How to Choose the Best Legal Structure for Your Business Pros amp Cons
How to Choose the Best Legal Structure for Your Business - Pros & Cons Skip to content
Motley Fool Stock Advisor recommendations have an average return of 397%. For $79 (or just $1.52 per week), join more than 1 million members and don't miss their upcoming stock picks. 30 day money-back guarantee. Sign Up Now Single Owner and Operator: A sole prop is owned and operated by one person only. Sole proprietors are free to hire employees and retain contractors, but they can’t add partners or issue stock to shareholders. If you want to bring new owners into the fold or sell equity in exchange for funding, you need to reorganize as a partnership or corporation.No Formal Incorporation: Sole proprietorships aren’t formally incorporated as corporations or organized as partnerships. Sole props that do business under a fictitious name, rather than the operator’s name, typically register those names with state authorities. (These names are known as “Doing Business As” names, or DBAs.) If your sole prop does business under your name, you don’t need to register a DBA.Tax Identification: If you’re your sole prop’s only employee, you can file taxes using your own Social Security number. If you hire employees, you’ll need to get an Employment Identification Number (EIN) from the IRS. This costs nothing and takes only a few minutes.Separate Finances: Sole prop owners aren’t legally obligated to maintain a wall of separation between their personal and business finances. However, it’s highly advisable that you do so, for multiple reasons: to determine that your business is profitable, to keep track of your income and expenses for tax purposes, and to provide potential creditors with a precise accounting of your company’s finances. Set up a business bank account and apply for a small business credit card. Route all income to the former and use the latter for business expenses only. This kills two birds with one stone: keeping your business finances separate while building credit.Pass-Through Taxation: Sole props do not file taxes separately from their operators. As the owner of a sole prop, you’ll attach Schedule C or Schedule C-EZ (Form 1040) to your personal tax return. If your enterprise was profitable during the tax year, you’ll likely be liable for self-employment tax. You’ll report self-employment income and calculate self-employment tax on Schedule SE (Form 1040). If you expect to owe more than $1,000 in tax after subtracting any withholding taxes, and if your withholding taxes comprise less than 90% of the taxes you expect to owe in the current tax year or 100% of the prior tax year’s tax obligation, you’ll need to make quarterly estimated tax payments. For more detail about this and all tax questions, consult our Tax Guide or a tax advisor.
Most partnerships are controlled by contracts known as partnership agreements. Partnership agreements govern matters like: The partnership’s legal name and DBA nameThe partnership’s term – either time-limited or in perpetuityGeneral purpose of the partnership – the business activities in which it’ll engageInitial contributions of each partner, such as cash and property, and the installment schedule on which those contributions will be madeProcedures for future contributions to the partnershipProcedures for admission of new partnersProcedures for distribution of profits and losses to each partner, including frequency and proportionalityManagement duties of each partnerVoting procedures – which matters require a vote and the number or proportion of votes needed to decide in favorProcedures for the sale or transfer of a partnership interest (buy-sell agreements)Procedures for the expulsion of a partnerProcedures for continuing or dissolving the partnership upon the death of a partner – often included in buy-sell agreementsProcedures for dispute resolution, such as mediation or arbitration You can find generic partnership agreement templates online and modify them to your partnership’s needs. However, these templates frequently leave out important eventualities that could affect your interest in the partnership – or the partnership’s very existence – going forward. For instance, a carelessly drafted partnership agreement could allow one partner to unilaterally bind the entire partnership, possibly against the other partners’ wishes. It’s therefore highly advisable to retain an attorney to draw up a customized partnership agreement on your behalf. If your budget doesn’t allow for this at the outset, revisit the situation as soon as possible. Your partner(s) should be amenable to creating a customized partnership agreement to protect their own interests. There are three main types of partnerships. You’ll designate which type of partnership you’ve chosen in the partnership agreement. General Partnership
A general partnership is the most common and straightforward type of partnership. Typically, general partners share equally in the partnership’s profits and liabilities, take on equitable duties, and have equal voting rights. The partnership agreement controls situations in which partners’ interests and duties diverge. For instance, many partnerships assign executive duties to a single managing partner. Others dole out profit shares according to seniority, with longer-serving partners taking a greater share of the entity’s net income. Limited Partnership
