Today we want to share a few thoughts about choosing a business type for your startup. It’s something you should do before you start spending money on your idea. And you’ll need to show your legal papers to the bank when its time to open an account for your business.
But which type of legal structure is right for your new company?
On its business structures page, the IRS lists five different business entity types you can choose from. Each has different requirements and benefits. They are:
Sole Proprietorship
A sole proprietor is someone who owns their business 100% herself. There are no partners and no investors with an ownership interest. This is most common for home-based businesses and those who are self-employed. There are almost no requirements for forming this type of business.
Partnerships
A partnership is a relationship between two or more people who join together to form a business. Each partner contributes money, property or labor and then shares in the profit or loss of the business. Partners are not treated as employees of the business for tax purposes and profits are passed through to each partner as income.
Corporations
A corporation is similar to a partnership, except that a person exchanges money, property, and labor for shares of the organization’s capital stock. For tax purposes, a C corp exists as a separate entity from the stockholders and has to file tax returns as if it were a person. Profits are distributed to stockholders after expenses and corporate taxes are paid. As S Corp has many of the advantages of a corporation, but instead of paying at the corporate level, the tax liability is passed through to the shareholders (like an LLC).
LLCs
The limited liability company is a business entity regulated by state statutes and because of that, differs a bit from state to state. Depending on the specifics, the IRS taxes an LLC as either a corporation, a partnership, or part of the owners’ personal taxes. This “pass-through” ability means that an LLC may not have to file a tax return, instead, profits and losses are passed through to its members.
Chances are, after reading the definitions above, you still don’t know which one is right for you. And let’s be honest, the IRS doesn’t seem to want to make it easy to figure out which one is best. So let’s see if we can make it a bit easier for you when it comes to choosing a business type.
Which Options Offer Liability Protection?
The first thing to consider is your personal liability if something goes wrong. If an accident occurs resulting in injuries or if your business has to declare bankruptcy, can you be held personally liable for damages? With a sole proprietorship, the answer is yes. With Corporations, Partnerships, and LLCs the answer is generally no. There are exceptions (fraud or the failure to pay taxes, for example). But generally, your liability is limited by these legal structures. For that reason, most serious startup owners don’t choose a sole proprietorship for their legal entity.
A Corporation or an LLC?
According to experts, there is almost no reason that a small business would want to file as a C Corporation unless you plan to take your business public in the near future. A corporation is limited in its decision-making flexibility by requirements to have a board of directors and regular board meetings, where an LLC or sole proprietorship may be able to make decisions on the fly. A corporation must also file annual reports of its business operations, while there are fewer requirements placed on limited liability companies and partnerships.
What’s worse, if you incorporate as a C Corp, you may suffer from double taxation as earnings are taxed once on the company level and a second time when paid out as dividends to the owners. (Money paid as salary isn’t taxed twice.) If you plan to take money out of your company, other than your salary, a C Corp isn’t the best option. S Corps don’t have this restriction and, in fact, may be an option to consider if you are going to take unearned income out of your company (see below).
There are restrictions on an S Corp that don’t apply to LLCs: S Corps can’t have any non-US shareholders. They can’t have more than 100 shareholders. And, they can’t be owned by other companies. These considerations won’t matter to the vast majority of companies just starting out, but if your company meets any of those restrictions, an S Corp isn’t an option.
Below is an informative video from our friends at MyCorporation which breaks down the differences between LLC versus Corporation:
Is a Corporation Always Wrong?
With all these disadvantages, why would a business owner consider a Corporation? Two reasons. First, an S Corp owner can be treated as an employee and paid a reasonable salary on which FICA taxes are paid. Additional profits may be passed through to the owner as unearned income which isn’t subject to FICA taxes. This may have a significant effect on the taxes you are expected to pay.
Secondly, most angel investors and venture funds will not invest in an LLC because of the protections a Corporation offers to shareholders. So if you plan on taking venture money in the near future to help fund your new business, it might be worth considering an S or C corporation as your legal status.
Most Small Businesses Should Start as an LLC
Our recommendation for most entrepreneurs just starting out (and not likely to take venture funding in the near future) is to form a Limited Liability Company (LLC) in the state of your choice. This is the structure that gives you the most flexibility, no double taxation on profits, and a shield against liability that protects you as an owner. Need help? We recommend MyCorporation. They can help you with everything from choosing a business type to trademarking your logo design.
Need some help deciding? Check out this business entity choice wizard.
When it comes to making the right decision, anyone starting a new business should consult their own legal and tax advisors, as the specifics of your business may lend itself to one of the above legal entities better than others. A legal or tax professional will provide more specific advice for your situation.
