What type of entity is best for my business?
One of the most critical choices you can make when starting a business is choosing the right legal entity for your business and tax structure. This very important choice will impact the complexity of operations and management of your company, your tax obligations, how you raise funds and incentivize employees, your personal liability, and a variety of other matters. In preparing to form your own business, you have likely come across terms like “S-corp,” “C- corp,” and “limited liability company” or “LLC.” This article sheds some light on what these terms mean and highlights some basic considerations to take into account when choosing which legal entity and tax election will be the right fit for your business
Differences in Business Entities:
Choosing your business entity is a very unique process that should be tailored to your company. The average business owner chooses between 6 different types of business entities; Sole Proprietorship, General Partnership, Limited Partnership (LP), Limited Liability Company (LLC), C-corporation (C-corp), and S-corporation (S-corp).
This article focuses solely on the LLC and C corporation because they are the most common forms of business entities used in the US.
Limited Liability Company (LLC):
A limited liability company, or LLC, is a type of legal entity formed pursuant to applicable State law. A key legal component of an LLC is that it shields owners from liabilities not arising from their own personal conduct and protects their outside assets. In other words, if the LLC is sued, the personal assets, such as a house or car, of those who have invested money in the LLC are generally protected from liability under the suit. Generally speaking, the only money at risk in a lawsuit against an LLC is money that the LLC has made or money that has been invested in the LLC.
LLC’s are also more open to a flexible structure than a corporation. Depending on how an LLC is structured, it can be (1) managed by its owners (so-called “member-managed”), (2) managed by a manager (which may be an individual or entity), or (3) managed by a governing board of managers comprised of owners and/or non-owners. All of the above management structures can further be adapted or modified to the particular business or investors’ requirements. Since LLCs are a relatively new form of a legal entity, the relevant case law is not as well established as corporations, but that is becoming less and less of a concern as the LLC has been around for many years at this point.
LLC Tax Considerations:
The tax rules for an LLC are determined either by how many members it has or whether it elects to be treated as a corporation for tax purposes. A single-member LLC is generally treated as a disregarded entity. This means that the LLC does not need to file taxes as an entity itself; rather, the single-member/owner is considered to own the assets and income of the LLC and they report these on their individual income tax return. The LLC and its assets in this scenario are basically treated as an extension of the single-member/owner for tax purposes.
A multi-member LLC is generally treated as a partnership for federal tax purposes. A partnership is a “pass-through” entity: any funds that come into the LLC are considered to “pass-through” it and go directly to its members. These members then report this income on their income tax returns, and taxes on this income are paid only once.
Alternatively, an LLC can choose to be taxed as a corporation. Corporations are taxed in one of two ways under federal law: as an “S corporation,” or “S-corp,” or as a “C corporation” or a “C- corp.” More on S-corp and S-corp tax considerations below.
A corporation is what most people often think of when they think of companies, but that doesn’t mean it is the best choice for every business. Corporations have a much more rigid structure and are subject to more stringent legal requirements than LLCs. By way of example, for corporations: (1) shareholders are required to elect a board of directors to manage the corporation’s business and affairs; (2) annual shareholder meetings are required, as are periodic meetings of the corporation’s board of directors who take action according to documented resolutions; (3) the corporation’s bylaws also can limit the board of directors’ decision-making authority by incorporating shareholder consent requirements where appropriate; and (4) officers are elected by the board of directors to act on the corporation’s behalf. As a result of these “corporate formalities”, generally speaking, corporations are best suited for larger companies, and LLCs are better for smaller companies and startups.
Owners of a corporation own shares of stock in the corporation. Owners of common shares receive corporate dividends, as declared by the corporation’s board of directors from time to time, in proportion to their share ownership. Thus, a shareholder holding shares representing 10% of the issued and outstanding shares of the corporation is entitled to receive 10% of declared dividends.
Holders of preferred stock may be entitled to receive a preferred return (for example, 5% per year multiplied by the price per share and a preferential return of capital upon liquidation). Shareholders in an S corporation may be entitled to the pass-through tax treatment of profits and losses, as described below. Except for a preferred shareholder’s right to receive a preferred return, however, neither dividends nor (in the case of an S corporation) profits, losses, or any item of income, gain, loss, deduction, or credit, may be shared other than in proportion to share ownership.
Differences in S-corp and C-corp Tax Treatment:
Please note that the terms S-corp or C-corp refer to tax elections; neither S-corps nor C-corps are legal entities. An LLC can elect to be treated as an S-corp or C-corp.
S-corp: An S-corp is a pass-through entity for tax purposes: income goes to the shareholders/members, who then report it on their income tax returns, and the income is taxed only once. However, there are strict limitations on what entities can classify as an S-corp. An S- corp can generally only have one class of stock or interest (e.g. not preferred interest or preferred return), a maximum of 100 shareholders/members, and all shareholders/members must be U.S. citizens or residents. A 100% owner of a company may benefit from an S-corp election, which can allow for reduced taxes on self-employment income in certain circumstances.
C-corp: All corporations that are not S-corps are C-corps. Unlike an S-corp, the income of a C- corp is taxed twice: first as the entity’s income, then again as the stockholder’s income. A C-corp can petition to be classified as an S-corp, but it must do so within 2 months and 15 days after the beginning of the tax year in which they want to be taxed as an S-corp. For example, a corporation electing to be an S-corp for the 2020 tax year must file within 2 months and 15 days of the start of the corporation’s 2020 tax year.
Please note that we are not an accounting or tax firm; you should consult with your accountant regarding what legal entity or tax election is best for your business.
Choosing a type of business entity requires the consideration of multiple factors. There is no best form of entity and, with the exception of tax objectives, most entity types provide liability protection and can be structured to meet the business objectives.