A limited partnership (LP), also known as a limited liability partnership, allows for a class of “limited partners” who essentially function as passive investors in the venture. Limited partners have little or no influence on the partnership’s decision-making processes and day-to-day management activities. They are not personally liable for the partnership’s debts or obligations. And they receive profit or loss shares proportional to their interest, which is usually smaller than that of general partners. LPs are more complicated than general partnerships. They are suitable for larger, capital-intensive ventures that attract lots of investors – not so much for small, two- or three-person ventures, which are easier to manage through general partnerships. On the bright side, they’re more discreet than traditional corporations. “The LP agreement is typically a privately signed document,” says Jason Powell, a corporate law attorney at Missoula, Montana-based Bjornson Jones Mungas, PLLC. “[LP agreements are] usually not recorded or available to the public, which allows for anonymity if desired.” Joint Venture
A joint venture is a time- and scope-limited general partnership. It’s ideal for one-off projects that require pooled resources, such as a commercial real estate development. Partners in a joint venture can convert the enterprise into a traditional general partnership by amending the partnership agreement.
Corporations must be formally incorporated with state business authorities, typically the Secretary of State office or equivalent. This requires drawing up and filing articles of incorporation, which include basic information about the entity: Company name and DBARegistered addressName and address of registered agent who handles official correspondenceThe company’s business activities or purposeNames of directors and offersInformation about issuance of corporate stock, including share count and par valueLimitation of liability (indemnification) of officers and directorsDuration of incorporationDissolution proceduresAdoption of corporate bylaws (operating agreement), if extant You can find low-cost articles of incorporation templates online. However, as with partnership agreement templates, cookie-cutter articles of incorporation aren’t ideal. It’s better to spend more for custom-drafted articles of incorporation that account for a wider range of eventualities specific to your company. Corporate Operating Agreements
In addition to articles of incorporation, which are required by law, most corporations are governed by operating agreements or bylaws. These documents spell out in detail the way the corporation is to be governed. Like partnership agreements, they’re not mandated by law, but they’re highly encouraged. Corporate Tax Obligations
Unlike sole props and partnerships, C-corps are not pass-through entities. For tax purposes, they are treated as legally separate entities from their shareholders. They pay federal, state, and sometimes local income tax at corporate rates, which are different than personal income tax rates. They are also subject to different credits and deductions than individual filers. Check with the IRS for more information about corporate tax obligations, including forms required to file.
According to the IRS, LLCs can be classified as corporations, partnerships, or sole proprietorships (disregarded entities) for tax purposes. The classification depends on the number of members (shareholders) and those members’ stated preferences (elections). By default, one-member (single-member) LLCs are treated as disregarded entities, with pass-through business income recorded on members’ personal tax returns (Schedule C or C-EZ). Single-member LLCs can file taxes using members’ Social Security numbers – no EINs required. LLCs with two or more members are treated as partnerships, regardless of the number of members. However, any LLC – including single-member LLCs – can elect to be treated as a corporation for tax purposes. And even disregarded entities are treated as separate corporate entities for certain tax purposes, such as employment and excise taxes. Filing and Regulatory Requirements
Like C-corps and S-corps, LLCs are required by law to file articles of incorporation with the appropriate state authorities. Operating agreements are strongly encouraged as well. According to the SBA, state law often leaves LLCs vulnerable to member losses – for instance, when a member dies or resigns from a multimember LLC, the LLC dissolves, and the remaining members must elect to form a new LLC if they wish to remain in business together. Capable business attorneys can draft detailed operating agreements that account for common (and not-so-common) eventualities like this. Going forward, LLCs’ regulatory burdens are lighter than S-corps’ or C-corps’. “The main difference between an LLC and S corporation is operational flexibility,” says Brian Thompson, a Chicago-based CPA and business attorney. “LLCs are not subject to the requirement of an annual shareholders’ meeting or annual directors’ meeting.”
