The three most popular legal formations for small businesses are: i) sole proprietorships, ii) Limited Liability Corporation (LLC) and iii) S-Corporation (S-Corp). There is no one size fits all formation for businesses. When choosing the most appropriate entity type for a business, you should consider the following factors: i) the potential risks and liabilities of your business, ii) the formalities and expenses involved in establishing and maintaining the various business structures, iii) your income tax situation, and iv) your investment needs. Also keep in mind that your business is not locked down to a certain entity type forever. In many cases, businesses initially opt for an ownership structure with lower start-up costs (e.g. sole proprietorship) and eventually opt-in for more sophisticated structures that protect personal assets from business liabilities and/or enable individuals to invest in the company. The following article touches on the pros and cons of the most popular small business legal formations.
If you’re the sole owner of your business and never legally formed the company, you’re running a sole proprietorship. Even if you filed a fictitious business name (or doing business as – DBA) in your county or state, you’re still a sole proprietorship. There is no legal difference between you and your company. Meaning, you’re completely liable as a sole proprietor for any activities related to your business. Also, any credit you obtain under the DBA is technically made to you and not a separate legal entity (i.e. you’re not building business credit history, only personal credit). The pros of this structure are there are hardly any start-up costs and tax preparation is easy. The cons are you have unlimited personal liability and it will be hard for you to raise capital (equity or debt) for your business.
Limited Liability Corporation
Unlike a sole proprietorship, LLCs provide members with personal asset protection against the company’s debts and other business-related obligations. This means that LLC members are not risking their homes and other personal assets when operating the business. BUT, there is still risk you can be held personally liable in the case of a lawsuit filed against your business. The trade-off here is forming an LLC comes with higher start-up costs. You need to file formation documents including Articles of Organization. Also depending on the state, each LLC needs to pay annual fees that vary widely by state (the annual tax fee in CA is $800). From a tax perspective, a LLC is considered a pass-through entity which means business profits or losses are taxed on the owner(s)’s personal tax return. If the LLC has only one owner, the business tax return is filed in the Schedule C of the individual tax return (exactly the same as a sole proprietorship). Lastly on taxes, if the owner of an LLC is considered to be self-employed, you must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax.
Similar to an LLC, the S-Corp offers limited liability protection and is a pass-through tax entity. Different from an LLC, the start-up and ongoing costs (and labor) tied to an S-Corp are higher. For instance, S-Corps are required to adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with corporate records. One of the best features of the S-Corp is the tax savings for you and your business. Recall that members of an LLC are subject to employment tax on the entire net income of the business. Conversely, only the wages of the S-Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a distribution which is taxed at a lower rate if at all. If you’re planning to raise capital with shareholders, read this article which lists several investment restrictions tied to an S-Corp.
One final twist, you can be an LLC yet be taxed as an S-Corp. Ask your accountant and attorney to ensure this is the best way to go.
S-Corp vs. LLC: http://www.bizfilings.com/learn/llc-vs-s-corp.aspx
SBA – Should My Company be an LLC, an S-Corp or Both?: https://www.sba.gov/blogs/should-my-company-be-llc-s-corp-or-both
Inc. – Should Your Business Be an LLC or an S Corp?: http://www.inc.com/guides/201103/s-corp-vs-llc.html
Compare company types: http://www.bizfilings.com/learn/compare-company-types.aspx
Choosing the Best Ownership Structure for Your Business: http://www.nolo.com/legal-encyclopedia/business-ownership-structure-choose-best-29618.html