. taxpayers. This is one of the reasons Angel and institutional investors tend to prefer C-corporations.
Ultimately, the structure of a business entity comes down to how its founders plan to run and manage the business and the tax structure that best aligns with the owners’ objectives including the number and composition of those owners and investors.
Authored by Andrew (Drew) Piunti, email@example.com, ©2016. DPL Law Group, 1100 Lincoln Ave. #381, San Jose, CA 95125