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By Brian Martucci Date September 14, 2021FEATURED PROMOTION
Are you thinking about turning your latest idea into a business venture? You’ll need to do a lot of work to get off the ground. The Small Business Administration‘s 10-point checklist for budding entrepreneurs is a great place to start. It ticks off a list of crucial to-dos for anyone in the early stages of business formation: Brainstorm and write your business planLook for assistance and training in your industry or area of expertiseChoose a business location (domicile and physical location, if you’re not working out of a home office or coworking space)Find startup financing for your small businessDetermine your company’s legal structure and set up your business with Rocket LawyerRegister your business name (“Doing Business As”)Get a tax identification number and ensure you’re in compliance with local, state, and federal tax regulationsGet a business license and permits, if requiredLearn your obligations vis-a-vis hiring employees, including responsibilities under the Fair Labor Standards Act and what to do if an employee files an FLSA complaint against youFind local assistance from the SBA and local business resources Were I in charge at the SBA, I’d add another point: Keep looking for ways to reduce your small business expenses. That’s more of an ongoing obligation, but its importance is impossible to overstate, and it’s never too early to get started. In any event, number five on that list (determining your company’s legal structure) is crucial, with plenty of pitfalls to avoid. Let’s look at the most common business structures available to U.S.-based entrepreneurs – and a handful of less-common structures too. You’ll learn the basic attributes, advantages, and disadvantages of each structure. Afterward, you’ll be able to properly assess which option is right for you.Sole Proprietorship
A sole proprietorship (sole prop) is the simplest and least formal business structure available to U.S. business owners. By definition, it’s also the least conducive to growth. All sole props share some essential attributes:Motley Fool Stock Advisor recommendations have an average return of 397%. For $79 (or just $1.52 per week), join more than 1 million members and don't miss their upcoming stock picks. 30 day money-back guarantee. Sign Up Now Single Owner and Operator: A sole prop is owned and operated by one person only. Sole proprietors are free to hire employees and retain contractors, but they can’t add partners or issue stock to shareholders. If you want to bring new owners into the fold or sell equity in exchange for funding, you need to reorganize as a partnership or corporation.No Formal Incorporation: Sole proprietorships aren’t formally incorporated as corporations or organized as partnerships. Sole props that do business under a fictitious name, rather than the operator’s name, typically register those names with state authorities. (These names are known as “Doing Business As” names, or DBAs.) If your sole prop does business under your name, you don’t need to register a DBA.Tax Identification: If you’re your sole prop’s only employee, you can file taxes using your own Social Security number. If you hire employees, you’ll need to get an Employment Identification Number (EIN) from the IRS. This costs nothing and takes only a few minutes.Separate Finances: Sole prop owners aren’t legally obligated to maintain a wall of separation between their personal and business finances. However, it’s highly advisable that you do so, for multiple reasons: to determine that your business is profitable, to keep track of your income and expenses for tax purposes, and to provide potential creditors with a precise accounting of your company’s finances. Set up a business bank account and apply for a small business credit card. Route all income to the former and use the latter for business expenses only. This kills two birds with one stone: keeping your business finances separate while building credit.Pass-Through Taxation: Sole props do not file taxes separately from their operators. As the owner of a sole prop, you’ll attach Schedule C or Schedule C-EZ (Form 1040) to your personal tax return. If your enterprise was profitable during the tax year, you’ll likely be liable for self-employment tax. You’ll report self-employment income and calculate self-employment tax on Schedule SE (Form 1040). If you expect to owe more than $1,000 in tax after subtracting any withholding taxes, and if your withholding taxes comprise less than 90% of the taxes you expect to owe in the current tax year or 100% of the prior tax year’s tax obligation, you’ll need to make quarterly estimated tax payments. For more detail about this and all tax questions, consult our Tax Guide or a tax advisor.
