Choosing the Right Business Entity Type
BUSINESS ENTITY FORMATION: AN OVERVIEW
As a business owner, it is absolutely crucial that you choose the right business entity type. Each business entity type comes with certain unique characteristics, advantages, and disadvantages; and you must know what these are before holding yourself out to the public as a business. If you do not, you might face heavy consequences including personal liability for the actions of your business, personal debt for the debts of your business, and less-than-favorable tax treatment.
While there are other business entity types (including sole proprietorships, partnerships, limited partnerships, and professional limited liability companies), three particular business entity types are most common for small businesses: limited liability companies (LLCs), C corporations, and S corporations.
What Are the Available Business Entity Types?
What is an LLC?
A limited liability company is a hybrid-type of legal structure that provides for limited liability of its members/owners. In order to form an LLC, its members must file Articles of Organization with the appropriate state entity. Also, the LLC may (and in some states, must) execute an Operating Agreement. An Operating Agreement governs an LLC’s business, as well as members’ financial and managerial rights and duties. If an Operating Agreement is not executed, the default rules of the state in which the entity is formed will apply.
Composition of an LLC
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, other LLCs, and even other entities. These members receive interest based on what they contribute to the business (capital and/or labor).
An LLC may also opt to elect officers with specific rights and duties as set forth in the LLC’s Operating Agreement. Most states allow one person to occupy more than one office.
Limited Liability of LLC Members
Like a corporation, the liability of LLC members is limited. This means that LLC members are not personally liable for the debts and obligations of the LLC. Limited liability is one of the main reasons why business owners choose to form an LLC.
Some exceptions to the general rule on limited liability for LLC members exist. These exceptions generally arise when the LLC fails to adhere to corporate formalities, such as maintaining a separate bank account for LLC transactions. If this happens, it is called “piercing the corporate veil.”
Taxation of LLC and its Members
Like sole proprietorships, 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 individual federal tax returns. However, LLCs may elect corporate tax status, which may be advantageous if the members want to reinvest profits in the business (ie, rent, advertising, marketing, hiring employees). This is because the amount taxed on an LLC for up to $75,000 in profit is significantly lower compared to the amount that would be taxed on an individual tax return. If corporate status is elected, the LLC is treated as a separate entity for tax purposes, and then the individual members will report and pay individual income tax only on salaries earned.
The federal government does not tax income on an LLC because the profits and losses are passed through to the individual members. For LLCs with employees, however, the LLC mut obtain a federal employee identification number (EIN). Also, as individual states may tax LLCs, it is important to be familiar with your individual state’s tax rules. An LLC may be required to register with a state tax agency and obtain a tax permit, pay state income tax, and pay certain state employment taxes.
What is a Corporation?
A corporation is formed by filing Articles of Incorporation with the appropriate state entity. A corporation is an independent legal entity owned by shareholders and managed by a board of directors. These directors must appoint officers.
As provided by the laws of the applicable state, the corporation must hold annual meetings, keep a paper trail of actions by the company, and maintain minutes of the meaning. Thus, corporations have more “corporate formalities” to adhere to compared with LLCs.
The liability of a corporation’s shareholders, directors and officers is limited. The corporation is held legally liable for the actions and debts incurred by the business. 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 (ie, they will lose the money they invested in the corporation).
What is an “S” Corporation?
An “S” corporation or 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.
An S corporation receives the pass-through tax treatment of a partnership or solo proprietorship and the limited liability of a corporation. While an S corporation used to be more common, it is now more common for a company to form as an LLC and then elect S Corporation tax treatment.
An S corporation possesses many benefits of an LLC with some restrictions or limitations. These include: 1) a limit on the maximum number of shareholders (generally 75); 2) ownership restrictions (owners must be U.S. citizens/residents); and 3) required allocation of profits and losses because only one class of stock is permitted.
What is a “C” Corporation?
A “C” corporation is a regular, for-profit corporation that is taxed under normal income tax rules. It is referred to as such after subchapter C of the IRS tax code.
Owners of a C corporation will pay individual income tax on the salaries they receive, and the corporation will pay corporate taxes on net profits. The corporate tax rates are lower than shareholders’ individual tax rates for the first $75,000 of income. Accordingly, if $75,000 in profit is kept in the business for expenses and other needs, it will be taxed at a rate that is lower than what would apply to individual tax returns.
A C corporation receives more incentive to provide employee fringe benefits than other types of entities. When a C corporation offers benefits, its employees are generally not responsible for paying tax on the value. Also, the corporation can generally deduct the cost of providing these benefits.
What are the Advantages and Disadvantages of Creating an LLC or a Corporation?
Forming an LLC or corporation comes with its share of disadvantages or, better phrased, inconveniences. A business owner must register with the state, pay a registration fee, pay an annual assessment, and become knowledgeable of other applicable taxes or licenses that apply. However, the following summarizes the main advantages of going to this trouble:
- Limited liability for business owners – If the business is sued, a business owner will not be held personally responsible
- Asset protection for business owners – Creditors cannot pursue personal assets to satisfy business debts
- Heightened credibility – Formally incorporating or forming your business entity type shows potential customers and clients that a business owner is committed to his or her business.
Advantages of an LLC Compared with a Corporation:
- Pass-through taxation – A single-owner LLC pays taxes only at the individual level (but may elect tax status)
- Flexible management structure – Can choose any structure agreed upon by LLC members
- Limited state compliance requirements compared with a corporation
- Less limitations on who can be an owner
Disadvantages of an LLC Compared with an Corporation:
- Ownership restrictions – Ownership in an LLC is harder to transfer than ownership in a corporation (issuance of shares gives greater flexibility)
- Less precedent – Because an LLC is a newer business entity type, there is less case law precedent compared with corporations
As a business owner, choosing the right business entity type is one of the most important steps towards success. It is essential to understand the different business entity types, which can be accomplished by consulting with an experienced business formation attorney.
For more information or for a free consultation, feel free to contact me at [email protected] or (618) 719-6140. I assist small and growing business in the jurisdictions of Virginia, D.C. and Illinois.
