Anyone starting or buying a small business has a lot of decisions to make. Here are three important ones to consider:
- Should you own the business yourself? This would be called a sole proprietorship (if there is only one owner) or a partnership (if there’s more than one owner). Or should you form a separate legal entity to own the business?
- If you decide on a separate entity, should you form a corporation or a limited liability company? (There are other entity types, but in general small businesses are corporations or LLCs.)
- How do you want the corporation or LLC to be taxed—as a separate taxable entity or as a pass-through entity? (More on that below.)
Every situation is different and the answers to these questions depend on many factors. But here are some things to know before starting out on a new business venture.
Why Would Anyone Form a Corporation or an LLC?
Forming and operating a corporation or an LLC is more expensive and can be more complex than owning a business yourself. So why do it?
The main reason would be to limit personal liability. Corporations and LLCs have their own existence. You can think of them as artificial persons. The corporation or LLC owns the business, not the people forming it. Instead, the people own the corporation or the LLC.
Corporations and LLCs enter into their own contracts and deals, can sue and be sued, and are liable for their own debts and obligations. If the business has debts, the creditor must try to recover from the corporation or LLC—not its shareholders or members.
How Is a Corporation or an LLC Formed?
Corporations and LLCs are formed in a similar way. You fill out a document—generally called articles of incorporation or articles of organization—and file it with the state business entity filing office. The state in which you file is the corporation or LLC’s home state.
The corporation or LLC will then have to comply with certain requirements of the home state’s corporation or LLC law. This means, for example, it will have to appoint and maintain a registered agent, file an annual report, pay an annual fee, and file documents if it makes certain significant changes.
Corporations vs. LLCs—Which Is Better?
You should remember two things. First, corporations and LLCs are not the same. Although they have some characteristics in common—like providing limited liability—they are very different in other ways.
Second, there are many factors and considerations involved in deciding which is better for any particular business or business owner. What could be considered an advantage of one of those entities over the other in one situation may be considered a disadvantage in another. That being said, here are some things to think about.
LLC Benefits over CorporationsThe advantages of an LLC is generally considered to have over a corporation include the following:
- LLCs can be governed more informally than corporations. Corporation laws require a board of directors, meetings, quorums, minute keeping, and other management “formalities” that LLC laws don’t require.
- LLCs have greater flexibility in deciding how to split their financial interests. An LLC can distribute its income to each member equally, based on their capital contributions, or in many other ways. A corporation distributes its income to shareholders on a per share basis.
- An LLC can be a pass-through tax entity without the restrictions imposed on corporations.
Corporation Benefits over LLCsThe advantages that a corporation is generally considered to have over an LLC include the following:
- Corporations are more familiar to investors, bankers, the legal, tax and other trusted advisers small businesses rely on, as well as the general public.
- Corporations can offer stock options and stock bonuses as incentives to employees and managers.
- It is easier for corporations to obtain outside financing from venture capitalists and private equity funds, and to have an initial public offering.
What About Taxation?
One of the main differences between corporations and LLCs is how they are taxed under the Internal Revenue Code.
CorporationsA corporation can be taxed for federal income tax purposes in one of two ways. It can be taxed as a C corporation or an S corporation.
A C corporation is a separate taxable entity. It pays corporate income taxes just like a private individual pays personal income taxes. In addition, if it distributes its income to its shareholders—say by declaring a dividend—the shareholders pay income taxes on that distribution. This is called “double taxation”.
An S corporation is a pass-through entity. That means it does not pay corporate income taxes. Its income passes through to its shareholders, who pay personal income taxes on their share of the corporation’s income. A corporation can be taxed as an S corporation by filing a form with the IRS and meeting a number of restrictions, including not having more than 100 shareholders, not having non-resident aliens as shareholders, and only having one class of stock.
LLCsThe IRS has default rules under which an LLC is a pass-through entity. (By default an LLC with one member is taxed as if it were a sole proprietorship, and an LLC with more than one member is taxed like a partnership.)
An LLC is not subject to the restrictions a corporation is subject to in order to be a pass-through. That means, for example, it can have more than 100 members and different classes of membership interests.
In addition, an LLC can elect to be taxed as a C corporation. This election is made by filing a document with the IRS. And if it meets the requirements, it can also choose to be taxed as an S corporation.
As you can see there is a lot for small business owners to think about when it comes to ownership and taxation structures. While it might seem overwhelming, remember there are legal, tax and other advisers out there to help, as well as corporate service companies.