Pros of a Sole Proprietorship
Simplicity. It’s super easy to set up a sole proprietorship. You don’t need to file articles of incorporation, draft an operating agreement, or make public financial disclosures. In many cases, you don’t even need to register a company name. You should keep a precise accounting of your business finances, but that’s not legally required.No Double Taxation. Sole props are taxed on a pass-through basis, meaning your business income is combined with nonbusiness income for tax purposes. Your sole prop doesn’t pay taxes on business income that then passes through to you as taxable personal income, a circumstance known as double taxation. If you sell taxable goods or services, you may be required to register with the appropriate tax authorities and pay local and state sales tax.Cons of a Sole Proprietorship
Personal Liability for Business Debts and Obligations. The glaring disadvantage of a sole proprietorship is the operator’s personal liability for any debts or obligations incurred by the business. For instance, if you purchase equipment on credit, then hit a rough patch and find yourself unable to meet the vendor’s payment terms, the vendor may have the right to seize your personal assets (including your personal bank account, house, and car) to satisfy the debt. Shareholders in incorporated entities aren’t personally liable for business debts.Reticent Lenders. Unless your sole proprietorship has substantial assets to put up as collateral, it’s not likely to qualify for loans from traditional lenders. This is especially true for newer entities and owners with spotty personal credit. You may have more luck with nontraditional online lenders, many of which market to sole props and smaller corporations. The devil’s often in the details, however – these loans typically come with high interest rates and unfavorable terms. You’re better off relying on personal savings, loans from family and friends, and other nontraditional startup financing options.Potential for Greater Tax Liability. Sole props are taxed on a pass-through basis. When they’re profitable, they increase their owners’ total taxable income. A big enough increase in your taxable income bumps you into a higher tax bracket and raises your marginal rate, reducing your take-home pay proportionally. While this sounds like a good problem to have, it’s not ideal for sole proprietors who operate their businesses for side income and rely on salaries or hourly wages for the bulk of their income. Neither is it ideal for sole prop owners who set aside substantial fractions of their business income to finance equipment, inventory, or unexpected purchases.Partnership
Think of a partnership as a multimember sole proprietorship. The Small Business Administration describes partnerships as “a single business where two or more people share ownership” and “each partner contributes to all aspects of the business, including money, property, labor or skill,” while sharing “in the profits and losses of the business.” Like sole proprietors, partners are by default personally liable for partnership debts and obligations. Like sole proprietorships, partnerships are informal. “Generally, partnerships do not require any filings with state agencies,” says Shawn Toor, a business law attorney with Seattle-based Williams Kastner. “A partnership can be formed merely by the act of two or more people agreeing to carry on business and share in the profits and ownership control.” Partnership AgreementsMost partnerships are controlled by contracts known as partnership agreements. Partnership agreements govern matters like: The partnership’s legal name and DBA nameThe partnership’s term – either time-limited or in perpetuityGeneral purpose of the partnership – the business activities in which it’ll engageInitial contributions of each partner, such as cash and property, and the installment schedule on which those contributions will be madeProcedures for future contributions to the partnershipProcedures for admission of new partnersProcedures for distribution of profits and losses to each partner, including frequency and proportionalityManagement duties of each partnerVoting procedures – which matters require a vote and the number or proportion of votes needed to decide in favorProcedures for the sale or transfer of a partnership interest (buy-sell agreements)Procedures for the expulsion of a partnerProcedures for continuing or dissolving the partnership upon the death of a partner – often included in buy-sell agreementsProcedures for dispute resolution, such as mediation or arbitration You can find generic partnership agreement templates online and modify them to your partnership’s needs. However, these templates frequently leave out important eventualities that could affect your interest in the partnership – or the partnership’s very existence – going forward. For instance, a carelessly drafted partnership agreement could allow one partner to unilaterally bind the entire partnership, possibly against the other partners’ wishes. It’s therefore highly advisable to retain an attorney to draw up a customized partnership agreement on your behalf. If your budget doesn’t allow for this at the outset, revisit the situation as soon as possible. Your partner(s) should be amenable to creating a customized partnership agreement to protect their own interests. There are three main types of partnerships. You’ll designate which type of partnership you’ve chosen in the partnership agreement. General Partnership
