When forming a business one of the most important decisions to consider is the entity type. The type of business entity chosen will have a direct impact on the tax impact of your newly formed company and the exposure to liability for yourself and your personal assets. Below is an overview of the most common types of business entities.
A. Limited Liability Company or “LLC”
A limited liability company is a business structure that combines the limited liability of a corporation and the tax efficiency with the operational flexibility of a partnership. This structure can be used for companies with only a single member (i.e. an owner) or numerous members.
LLCs can be either manager-managed or member-managed. An LLC that is “manager-managed” is operated by a manager appointed by the members. An LLC that is “member-managed” is managed by the owners of the LLC.
LLCs are subject to flow-through taxation which means that income and other tax attributes are reported by the members on their individual tax returns via a K-1. LLCs may also elect to be taxes as a C-Corporation or an S-Corporation, as explained below.
This type of business structure has become increasingly popular due to the relative ease of organization and maintenance but also because the LLC structure provides personal asset protection to the members if managed. For these same reasons, LLCs can be a useful tool in estate planning for individuals whose portfolio includes diverse assets.
B. S Corporations or “S-Corp.”
S-Corps. provide personal asset protection and similar tax advantages to LLCs, if managed correctly. Namely, the S-Corporation itself doesn’t pay income tax; instead, the income flows out to the shareholders who pay the tax.
However, S-Corps. are somewhat trickier to maintain as there are many regulatory requirements to which the S-Corp. must abide.
Notably, only U.S. companies of less than one hundred shareholders can elect to be an S-Corp., and all shareholders must be fall under the IRS’s designation of “eligible shareholders.” Non-eligible shareholders include non-US residents, other partnerships and corporations, and certain types of trusts and estates.
Failure to strictly abide by the IRS’s requirements could lead to disastrous tax consequences for the company and its shareholders.
C. C Corporations or “C-Corp.”
Like S-Corporations, C-Corporations are owned by shareholders.
However, one of the biggest differences between a C-Corp. and an S-Corp. is that unlike an S-Corp., a C-Corp. is not taxed as a “flow-through” entity. This means that there is technically a double taxation on the profit earned by the company. First, the company itself must pay taxes on the profits, and then once the profit after taxes is distributed to the shareholders as a dividend, the shareholders must recognize that income on their personal tax returns. This double taxation may be avoided if the appropriate steps are taken.
C-Corps. are not subject to the same restrictions as S-Corps, as described in Section B above. As such, this type of structure is used most often by large and/or Non-US companies.
This type of structure would not generally be used for those interested in starting a small business.
D. General Partnership and Sole Proprietorships
General Partnerships – A partnership is a single business where two or more people share ownership. Generally, profits, liabilities, and management duties are split among partners.
Sole Proprietorships – A sole proprietorship is the simplest business form under which one can operate a business. It legally has no separate existence from its owner. Many times, individuals operating under Sole Proprietorships operate under a DBA or “Doing Business As”. The owner must report all profits and losses on his or her personal taxes.
Unfortunately, General Partnerships and Sole Proprietorships do not provide any type of personal asset protection. As such, individually-owned assets of the general partners or sole proprietors are subject to claims from creditors or other liabilities of the company. This is the case even if such assets are unrelated to the business.
The lack of personal asset protection has led more and more individuals who otherwise would be operating under a general partnership or sole proprietorship to establish LLCs or an S-corp.
There are many variables to consider when deciding the structure of your business. Choosing the right structure is instrumental to the solid foundation of a burgeoning company. The business law attorneys at Mathis, Marifian & Richter, Ltd. have a great deal of experience and knowledge to assist you in the process.