Which Business Type Should I Choose? A Comprehensive Guide
There are a few things to consider when choosing the business type that is right for you. The first step is to decide what legal structure you want your business to have. There are three main types of legal structures: S corporations, limited liability companies (LLCs), and C corporations. Each one has its own set of benefits and drawbacks, so it's important to understand them before making a decision. In this blog post, we will discuss each type of business and help you decide which one is right for you!
Your chosen organization will help you make critical choices, save money on taxes, and expand your business.
You can decrease risk by carefully selecting the forms of business entity that are accessible and then making an educated selection. You may save money on taxes and start the business in a form that is capable of being financed and run efficiently by choosing a responsible form of business entity. Formalization also aids in the prevention of misunderstandings among company participants by defining their roles in the business.
Reduce your taxes and protect your personal assets this important business decision.
The most important factors to consider when deciding on a business structure are how to protect your personal assets from the company's liabilities, whether through tax methods such as using startup losses to minimize double (or even triple) layers of taxation and converting ordinary income into long-term capital gain, which is taxed at lower income tax rates; selecting a business structure that will reduce personal liability, help pay self-employment taxes and protect your personal assets is essential when starting a new business.
The four main forms of business structures: C-Corporations, S Corporations, Partnerships, Limited Liability Companies
Business structure can take the form of four main forms:
a corporation;
Partnerships;
Limited Liability Company or LLC; or
A sole proprietorship.
Companies may be formed and run under the laws of each state. A corporation is a separate legal entity that is owned by its shareholders and governed by a board of directors. A partnership, in certain circumstances, is regarded as a collection of individual partners; it does not pay taxes; instead, its activities are taxed by its partners depending on the law in that State.
The limited liability company (LLC) attempts to combine the best features of a corporation and a partnership. If established correctly, the limited liability company is taxed in the same manner as a partnership. A sole proprietorship is a company run by one person, which has little legal significance apart from its owner. Nonetheless, because there are so many small businesses in the United States, sole proprietorships or a single-member LLC can be another good choice for a new business owner looking for limited liability status without the unnecessary complications of a formal corporation.
Most large business organizations operate as corporations for limited liability status that comes along with this business form, despite the tax incentives to utilize the partnership or LLC form of doing business. The advantages of the business form include limited liability, its familiarity and well-known governance rules, and the ease with which corporate stock may be transferred (particularly in the public securities markets). Because their major investors are pension and profit-sharing trusts and other tax-exempt organizations that are subject to certain tax limitations, many venture capital and other investment funds are unable to invest in partnerships or LLCs.
What to choose: C Corp, S Corp, Partnership, or Limited Liability Company (LLC).
The two most important variables to consider when choosing a business form are (1) who the company's owners will be, and (2) how profits will be distributed to them. Addtionally, there are some considerations surrounding personal income tax and the
Who Will Be the Owners
If a company is owned by a small group of people, the entity that is most appropriate may be one of the above. If a business will be widely held, the C Corp is frequently the best form because to the following reasons:
A corporation has an unlimited life and free transferability of ownership. Additionally, it can be beneficial for federal income tax purposes because of a C Corps filing requirements; a corporation is required to file its taxes separately from its owners. Finally, there is no limit of how many owners the corporation can have because
S corp is not suitable for a widely-held corporation because it can only have up to 100 stockholders all of whom must generally be individuals or eligible trusts for the benefit of individuals, and U.S. citizens or resident aliens. Additionally, unlike corporations, there is less flexibility with the classes of stock which can make it difficult to source investors.
If ownership interests in the business are going to be provided to employees, the C Corporation will generally be the preferred entity for several reasons. First, stock ownership is easier to explain to employees than equity interests in partnerships and LLCs. Second, creating favorably priced equity incentives is easiest to accomplish in a C Corporation because ownership can be held through various classes of stock. It is quite common for a corporation to issue preferred stock to investors and common stock to management and other employees. Because of the distinct privileges and preferences of preferred stock, the common stock may be sold at a significant discount from the preferred stock. Finally, the tax code provides for special "incentive" stock options in which the option holder does not pay taxes until the shares obtained on exercise of the options are sold. Instead of being taxed at ordinary income rates, the profit that is recognized in the end is taxed at more favorable long-term capital gain rates.
If the business raises capital from a venture capital fund, the business will usually be formed as a corporation because most venture capital funds raise money from tax-exempt entities such as pension and profit-sharing trusts, universities and other charitable organizations and these entities would incur taxable unrelated business income if the venture fund invested in a flow-through entity such as a partnership or LLC. Additionally, owner's of a corporation are not personally liable for the company's business debts which can make it a favorable tax status in some situations.
S Corporation - When you are looking to save on Taxes
Another option for small business owners is the S corp. S corps have many benefits, including using elements of both a corporation and elements of flow-through taxation which allows owners to avoid double taxation. The primary benefit is that S corp owners can avoid paying self-employment taxes on a portion of their compensation. S corps are only taxed once and all taxes are paid on the owner's personal income tax returns. This "double taxation" avoidance can be beneficial because it allows shareholders to deduct employment taxes that are paid to the owner-shareholder.
An S Corporation can be formed with only one member and can be formed under the LLC laws or the corporate laws. When forming an S corporation, it is important to understand your state law around businesses and how this will impact you. Typically, a state will follow the Internal Revenue Service treatment of the corporation and respect the corporate structure and tax treatemnt.
Limited Liability Company - Partnership or Disregarded Entity
Another type of company that a new business owner can choose is the limited liability company, or for professionals a "professional limited liability company."
This company is a bit more flexible because it can take on different tax statuses and can be taxed as a disregarded entity, partnership, or S corporation. The members in an LLC are not personally liable for the debts of the business and can have a flexible management structure.
An LLC is easy to form and maintain. You will need to file articles of organization with your state and pay a filing fee. You will also need to have a written LLC operating agreement that outlines the ownership and management structure of the company as well as the rights and responsibilities of the members. The LLC can be managed by one or more people, which makes it a good choice for small businesses.
Sole Proprietor - The one business type you should avoid
Unlike the other corporate structures, when an individual owns and runs a business without any legal business formed, this personal is running the business as a Sole Proprietor.
There are a number of reasons why you would not want to run your business as a sole proprietor . One of the primary reasons is that you, the owner, are fully liable for all debts and obligations of the business. This means that if the business cannot pay its bills, creditors can come after your personal assets, including your home or savings. In addition, sole proprietorships are not separate legal entities from their owners, which means that they do not offer any personal liability protection to the owner. Finally, sole proprietorships are taxed as flow-through entities, which means that they are subject to self-employment taxes.
Since a Sole Proprietorship is not a separate business entity, there is unlimited liability and all business assets are owned by your outright. The issue with this business structure, is that it isn't much of a structure at all. A Sole Proprietorship can open the doo to significant adverse consequences that greatly impact you and your business.
Get In Touch to See How We Can Help Today
As a new business owner, you have a lot of choices to make about what kind of company you want to form. The most important choice is what type of business entity you want to create. Creating a separate entity, is one of many decisions during the lifetime of a new business.
When choosing what business type is right for your company, it is important to understand the S Corporation, Limited Liability Corporation, and C Corporation. Each have their own benefits that could save your company money in taxes or protect your personal assets. The Michigan Virtual Attorney offers a wide range of legal services to help new business owners make the best decision for their company. Give us a call today to get started!