A general partnership is the most common and straightforward type of partnership. Typically, general partners share equally in the partnership’s profits and liabilities, take on equitable duties, and have equal voting rights. The partnership agreement controls situations in which partners’ interests and duties diverge. For instance, many partnerships assign executive duties to a single managing partner. Others dole out profit shares according to seniority, with longer-serving partners taking a greater share of the entity’s net income. Limited Partnership
A limited partnership (LP), also known as a limited liability partnership, allows for a class of “limited partners” who essentially function as passive investors in the venture. Limited partners have little or no influence on the partnership’s decision-making processes and day-to-day management activities. They are not personally liable for the partnership’s debts or obligations. And they receive profit or loss shares proportional to their interest, which is usually smaller than that of general partners. LPs are more complicated than general partnerships. They are suitable for larger, capital-intensive ventures that attract lots of investors – not so much for small, two- or three-person ventures, which are easier to manage through general partnerships. On the bright side, they’re more discreet than traditional corporations. “The LP agreement is typically a privately signed document,” says Jason Powell, a corporate law attorney at Missoula, Montana-based Bjornson Jones Mungas, PLLC. “[LP agreements are] usually not recorded or available to the public, which allows for anonymity if desired.” Joint Venture
A joint venture is a time- and scope-limited general partnership. It’s ideal for one-off projects that require pooled resources, such as a commercial real estate development. Partners in a joint venture can convert the enterprise into a traditional general partnership by amending the partnership agreement.
Pros of a Partnership
Pooled Resources and Shared Responsibilities. Unlike sole proprietors, partners can pool resources without seeking outside investors or taking on debt. They can also share day-to-day management and executive decision-making responsibilities commensurate with their credentials and abilities.No Formal Incorporation Required. Unlike corporations, partnerships aren’t required to file articles of incorporation. For a variety of reasons, most partnerships are governed by written, legally binding partnership agreements to which all partners consent, but these agreements don’t have to be reviewed by or filed with local or state authorities.No Double Taxation. Partnership income is taxed on a pass-through basis. Partnership income is reported on Schedule K-1 (Form 1065), which the partnership must furnish to each partner by the annual deadline. Each partner adds his or her share of the partnership income, as reported on Schedule K-1, to his or her personal income from other sources.Flexible Time Horizon. Partnerships do not necessarily exist in perpetuity. If you need to pool your resources with other investors for a single project or venture, but have no wish to associate with them once the project is completed, you can create a joint venture specifically for that purpose. When the project wraps up, the partnership dissolves, and you and your partners part ways.Cons of a Partnership
Personal Liability for Business Obligations. As with sole props, the greatest disadvantage of a partnership is personal liability for business debts and obligations. Your share of liability is proportional to your interest in the partnership – if you own 30% of the partnership, you’re responsible for 30% of its liabilities.Potential for Greater Tax Liability. Like sole prop income, partnership income is treated as personal income. If your partnership is profitable, your personal income will increase, potentially raising your marginal tax rate, increasing your overall tax burden, and reducing your usable cash on hand.Requires a Formal Agreement. Though partnerships don’t require formal articles of incorporation, virtually all are governed by partnership agreements. These contracts can be quite complex, and while it’s possible to modify a serviceable template at low cost, it’s expensive to hire an attorney to draft a customized agreement that accounts for the widest possible range of eventualities.Dependent on Human Relationships. Successful partnerships depend on amicable relations between the partners – at least, between general partners. A falling out among partners, for whatever reason, can cripple or destroy an otherwise successful partnership. Before entering into a long-term partnership (as opposed to a joint venture), consider your relations with the other partners carefully and ask yourself whether you can see yourself working with them for years to come. If you’re not sure, think twice.Shared Decision-Making Processes. Successful partnerships also depend on a consensus-driven decision-making process, especially when only two or three partners are involved. If you’re not comfortable talking through decisions with your collaborators, a closely held partnership may not be the best fit.Corporation C-Corp
