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Introduction
Are you getting ready to launch your business? Or maybe you're currently operating one and wondering what legal structure is best to use. There are a number of different legal entities to choose from. And each has its own set of pros and cons.
To determine which business entity is the best fit, you'll want to see which one most applies to your situation and then carefully go over the pros and cons. It's also a great idea to speak with your tax professional and an attorney.
Some things that will affect your decisions, and your long-term success, are liability protection, taxation, the complexity of management, annual requirements, and the ability to raise money from investors, if applicable.
What are the options?
New businesses in the US have a choice of five basic structures:
C-Corporation
LLC (Limited Liability Company)
S-Corporation
Sole Proprietorship
Partnership (aka General Partnership)
You'll want to learn about each business structure and decide which best suits your needs. We'll explain each type below and will also go over how they are different from each other.
Corporation (aka C-Corporation)
A Corporation is a separate legal entity created by state law. A Corporation is formed by filing a document called the Articles of Incorporation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
A Corporation must designate a Registered Agent in order to receive service of process and state correspondence.
By default, a Corporation is taxed under subchapter C of the Internal Revenue Code. This is often why Corporations are referred to as C-Corporations.
On the other hand, a Corporation can elect to be taxed as an S-Corporation (aka being taxed under subchapter S of the Internal Revenue Code) by filing Form 2553 with the IRS.
If the Corporation is taxed in its default status (taxed as a C-Corporation), the Corporation will face double taxation. Essentially, the Corporation is taxed at the corporate level on its profits. And then the Shareholders are taxed again, at the individual level, after they receive distributions (their share of profit).
C-Corporations are also responsible for paying state corporate income tax, if applicable, where they are domiciled and/or transacting business.
Corporations also have statutory requirements, such as electing a board of directors, designating corporate offers, holding annual meetings, and recording meeting minutes.
Corporations are not commonly used by small business owners. Instead, they are used by larger companies or tech startups often looking to raise venture capital from investors.
LLC (Limited Liability Company)
An LLC, aka Limited Liability Company, is a separate legal entity created by state law. An LLC is often formed by filing a document called the Articles of Organization. However, depending on the state, this form is also known as the Certificate of Organization or Certificate of Formation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
An LLC must also designate, and maintain, a Registered Agent. A Registered Agent must be located in the state where the LLC is formed. For example, if an LLC is formed in Texas, it must designate a Registered Agent in Texas.
The LLC is unique when it comes to tax treatment by the IRS. This means, there is no "LLC tax classification". Instead, the LLC is taxed based on the number of owners. Alternatively, the LLC can make an election with the IRS, requesting to be taxed as a Corporation (C-Corporation or S-Corporation).
An LLC with one owner is known as a Disregarded Entity. This simply means the IRS "looks through" the LLC; looks at who the owner is, and taxes the individual or company accordingly. For example, if an American taxpayer is the single owner of an LLC, the LLC will be taxed as a Sole Proprietorship. If the LLC is owned by two or more people, the LLC will be taxed as a Partnership. And if the LLC is owned by another company, it will be taxed as a branch/division of the parent company.
And alternatively, the LLC can elect to be taxed as either a C-Corporation (by filing Form 8832) or an S-Corporation (by filing Form 2553).
LLCs taxed as Sole Proprietorship, Partnerships, and S-Corporations are all known as pass-through entities. This means there is no corporate-level taxation (company-level taxation). Instead, the taxes flow through to the owners and are reported and paid on their personal tax returns.
In the more uncommon setup – an LLC taxed as a C-Corporation – the LLC would face double taxation, just like a regular Corporation would.
And while an LLC may be able to be used for estate planning purposes, it's often wiser to have your LLC owned by your trust(s). Of course, it's best to speak with an estate planning attorney on such a matter.
In summary, for many small business owners, LLCs are the "best of all worlds". They receive liability protection, just like a Corporation, but they are, by default, pass-through tax entities. And if the LLC would like to be subject to corporate tax treatment by the IRS, the LLC can make the necessary election. Said another way, while providing liability protection to its owners, the LLC can pretty much choose how it would like to be taxed.
LLCs also have more flexible management options and don't have as many formal, and annual requirements, such as Corporations.
LLCs are the most popular type of business entity in the United States, mostly because of their flexibility and the personal liability protection they offer to owners.
S-Corporation (aka S Corp)
An S-Corporation is unique because it is not a legal entity, like an LLC or a Corporation. Instead, it's a tax election made with the IRS.
It's easier to think of it this way: The S-Corporation tax election "sits on top of" a state-level entity, such as an LLC or Corporation.
This is one of the most common myths with S-Corporations. People think you can just "form" an S-Corp. You simply cannot. There is no state or federal filing to "form" an S-Corp. Instead, one must first form an LLC or Corporation, and then timely file Form 2553 with the IRS to request to be taxed under Subchapter S of the Internal Revenue Code.
Once the IRS grants the elective status, it's common to refer to the entity as an S-Corporation and its owners as Shareholders.
For most, the primary reason to explore S-Corp tax treatment is to save money on self-employment taxes.
