Should I form an LLC or a Corporation?

One of the most important decisions a business owner can make is what entity is best to fit the needs of the new business. Choosing a business structure can be complicated and a little overwhelming. However, most of the differences come down to liability and tax treatment. This article discusses some of the differences between Limited Liability Corporations and C-Corporations with a little info on S-Corporations and Sole Proprietorships. These are not the only options out there, but they are the most common structures.

Sole Proprietorships

The simplest way to start a business is to declare your business as a “sole proprietorship.” There’s not much involved in forming this kind of business. You really don’t have to do anything other than the usual license, permit, and any other regulatory requirements that your state or locality may require. A sole proprietorship is just that, a one-person business. So, if you wish to include others in your business ownership, you should choose another business structure.

Sole proprietors report their business profits or losses on an IRS Schedule C, “Profit or Loss from Business,” which is filed with their 1040 individual federal tax returns. The owner’s profits are taxed at the individual’s income tax rate. This is called “pass-through” taxation because the income passes through the business to the owner’s individual tax return.  Sole proprietors must pay all of their social security and Medicare taxes (self-employment taxes) and the “FICA” taxes.

Although the sole proprietorship is the easiest and simplest to form, it is also the riskiest when it comes to liability. That’s because sole proprietors are 100% personally liable for all business debts and legal claims. This means the owner’s personal assets, such as the owner’s personal bank accounts, equity in the home or car, and any other personal assets are fair game to be taken by a court order and sold to repay the business debts and/or judgments.

This type of business structure is most suitable for a small business startup, maybe even a part-time venture that has little liability risk. All that would be required to start up is a name, maybe a license if required, and a possible tax permit. No complicated process and no real startup cost due to formation.

Limited Liability Company

Like a sole proprietorship, an LLC can be a one person business. One advantage over a sole proprietorship is that an LLC can have more than one owner. It does take some paperwork to get an LLC started. You must file a legal document with the state business filing office. These are called Articles of Organization. If the LLC is going to maintain a business presence in another state, such as a branch office, you must also file registration papers with the other state’s business filing office. You will likely need a federal tax identification number (EIN). Most banks will require this in order to set an account up for the business.

Probably the number one reason that businesses are formed as LLC’s is because of the protection it provides. After all, it’s in the name, Limited Liability. LLC’s, as well as other corporations, leaves the liability in the business and protects the personal assets of the owner (s). This is known as the “corporate shield.” However, businesses can screw this up and they often do. If there isn’t sufficient money in the business, then the adversary will come after the business owner personally. However, in order to do so, the adversary will have to “pierce the corporate veil.” There are several factors the court considers in deciding whether the veil can be pierced, but the one most commonly used is the commingling of funds. This can be shown by using business money for personal use or personal money for business use. The point of piercing the corporate veil is to show that the company does not have its own identity as a separate and distinguishable entity. The take away here is to run your business correctly. Document all that goes in and out and make sure that if your spending money on personal stuff that it comes out of your salary (your personal accounts).

Another major benefit with an LLC is in the charging order. Charging order protection provides a double liability protection, because LLC owners are protected from business liabilities and the LLC is protected from the member’s liabilities. This type of protection in unique with LLC’s only. However, in some states the single member LLC and charging order protection has come under attack. For example, Florida courts have held that a single member LLC could go directly against the LLC and take the assets of the LLC. Olmstead vs Federal Trade Commission. This holding immediately meant that every single member LLC in Florida no longer qualified for charging order protection. The corporate shield protection was not affected.

When you form an LLC, you will need to decide how your LLC will be managed. You can have a Member Managed LLC where all the members (owners) participate in running the business. Alternatively, you can have a manager-managed LLC where only designated members, designated non-members, or a combination of the two run the business. In a manager-managed LLC, the members select the managers of the company. In some situations, a manager-management structure may be preferable. The most common example is when some members only want to be passive investors in the business instead of being involved in the day-to-day operations. In this case, a manager-managed LLC is operated by managers who are appointed to run the company. This is similar to a corporation that has a board of directors to control the company’s affairs.

An operating agreement is important in any LLC formation. This agreement will need to define the basic rights and responsibilities of the members (and managers if you have them). This would include voting rights, additional capital contributions, buy out provisions, dissolution guidelines, any other managerial or operational issues that need to be addressed.  If you fail to create an operating agreement, then the State’s LLC rules will apply. This may not be your best interest.