A corporation, sometimes known as a C corporation or C-corp, is defined by the Small Business Administration as “an independent legal entity owned by shareholders.” “Creating a corporation is like creating a human being,” says Toor. “Corporations can be sued, sue others, hold property, [and exist within] a partnership.” According to the SBA, “the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.” Compared with sole proprietorships and partnerships, whose members are held personally liable for business debts and activities, this is a major advantage for corporate shareholders. C-corps are subject to greater regulation than partnerships and sole proprietorships. In addition to onerous incorporation requirements, C-corps face ongoing regulatory burdens, such as the requirement that they hold annual shareholder and director meetings. If you’re running a small enterprise with limited overhead, incorporation could be more trouble than it’s worth. Here’s a look at the basic initial and ongoing steps you’ll need to take to set up a C-corp. Incorporation RequirementsCorporations must be formally incorporated with state business authorities, typically the Secretary of State office or equivalent. This requires drawing up and filing articles of incorporation, which include basic information about the entity: Company name and DBARegistered addressName and address of registered agent who handles official correspondenceThe company’s business activities or purposeNames of directors and offersInformation about issuance of corporate stock, including share count and par valueLimitation of liability (indemnification) of officers and directorsDuration of incorporationDissolution proceduresAdoption of corporate bylaws (operating agreement), if extant You can find low-cost articles of incorporation templates online. However, as with partnership agreement templates, cookie-cutter articles of incorporation aren’t ideal. It’s better to spend more for custom-drafted articles of incorporation that account for a wider range of eventualities specific to your company. Corporate Operating Agreements
In addition to articles of incorporation, which are required by law, most corporations are governed by operating agreements or bylaws. These documents spell out in detail the way the corporation is to be governed. Like partnership agreements, they’re not mandated by law, but they’re highly encouraged. Corporate Tax Obligations
Unlike sole props and partnerships, C-corps are not pass-through entities. For tax purposes, they are treated as legally separate entities from their shareholders. They pay federal, state, and sometimes local income tax at corporate rates, which are different than personal income tax rates. They are also subject to different credits and deductions than individual filers. Check with the IRS for more information about corporate tax obligations, including forms required to file.
Pros of a Corporation
Limited Liability for Owners. As long as the corporate veil is preserved, meaning shareholder and business assets are kept strictly separate (not commingled), C-corp shareholders are not personally liable for the entity’s debts and obligations. They aren’t required to personally guarantee loans or purchases made on credit, and their personal assets can’t be seized to satisfy creditor claims.Easier to Generate Capital. Corporations can raise capital by selling shares of stock (equity). Partnerships that wish to raise funds without taking on debt must take on new partners or compel additional contributions from existing partners. Sole proprietors are even more constrained – they need to dip into their personal savings, borrow against tax-advantaged accounts, ask friends and family members for loans, or pursue other less-than-ideal options.Greater Legitimacy. For better or worse, incorporated entities appear more legitimate to lenders, vendors, and potential customers. This legitimacy can open lucrative doors: loans approved at more favorable terms, discounts or favorable credit arrangements on big-ticket equipment or inventory purchases, and greater credence from sales prospects. For ambitious companies hoping to raise funds from venture capitalists or private equity firms, the C-corp is the gold standard. I spoke with Bryan Clayton, CEO of Nashville-based GreenPal, about his initial choice to incorporate locally as an LLC. “[Incorporating as an LLC] was quick and easy and cheap. We