At some point in your small business career, you probably will be deciding whether or not to form a corporation or a limited liability company. The big question is which is best for your business?
You might be surprised, but there is no right or wrong answer. Both structures have positives and both have negatives. Your goal is to find the one that works best for your current situation and business needs. Also keep in mind; the decision of which entity is best may change in the future based on your company?s profitability, growth, ownership, state & federal taxes and many other variables.
One other thing that is important to note is that you will probably not be able to assess all variables yourself without the assistance of at least a good business accountant and possibly a good corporate attorney. This article will give you a basic understanding of the differences. However, I can pretty much guarantee you that your situation is different enough that you will want to seek expert counsel before making this decision.
In the past, the cost of forming a corporation and later a LLC (LLC?s are a fairly recent creation) were cost prohibitive for many small business people because of excessive state and attorney?s fees. Consequently, many small businesses remained as sole proprietorships or partnerships until it made financial sense to form an entity. State fees have come down significantly in most states and incorporation services, like this one, and other competition have lowered the cost of filing an entity.
Now, most small businesses should be either a LLC or corporation! Whether you are just starting your business or you?ve been in business for a while, there are simply too many reasons not to form an entity. The two biggest reasons are limiting your personal liability for business debts and judgments and federal (and sometimes state) income tax savings.
Probably the best reason for forming either an INC or LLC for your business is to protect your personal assets from business liability. Generally, your business liability is limited to the assets that are owned by the INC or LLC. This means that your personal assets (i.e. home, auto, retirement accounts, etc.) potentially aren?t at risk because of your business debts or liabilities.
Notice, I said ?potentially.? Just because you operate your business as an INC or LLC doesn?t mean that there is no way a creditor can go after your personal assets as an owner (or representative) of that INC or LLC. If you personally sign for a bank loan, on behalf of your business, and your business cannot pay, you become personally liable for that loan. If you cannot pay, then the bank can go after your personal assets. Likewise, if you act negligently as a representative of your business, you may be personally liable for a lawsuit (in addition to your business) due to your negligence. Just think of those officers and directors of Enron or Worldcom that are being sued for negligence.
Additionally, lawyers will sometimes attempt to ?pierce the veil? of protection of the INC or LLC and go after the owners personally in a lawsuit. This can easily happen if you fail to pay your state?s annual report fees or franchise taxes. This can also happen if you fail to maintain your corporation?s organizational paperwork (i.e. minutes, bylaws, etc.).
However, if you operate your INC or LLC properly; you don?t act outside of your duties as an officer/member/manager/director; and you don?t sign personally for your company?s debts, you will limit your liability. Even a business just starting out, with little income or assets, may want to form an INC or LLC just for the liability protection.
INCOME TAX SAVINGS
In most cases, forming a corporation or limited liability company will save you money on your federal and sometimes your state income taxes. This is because an INC/LLC is recognized as a separate entity with its own tax rules (and often its own rate schedules) from a sole proprietor.
Sole proprietors figure business income and expenses on a Schedule C and pay personal income taxes on the net income. Corporations (and many cases LLCs) file separate returns for the business income and expenses. C Corporations actually pay taxes, based on it?s own income tax rate schedule, on its net income. The owners (stockholders) only get taxed on the dividends they receive (NOTE: As of the writing of this article, dividends are fully taxable as ordinary income to individuals. However, there are several proposals being discussed to reduce or eliminate federal income taxes on dividends. This benefit may make forming a C Corporation more beneficial to more business owners). Sub S Corporations and most LLCs (except those taxed as a C Corporation and entity disregarded) file an informational return which disclose the net tax loss or income of the business and what is each owner?s representative share of the net loss or income.
Which entity has the best tax benefits? This is truly different with each business, state, industry, income level, etc. and why it is so important that you check with your accountant before making your final decision.
For many small businesses, the simplicity and flexibility of a LLC may be very compelling. Corporations are required to have initial organizational meetings, annual meetings, adopt bylaws and issue stock certificates. LLCs do not have these requirements. Instead LLCs should have, although not required to have, an operating agreement (possibly a requirement in your state), which spells out who has authority to do what and how the business will be managed. LLCs, as alluded to earlier, are given the flexibility to choose to be taxed as a corporation or as a partnership (or disregarded as an entity for single member LLCs) by the IRS. Corporations can only choose to be taxed as a C Corporation (standard) or as a Sub S Corporation.
Some industries and types of businesses are perfect for a LLC. For instance ownership of real estate is often best done using a LLC. Often you?ll see the headlines in your business paper, ?Swan-Broadway I, LLC has purchased the shopping center at the North East corner of Swan and Broadway?? This LLC probably didn?t even exist before the purchase of the property, but was formed prior to the purchase. Often, another LLC or corporation owns the LLC. LLCs offer an easy way of limiting the liability to the property owned by the LLC. Many real estate executives form separate LLCs for each property they purchase or develop so as to compartmentalize the liability to each property. That way, liability from one property won?t destroy the other property assets owned by each LLC.
So, why not always form a LLC? Corporations offer some benefits not available to LLCs. Corporations have, in some states, hundreds of years of case law behind them where as LLCs have maybe twenty or so years of case law history. Corporations are generally more accepted as separate from you as the owner, especially when you are the only owner. For instance, some banks will lend money to a corporation, but not to a LLC without the personal guarantee of the owner(s). Generally, investors will not invest in a business unless it is a corporation as corporations can limit stock ownership rights based on different classes of stock. If your business is potentially going to be big, with lots of shareholders, a corporation may be a better vehicle.
Finally, states tax corporations and limited liability companies differently. For instance, California requires LLCs to pay the minimum franchise tax of $800 regardless of its income or when the LLC was formed. So, if your LLC is formed on December 1st, you would be required to pay $800 for that tax year and $800 more for the following tax year (only one month away). This is even if you didn?t have any income. However, California corporations are eligible for a waiver of this $800 tax in its first year if it hasn?t reached a minimum income level. So, it may be more beneficial to form as corporation in California to avoid some of the state?s initial taxes.
Again, even if you are leaning towards one entity type, go see an accountant first to make sure there are no hidden pitfalls.
Whatever you decide, keep in mind that your decision does not have to be permanent. You can convert your business from an INC to a LLC or visa versa. Often, one entity type may be best now, but later (because of income, liability concerns, growth, ownership, state of operation, etc.) another entity type may be better.
Other recommend articles to read:
Sub S Corps