Please note the information below is intended to provide generalized information that is appropriate in certain situations. It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer. The contents of the information provided below should not be acted upon without specific professional guidance. Please call us if you have any questions.
This is the first question that most startups ask. There are both tax and legal factors that you should consider before setting up a legal structure. It is important that you set up the correct legal structure for your needs and set it up properly. Here are some of the more common entities that startups use:
Sole Proprietorship
A sole proprietorship, also known as the sole trader or simply a proprietorship, is a type of business entity that is owned and run by one individual and in which there is no legal distinction between the owner and the business.
The owner receives all profits (subject to taxation specific to the business) and has unlimited responsibility for all losses and debts. Every asset of the business is owned by the proprietor and all debts of the business are the proprietor's. A sole proprietor may use a trade name or business name other than his or her legal name.
Advantages:
- East to setup and needs only small amounts of capital to start and run.
- Permits a high degree of flexibility for the owner since he/she is the boss of the business establishment.
- Due to the owner's unlimited liability, some creditors are more willing to extend credit.
- The owner receives all the profit of the business.
Disadvantages:
- Unlimited liability for business debts. The single owner is responsible for paying all debts and damages of their business.
- If the firm fails, creditors may force the sale of the proprietor's personal property as well as their business property to satisfy their claim.
- When the owner dies, the continuation of the business is difficult, because a new owner must typically accept all liabilities of the business
Limited Liability Company
A Limited Liability Company (LLC) is a hybrid business entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). An LLC, although a business entity, is a type of unincorporated association and is not a corporation. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. It is often more flexible than a corporation, and it is well-suited for companies with a single owner.
It is more difficult to pierce the LLC veil because LLCs do not have many formalities to maintain. So long as the LLC and the members do not commingle funds, it would be difficult to pierce its veil. Membership interests in LLCs and partnership interests are also afforded a significant level of protection through the charging order mechanism. The charging order limits the creditor of a debtor-partner or a debtor-member to the debtor’s share of distributions, without conferring on the creditor any voting or management rights. Limited liability company members may, in certain circumstances, also incur a personal liability in cases where distributions to members render the LLC insolvent.
Advantages:
- LLCs provide limited liability protection to their owners (members), who are typically not personally responsible for the business debts and liabilities of the LLC. Creditors cannot pursue the personal assets (house, savings accounts, etc.) of the owners to pay business debts.
- LLCs typically do not pay taxes at the business level. Any business income or loss is "passed-through" to owners and reported on their personal income tax returns. Any tax due is paid at the individual level.
- Forming an LLC may help a new business establish credibility with potential customers, employees, vendors and partners because they see you have made a formal commitment to your business.
- LLCs face fewer state-imposed annual requirements and ongoing formalities than S corporations and C corporations.
- LLCs are free to establish any organizational structure agreed upon by the company owners. LLCs can be managed by the owners (members) or by managers, unlike corporations which have a board of directors who oversee the major business decisions of the company and officers who manage the day-to-day affairs.
- There are few restrictions on who can be an LLC owner or how many owners an LLC may have (unlike S corporations).
Disadvantages
- To form an LLC, Articles of Organization must be filed with the state and the applicable state filing fees paid. Many states impose ongoing fees, such as annual report and/or franchise tax fees. While these fees often are not very expensive for small businesses, LLC formation is more expensive than that of a sole proprietorship or general partnership, both of which are not required to file formation documents with the state. A few states, such as New York and Arizona, also require LLC owners to publish notice of the LLC formation in local newspapers for several weeks. This can be costly.
- Ownership in an LLC is often harder to transfer than with a corporation. With corporations, shares of stock can be sold to increase ownership. Typically with LLCs, all owners must approve adding new owners or altering the ownership percentages of existing owners.
- Because the LLC is a newer type of business structure, there is not as much case law or legal precedent for LLCs as there is for corporations.
S Corporation
An S corporation is a corporation that is treated, for federal tax purposes, as a pass-through entity through an election made with the Internal Revenue Service (IRS) to be considered an S Corporation.
As a corporation, an S corporation is created through filing Articles of Incorporation with the Secretary of State or similar government body. It issues stock and is governed as a corporation. The owners, who are called shareholders, have the same protection from liability as shareholders of a C corporation. An S corporation shareholder’s personal assets, such as personal bank accounts, cannot be seized to satisfy business liabilities.
However, like a sole proprietorship or a partnership, an S corporation passes through most of its income and loss items to the shareholders. Unlike a regular corporation, there is no "double taxation," once at the corporate level and again on the individual shareholder level. Each shareholder is subject to his or her own individual tax rate on the income (or losses) passed through to him or her.
Advantages:
- An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities of the corporation. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts.
- An S corporation does not pay federal taxes at the corporate level. Any business income or loss is "passed through" to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns. This can be extremely helpful in the startup phase of a new business.
- S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonablecharacterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.
- Interests in an S corporation can be freely transferred without triggering adverse tax consequences. The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
- Operating as an S corporation may help a new business establish credibility with potential customers, employees, vendors and partners because they see the owners have made a formal commitment to their business.
Disadvantages:
- To operate as an S corporation, it is necessary to first incorporate the business by filing Articles of Incorporation with your desired state of incorporation, obtain a registered agent for your company, and pay the appropriate fees. Many states also impose ongoing fees, such as annual report and/or franchise tax fees. Although these fees usually are not expensive, and can be deducted as a cost of doing business, they are expenses that a sole proprietor or general partnership will not incur.
- Mistakes regarding the various election, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status. Although this is relatively rare, and usually can be remedied easily, it is still an issue that is not a factor with other business forms.
- An S corporation can have only one class of stock, although it can have both voting and non-voting shares. Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights. Also, there cannot be more than 100 shareholders. Foreign ownership is prohibited, as is ownership by certain types of trusts and other entities.
- Because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality. As a result, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.
- Because of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement. Also, the necessary accumulated adjustment account can be cumbersome to maintain, requiring input from an accounting professional.
It is important that you consult a professional before selecting a legal entity and ensuring that you correctly set up the legal entity. Please do not hesitate to contact us if you need more information of selecting a legal entity.