figured it was the best way to get our company up and rolling,” he says. “What we didn’t realize is that an LLC is a no go for institutional investors. Any outside investors such as private equity, angel investors, or venture capitalists will insist that your company be a…C-corp.” Clayton adds that the incorporation domicile is important too: “Delaware has an abundance of case law that is favorable to corporate structure, investors, and board members,” he says, “and is [therefore] generally accepted as the standard by the investor community.”Built-In Incentives for Employees. Equity is a powerful incentive for current and prospective employees. Corporations frequently reward performance, longevity, and other value-adds with stock or stock options, attracting high-quality employees and incentivizing them to stick around. In partnerships, the possibility of making partner is a comparable incentive, but it’s not practical to offer that carrot to hundreds or thousands of associates. Corporations can offer stock to any employee they like.Cons of a Corporation
Potential Tax Disadvantages. C-corps’ shareholder distributions are effectively taxed twice: once at the corporate level, before distributions are made, and again as personal income on shareholders’ personal tax returns. Though corporate income tax rates tend to be lower than individual income tax rates, and most corporations use generous deductions and credits to reduce their tax burdens, that’s not always enough to offset the effects of double taxation.Expensive and Cumbersome to Form. C-corps are expensive and cumbersome to form. Proper incorporation requires substantial legal and financial assistance, especially in heavily regulated industries.Greater Regulatory Burden. Even privately held corporations are subject to greater regulatory burdens than partnerships and sole proprietorships. If insulation from personal liability and greater capital-generation potential don’t outweigh these considerations, look to a lower-key business structure.Lots of Potential Stakeholders. Larger corporations can have hundreds or thousands of individual voting shareholders, all of whom need to be kept informed about the company’s activities and given a voice in the company’s direction. This requires a tremendous investment of financial and human resources. Even in more closely held corporations with tens of voting shareholders, the potential for disagreement is greater than in general partnerships, which usually involve only a handful of egos. As countless clashes between publicly traded firms’ boards and activist investors attest, larger shareholders can cause a lot of trouble when they’re determined to throw their weight around.S Corporation S-Corp
An S corporation, also known as an S-corp, is a special type of incorporated entity that’s ideal for small to midsize businesses. Like C-corp owners, S-corp owners and shareholders are insulated from personal liability for business debts, obligations, and actions. Unlike C-corps, S-corps are pass-through entities. Their income isn’t subject to corporate income tax – it passes through as distributions to shareholders, who then pay personal income tax at an appropriate rate (usually lower than rates on wage income). Incorporating and operating an S-corp is an intensive process. Like C-corps, S-corps require articles of incorporation filed with the appropriate authorities, as well as annual shareholder meetings. Operating agreements are also strongly encouraged. S-corps have a few noteworthy twists: S Corporation Election: After incorporating, all shareholders must sign and file IRS Form 2553. Known as a Subchapter S election, this establishes the corporation as a pass-through entity subject to certain restrictions. The Subchapter S election must be made within two months and 15 days of the beginning of the tax year to which it applies, or anytime before the beginning of the tax year.Shareholder Compensation: S-corp shareholders who also work as employees – for instance, owner-operators or executives with ownership stakes – must take “reasonable compensation” (salary taxed as wage income) in addition to their profit distributions.Shareholder Restrictions: By law, S-corps can have only 100 shareholders. The potential pool of shareholders is restrictive as well: S-corp shareholders must be U.S. citizens and (in most cases) human beings. With rare exceptions, S-corps can’t be owned by other businesses or legal structures, such as trusts.Stock Restrictions: Unlike C-corps, which can issue common and preferred shares, S-corps can only issue common stock. Common shares represent equity stakes and confer voting rights, widening the pool of shareholders with sway over the company’s decision-making processes.Uneven State Tax Treatment: According to the Small Business Administration, S-corps are treated uniformly under the federal tax code, but they’re subject to varying treatments at the state level. While most states recognize S-corps as pass-through entities, some (such as New York and New Jersey) tax S-corps’ profits and shareholders’ income from said profits. If you live in a state that treats S-corps differently than the federal government, you may need to file an additional state form. This blog post from Wyoming LLC Attorney has more on the differences between S-corps and C-corps – it’s required reading for entrepreneurs deciding between the two.Pros of an S Corporation