Owners of an S-Corporation must take a "reasonable salary" (which is subject to self-employment taxes), but any remaining profit can be taken as a distribution (which isn't subject to self-employment taxes). And that's the main appeal of S-Corporations right there.
It's important to keep in mind that with an S-Corporation, you must regularly run payroll, withhold taxes, file quarterly payroll returns (federal and state), hire a bookkeeper (or manage your own books), keep an accurate balance sheet (since it's required to be filed with the IRS), file a corporate tax return (Form 1120S, K-1s for shareholders/owners, and any additional Schedules), and hire an accountant if you don't have one already.
All of the above costs money. And those costs – which average $2,000 - $4,000 for small business owners – need to be compared to the potential self-employment tax savings; in order to make sure the S-Corp tax treatment makes sense.
S-Corporations can be owned by US citizens, US trusts (depending on how they're taxed), US estates, US resident aliens, and US tax-exempt organizations.
S-Corporations cannot be owned by Non-US residents (aka non-resident aliens), foreign companies, C-Corporations, Partnerships, financial institutions, or insurance companies.
If you're considering having your entity taxed as an S-Corporation, it's important to speak with an accountant to make sure the extra cost – and additional filing requirements – are worth the self-employment tax savings. Having your business entity taxed as an S-Corporation can be a good idea for some, but isn't necessarily a good idea for everyone.
Sole proprietorship
A Sole Proprietorship is an informal "business structure" with one owner.
There is no paperwork to file with the Secretary of State, or a similar government agency, to create a Sole Proprietorship.
You simply are a Sole Proprietorship once you engage in business activities, or engage in activities with the goal of making money.
A Sole Proprietor can do business under their own name or they can file a DBA (Doing Business As) Name. For example, John Doe can do business under his name, John Doe, or he can file a DBA called "John's Painting Company".
The advantage of a Sole Proprietorship is that they are easy to set up.
And taxes are pretty straightforward with a Sole Proprietorship. The owner will simply file a Schedule C and report their business income (or loss) on their personal tax return.
The largest disadvantage of Sole Proprietorship is that there is no liability protection for the owner. In the eyes of the law, the owner and their business are one and the same. If the business is involved in a lawsuit, the owner's personal assets (home, cars, bank account, etc.) could be used to settle business debts and liabilities.
Another disadvantage of a Sole Proprietorship is that if you eventually form an LLC or Corporation, there is no official "conversion" filing. So you basically have to start all over again – filing paperwork with the state, getting an EIN (Federal Tax ID Number), opening a business bank account, etc. So if you're on the fence, between an LLC or Sole Proprietorship, for example, it's often easier to just form an LLC.
However, if you believe your business has a low liability risk and you don't have money to form an LLC or Corporation, starting your business as a Sole Proprietorship may be the best method to getting your business off the ground.
General Partnership (aka Partnership)
A General Partnership (Partnership) is pretty much a Sole Proprietorship with 2 or more people. Said another way, it's an informal "business structure" with multiple owners.
In most states, there is no paperwork to file with the Secretary of State, or a similar government agency, to create a General Partnership (there are few states though that require General Partnerships to register).
A Partnership can do business under the names of the owners or it can file a DBA (Doing Business As) Name.
The advantage of a General Partnership is that it is easy to set up.
Partnership taxes are not as straightforward as with a Sole Proprietorship though. For instance, the Partnership must file a Form 1065 and issue K-1s to the partners. Then the partners report their K-1 income on their personal tax returns.
The largest disadvantage of a Partnership is that there is no liability protection for the owners. Again, in the eyes of the law, the owners and their businesses are one and the same. If the business is involved in a lawsuit, the owner's personal assets (home, cars, bank accounts, etc.) could be used to settle business debts and liabilities.
While a Partnership may be a good way to save money and get a business off the ground, most people quickly shift to a legal business entity, like an LLC or Corporation.
Choosing the best entity structure for your business
Generally speaking, the LLC is the most adaptable corporate structure, and for that reason the most popular choice in the U.S. The LLC can pretty much choose how it would like to be taxed by the IRS, all while providing its owners' personal liability protection.
Having said that, some owners may elect for their LLC to be taxed as an S-Corporation to save money on self-employment taxes.
Or larger businesses (or those raising money) may prefer to form a Corporation, especially if they have large healthcare expenses.
And while Sole Proprietorships and General Partnerships may be good to start off with, owners may quickly outgrow them or not feel comfortable with the lack of personal liability protection.
Conclusion
Choosing the best legal entity for your business is a game of weighing the pros and cons. Things to consider are liability protection for the owners, tax treatment by the IRS, and the reporting requirements, among other things. Typically, larger companies or those raising money from investors opt for the Corporation, while most small business owners choose to form an LLC.
© Copyright 2010 LLC University National Law Review, Volume XII, Number 220
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Matt Horwitz is the founder of LLC University, a website that teaches people how to form LLCs. Matt is the leading authority in LLC education and is featured in CNBC, Yahoo Finance, Entrepreneur Magazine, and the US Chamber of Commerce. Matt holds a Bachelor's Degree in business from Drexel University with a concentration in business law. LLC University®, established in 2010, was the first company to create free LLC courses in all 50 states.