When you are looking to start a new business, the most common question a prospective business owner faces is what type of business entity should I form? The four most commonly used structures are a corporation, a limited liability company (LLC), a partnership and sole proprietorship.
Since every business startup is unique, we will examine two fact scenarios and discuss why one entity might be a better choice than another.
You are a single owner service provider or retail establishment, such as a designer, building contractor or clothing boutique owner, looking to form a new business with minimal capital investment. You are concerned about personal liability for business debts, want a business that does not require excessive accounting and professional fees, is relatively low maintenance in terms of annual documentation and filings, yet to the outside world looks and acts like a legitimate, professionally organized business entity that stands apart from you as the owner. You are not sure at this time whether bringing in outside investors to help build your business faster is a good idea, but you have not ruled it out.
In this hypothetical your business may start off with one or two employees and have estimated annual earnings under $500,000.
In deciding which entity is the best choice, we can immediately rule out a partnership, since you are a single owner and a partnership by its nature requires a minimum of two owners. Similarly we can immediately rule out a sole proprietorship since there is no personal liability protection afforded by this type of entity.
We are then left with a choice to incorporate as a C or S corporation or organize as an LLC. Either a corporation or an LLC will provide you with protection from business debts. An LLC is a simpler organization process, relatively low maintenance and provides the appearance of a legitimate and professional business operation. Since LLC’s do not have assets of their own, as all assets are owned by the individual members, attracting outside investors or venture capital groups is extremely difficult. Typically third party financing of LLC’s is secured by repayment plans that can include profit sharing, interest bearing dividend payments and at times, offering the investor an ownership/management interest in the business.
In contrast, a corporation is an entity that is capable of owning its own assets, and can therefore sell shares of stock in order to raise capital. This type of third party financing is typically referred to as “going public”. When stock is sold, the new investors become part owners of the company but do not take on any management responsibilities, reserved for the board of directors.
In this scenario, it would appear that the organization of an LLC would be the most effective type of business entity to satisfy the owner’s concerns. Additionally, if at some point in the future, should you decide to expand your business and seek third party financing, the procedure to transfer your LLC to an S corporation is fairly simple and cost effective.
If you are an entrepreneur looking to build a new business and seeking to raise outside capital or find third party financing, you most probably are considering a C corporation.
Some of the most common reasons why you would want to form a C corporation are that you will have more access to different types of capitalization and/or financing than you would with any other type of entity. A C corporation is not limited to 75 shareholders like an S corporation, it allows you to form a stock option plan for your employees, and if you have dreams of going public, a C corporation is the type of structure you will need.
Similar to an S corporation and the LLC, you and your shareholders will have limited liability for corporate debts. Typically, only the amount of the investment is at risk, and not the investor’s/shareholders personal wealth.
Another key advantage of the C corporation unlike the S corporation or an LLC, is that fringe benefits paid to employees are tax-deductible. Generally, in order for the C corporation to take advantage of this deduction, at least 70% of the employees must be able to participate in or take advantage of the company’s benefits program. Also it should be noted that C corporations are audited less frequently than business owners who file a Schedule C (used with both the S corporation and LLC formats).
The biggest downside to the C corporation is the issue of double taxation. Because the corporation is considered a separate entity, the taxable income of the entity is first taxed at the corporate rate. Thereafter, if the entity distributes its remaining income to its shareholders, that income is taxed a second time based on the individual’s personal income tax bracket. This is where incorporating as an S corporation can make a difference, in that an S corporation is not subject to a “corporate or separate entity” tax.
A secondary downside is that a C corporation will require more documentation and annual meetings where a limited liability company will not.
The bottom line is that a C corporation may be the more desirable business structure if you are looking to form a business that:
· Has already or will be actively seeking outside capitalization or financing;
· Is likely to have more than a handful of employees and where employee benefits such as a stock option plan, retirement plan, and health and life insurance will be offered;
· Requires easy transferability of the ownership interest by way of transfers of shares of stock; and
· Where the slightly more burdensome issue of a more formal business structure and administration is of little concern.