Limited Liability for Owners. Like C-corps, S-corps limit shareholder liability. As an S-corp shareholder, you’re not required to personally guarantee loans made to the business or expose personal assets to creditor seizure.No Double Taxation. Like sole proprietorships, S-corps are pass-through entities. Unlike C-corps, S-corps are not subject to corporate income tax. By extension, S-corp shareholders are permitted to deduct their firms’ losses, if any, from their personal income. “Most businesses initially lose money,” says Toor. “S-Corps may help lessen the blow of operating at a loss [because] S-Corp shareholders can deduct corporate losses on their personal tax returns.”Easier to Raise Capital. As corporations, S-corps can raise capital by selling stock. Though they’re permitted to issue common stock only, they still have more flexibility to raise capital on favorable terms than sole proprietorships and partnerships.Greater Legitimacy. Like C-corps, S-corps are incorporated entities, with all the legitimacy that entails. However, S-corps aren’t ideal for institutional investors, so you may need to reincorporate down the line before seeking outside equity funding.Cons of an S Corporation
Size of Ownership Class Is Limited. S-corps can’t have more than 100 individual (human) shareholders. If you need to raise lots of capital from a wide investor pool, C-corp status is a better fit.Potentially Expensive to Incorporate and Operate. Like C-corps, S-corps are expensive and cumbersome to incorporate. They have high ongoing operating costs and burdens, such as the annual shareholder meeting requirement. And S-corp shareholders have to worry about another wrinkle: the annual Subchapter S election. C-corp shareholders can disregard that one.Reasonable Compensation Requirements. Since wage income is taxed at a higher rate than the “reasonable compensation” requirement, this raises S-corp shareholder-employees’ overall tax burden.Greater Record-Keeping and Regulatory Burden. Like C-corps, S-corps have greater record-keeping and regulatory burdens than sole props and partnerships. If the costs of increased compliance outweigh the benefits, a simpler structure is probably right for you.Shareholders Must Be U.S. Citizens. S-corp shareholders must be U.S. citizens. If you’d like to start a business with noncitizens living in the U.S. on visas, you need to choose another structure.Limited Liability Company LLC
Extant only since 1977, the limited liability company (LLC) model is the newest common business structure available to U.S. business owners. By some measures, it’s the most flexible. “LLCs are hybrids between corporations and a partnership,” says Toor. “LLC members have the same rights and limited liability of shareholders in a corporation, and LLCs themselves have the added benefit of being treated like a partnership for tax treatment.” Tax TreatmentAccording to the IRS, LLCs can be classified as corporations, partnerships, or sole proprietorships (disregarded entities) for tax purposes. The classification depends on the number of members (shareholders) and those members’ stated preferences (elections). By default, one-member (single-member) LLCs are treated as disregarded entities, with pass-through business income recorded on members’ personal tax returns (Schedule C or C-EZ). Single-member LLCs can file taxes using members’ Social Security numbers – no EINs required. LLCs with two or more members are treated as partnerships, regardless of the number of members. However, any LLC – including single-member LLCs – can elect to be treated as a corporation for tax purposes. And even disregarded entities are treated as separate corporate entities for certain tax purposes, such as employment and excise taxes. Filing and Regulatory Requirements
Like C-corps and S-corps, LLCs are required by law to file articles of incorporation with the appropriate state authorities. Operating agreements are strongly encouraged as well. According to the SBA, state law often leaves LLCs vulnerable to member losses – for instance, when a member dies or resigns from a multimember LLC, the LLC dissolves, and the remaining members must elect to form a new LLC if they wish to remain in business together. Capable business attorneys can draft detailed operating agreements that account for common (and not-so-common) eventualities like this. Going forward, LLCs’ regulatory burdens are lighter than S-corps’ or C-corps’. “The main difference between an LLC and S corporation is operational flexibility,” says Brian Thompson, a Chicago-based CPA and business attorney. “LLCs are not subject to the requirement of an annual shareholders’ meeting or annual directors’ meeting.”