When choosing a business structure, the decision usually comes down to the tax treatment of that choice. For tax purposes, an LLC is taxed as a sole proprietorship when there is one owner. It is taxed as a general partnership when there are two owners. Neither the sole proprietorship nor the general partnership is a tax paying entity. They are referred to as “pass-through entities.” The owners report their share of profit and loss on their personal income tax returns. This means that the owners would pay income taxes and self-employment taxes on all the profits. There are tax rules that allow an LLC to elect corporate tax treatment if its owners wish to leave income in the business and have it taxed at separate corporate income tax rates. If the LLC elects corporate tax treatment, the LLC is treated and taxed as a corporation. The LLC would file corporate income tax returns, reporting and paying corporate income tax on any profits retained in the LLC. The LLC members report and pay individual income tax only on salaries paid to them or distributions of LLC profits or losses that are paid as “dividends.”

Corporations

What sets the corporation apart from all other types of business structures is that it is a legal and tax entity separate from any of the people who own, control, manage, or operate it. Corporations are viewed as a legal “person,” meaning that it can enter into its own contracts, incur its own debts, and pay its own taxes. There are two types of corporations: C Corporations and S Corporations. The letters C and S come from the Internal Revenue Code that is used to distinguish the different tax treatment given to these two different type structures. To form a corporation, you pay corporate filing fees and prepare and file formal organizational papers, usually called “articles of incorporation.” This is filed with a state agency, usually, the secretary of state.

The owners of corporations are called “shareholders” as they hold stock in the company. A corporation can have as few or many shareholders as it wants. A corporation issues stock to its shareholders in exchange for capital they invest in the business. These shares of stock can be divided into classes, each with different rights to vote, ability to receive dividends, and ability receive cash if the business is liquidated. An advantage of corporations is that your employees can become stockholders or owners of the business.  Corporate stock is a useful way to fund employee stock options or bonus plans.

Corporations are owned by shareholders but they are managed by a board of directors. There is a lot more “red tape” with the running of a corporation. There must be annual meetings by the directors as required by state law. They must keep meeting minutes and prepare formal documentation in the form of resolutions or written consents to corporate actions of important decisions made during the life of the corporation. There must be proper documentation of all legal and financial dealings between the corporation and its shareholders. Typically with a corporation, the board of directors appoints officers to supervise daily corporate business. They appoint the CEO, the secretary, and a treasurer.

Corporations offer a greater variety of fringe benefit plans than any other business entity. Various retirements, stock option and employee stock purchase plans are available only for corporations. In addition, sole proprietors, partners and employees owning more than 2% of an S corporation must pay taxes on fringe benefits (such as group-term life insurance, medical reimbursement plans, and medical insurance premiums). Shareholder/employees of a C-corporation do not have to pay taxes on these benefits. Corporations also have the liability protection of the “corporate shield” same as the LLC. Same rules apply as to piercing the shield as well.

Corporations are definitely a more complex entity when it comes to managing all the “red tape.” There is more paperwork to comply with regulations at the local, state, and federal level. Another disadvantage is double taxation. Shareholders pay taxes on their earnings and the corporation also pays its own taxes. C- Corporation owners are taxed only on the actual amount they receive as dividends. Profits can be left in the business as retained earnings and taxed in lower income brackets.

With S-Corporations, owners can pay themselves salaries plus receive dividends from any additional profits the corporation may earn. If you compare this to an LLC, all income gets reported on the owner’s personal income tax return. This means that LLC owners are required to pay self-employment tax on income generated in the LLC. However, S-Corps do have stricter guidelines compared to LLC’s. S-Corps must be a U.S. citizen or resident. S-Corps cannot have more than 100 shareholders and they can only have one class of stock whereas C-Corps can have more.  Shareholders of S-corps should pay close attention to paying themselves a “reasonable” salary as this may lead to IRS scrutiny.

Conclusion:

Business goals come in all shapes and sizes and there is no real “one size fits all” kind of structure. If you are just starting out with very little money and business liability is not a real issue, then sole proprietorship is a good option. If you’re looking at raising capital through stock, offering fringe benefit plans, having directors, or having your business be its own separate entity; then the C-Corporation is your pic. Both LLC’s and S-Corps will give some measure of personal liability and overall legitimacy. Both are good options to upgrade from a sole proprietorship or if you’re just starting. For flexibility and ease of startup, the LLC is the most attractive option. Again, there is no one answer. A business owner needs to know what their goals and intentions are. Once that is defined, the proper entity should be an easier choice.