With every New Year comes a slew of resolutions? Eat better, eat less, join a gym, actually go to the gym, quit smoking. While well-intentioned Americans focus on getting more physically fit, how fit is your business when it comes to its legal business structure? Have you been avoiding the question for years?
After all, as business owners, there are countless others things to focus on – keeping customers happy, finding new customers, entering new markets to name a few. Or maybe you formed one business structure years ago, but what may have worked for your business during its first few years of existence may not be optimal for you now.
To help you assess what’s right for your business, here’s a run-down of the most common business structures in the United States. As expected, there can be significant tax implications involved and it’s always best to seek the advice of an accountant or tax advisor to determine what’s best for your business.
The most basic of all business legal structures is the sole proprietorship; there’s no corporation or limited liability status. As the owner of the business, you represent the company legally and fully – and are open to unlimited liability for any acts on behalf of your business. A sole proprietor is taxed as an individual (and fills out the Schedule C on his/her personal tax returns). There are no steps involved in forming a Sole Proprietor; if you’ve started a business alone and have not filed for LLC or Corp status, then you’re a Sole Proprietor.
Bottom Line: Considering we live in such a litigious society (and how easy it is to form an LLC), there’s virtually no reason to stay a Sole Proprietor. If you’re operating as a Sole Proprietor, you should consider forming an LLC in 2012.
The LLC (Limited Liability Company)
Owners of an LLC enjoy limited liability, which protects their personal assets from judgments and other obligations of the entity. If the LLC incurs debts or liabilities, the creditors are limited to the assets of the LLC.
An LLC requires fewer corporate formalities, such as regular meetings of a board of directors and an annual meeting of shareholders, than either an S or C-Corporation. An LLC does, however, require proper filing of Articles of Organization with the Secretary of State to be formed and the members of the LLC are required to enter into an Operating Agreement that governs how the LLC will be operated.
The LLC features pass-through tax treatment. If you’re a single member LLC, you will be taxed as an individual using the Schedule C form, unless you choose to be taxed as a corporation. Likewise, a multi-member LLC will be taxed as a partnership with the K-1 form.
Bottom Line: The LLC is great for a business that wants liability protection, but seeks minimal formality. It’s also the perfect structure for a business with foreign owners since anyone (C Corp, S Corp, another LLC, a trust, or an estate) can be an owner of an LLC.
The C Corporation
The C Corporation is the most common form of corporate entity. The C Corporation is owned by shareholders; shareholders elect a board of directors to create and direct the high-level policies of the business. There is no limit on the number of shareholders in a C Corporation. With a C Corp, your personal liability is only up to the amount of your investment.
A C Corp is a separately taxable entity, meaning that it must file its own tax return and pay corporate taxes on its profits. And if the company earns a profit and decides to divide the excess cash among the owners/shareholders in the form of dividends, the earnings are taxed twice: first when the company pays taxes on its earning and then second, when shareholders are taxed on received dividends. Of course, if the company chooses to re-invest its profits back in the company, this double taxation is a non-issue.
Bottom Line: Because of ‘double taxation” and added complexity, the C Corporation is not recommended for small business owners. The C Corp is ideal for a business that intends to raise capital by issuing stock or attracting investors through VC funding. If you have an LLC and are considering bringing in outside investors in 2012 or down the road, you’ll need to switch your LLC to a C Corporation first.
The S Corporation
The S Corporation starts off as a C Corporation, but an S Corp makes an election to be taxed as a “pass-through entity” under subchapter S of the Internal Revenue Code. This means that an S Corporation is not taxed separately from its owners/shareholders. Instead, corporate profits and losses are “passed-through” and reported on the personal income tax returns of the shareholders, much like a partnership.
Bottom Line: The S Corporation is great for the small business owner who can qualify. The IRS places limits on the number of owners and who can be an owner in an S Corporation. For example, owners of an S Corp must be U.S. citizens. And an S Corp can have no more than 100 shareholders.
Plus, all owners are taxed strictly based on their percentage of ownership; if you need more flexibility when it comes to ownership, profits, and taxes, the LLC is a better choice. In addition, the IRS only allows S Corporations to issue one class of stock ? so if you plan on finding an angel investor, VC funding, or go public, a C Corporation is better.
Get started in the New Year
With the new calendar year, it’s a great time to get your legal structure squared away and your business will be set for years to come. Don’t let daily interruptions keep you from doing something that is fundamentally crucial to your business’ long-term health and to the security of your finances.