If you’re starting a business, you may feel overwhelmed with all the decisions—big and small—that you have to make to even get started. It’s a lot to think about, and there’s a lot of information out there to process. Figuring out who will own your business is one of the first decisions you need to make. Here are three things to consider:
Do you want to own the business yourself? This would be called a sole proprietorship, or a partnership if it’s owned by multiple people. The alternative would be to form a separate legal entity that would technically own the business.
If you do decide on forming a separate entity, should you form a corporation or an LLC? Do you want the corporation or LLC to be taxed as a separate taxable entity or as a pass-through entity? Having these important questions in mind will make the decision much simpler.
Why Form a Corporation or LLC?
Forming and operating a corporation or LLC is more expensive and more complicated than owning the business yourself, but there are a lot of benefits you should consider. The main reason to form either is to limit personal liability—this means that, if the business accrues debts or becomes involved in a lawsuit, only the assets of the business are at risk. Without have the title of LLC, a business debt or other lawsuit could claim your personal assets.
Forming corporations and LLCs requires similar steps. You’ll fill out a document, generally called articles of incorporation or articles of organization, and file it with the state business entity filing office. Whatever state you submit your file in will be the state your business is officially based out of.
Corporation or LLC: Which Should I Choose?
When trying to decide which is best for your business, it’s important to remember that they’re very similar in their main purposes—to limit liability. Here’s how they differ.
An LLC can be governed a little less formally than a corporation. Corporation laws require a lot more than LLCs, including a board of directors, meetings and quorums, minute keeping and other management “formalities” that LLC laws simply don’t require. There’s also greater flexibility within an LLC in terms of how you split financial interests. You can choose how you distribute the business’ income to each member, while corporations have to distribute income to shareholders based on how many shares they have. Another benefit to forming an LLC is that it can be a pass-through tax entity without the restrictions that are imposed on corporations.
But corporations have a lot of unique benefits as well. In general, corporations are more familiar to investors, bankers, legal, tax and other trusted advisers—advisers that small businesses rely on. They’re also more familiar to the general public. Corporations can offer more stock options, like stock bonuses as incentives to employees and managers. It’s also easier to obtain outside financing for a corporation.
How you want your business to be taxed will directly affect the way you form your business. With LLCs, the IRS has default rules that dub LLCs as pass-through entities. This means that they aren’t subject to the specific restrictions that corporations are under. For example, an LLC can have more than 100 members and different classes of membership interests without being treated differently in terms of taxation.
A corporation can be taxed for federal income tax purposes in one of two ways—as a C corporation or an S corporation. A C corporation is a separate taxable entity, which means that it pays income taxes just like a private individual pays personal income taxes, and if it distributes income to its shareholders, they pay income taxes on what they get. This is referred to as “double taxation.”
An S corporation is a pass-through entity like an LLC. It doesn’t pay corporate income tax, and the shareholders pay personal income tax on their share of the profits. A corporation can be taxed as an S corporation by filing a specific form with the IRS and by, of course, meeting their requirements. These requirements can include the number of shareholders allowed, not having non-resident aliens as shareholders or having a limited number of stock classes.
Figure out what is most important to you, as well as what your most crucial business needs are, and choose whichever business model works best for you.
For more small business advice, information and support, contact Entrepreneurs’ Organization Birmingham today.