After years of dreaming of starting your own business, you have finally decided to take the chance in search of a better life. That’s a big step in the right direction—however, there is still so much to figure out. Among these unknowns is the type of legal entity you should use to structure your business. You’ve done a little research and are aware of corporations, limited liability companies and even limited liability partnerships. However, determining the legal structure that is best for your budding business can be overwhelming, and it is an important decision. This brief article should give you a basic understanding of the different legal entities, but consulting an attorney will always be the best way to ensure you are starting your business on the right foot.
The simplest way to structure your new business is without a legal entity at all. This is what is called a sole proprietorship. A sole proprietorship is an arrangement that is very informal and consists of no organization. The business is the individual themselves. This poses a few legal problems.
First, there is absolutely no liability protection for the individual. For example, if you are an electrician operating as a sole proprietor, and you make a mistake that results in a house burning down, your entire net worth may be at risk in a lawsuit, including your house, vehicle, and retirement. Although you may have insurance, it may not cover all incidents and it may have a policy limit, leaving your personal assets exposed.
Second, sole proprietorships are more difficult to sell to a third party or pass down to your next generation. Because there is no legal entity, there is no business interest that can be sold, like stock or a partnership interest. Instead, there are simply the assets owned by the individual that can be purchased by a third party or passed to the next generation. This can be difficult to coordinate and market, reducing the value of the business. Furthermore, it could have negative tax implications.
For these reasons alone, most attorneys would not generally recommend that a person operate a business as a sole proprietorship.
Corporations, on the other hand, are their own legal entity, completely separate from the individual owners. Corporations are a structure in which the owners of the business own shares of the corporation. The corporation owns the business assets and conducts operations. The corporation income can then be paid out to the shareholders in the form of a dividend. The most commonly known characteristics of a corporation is its liability protection for shareholders and what is commonly known as double-taxation.
Since a corporation is its own legal entity, any claims against the corporation generally end at the corporation level, thus protecting the corporation’s shareholders. Of course, if there is some sort fraudulent action taken by a shareholder, liability could flow to that shareholder. However, in general, corporations protect the shareholders from any liability that may result from the business’s actions.
The major downside to most corporations is the what is commonly referred to as “double-taxation.” When a corporation earns net income, that income is taxed at the corporate level. The rate is currently 21%. However, as mentioned above, the owners of the company do not have access to the corporation’s earnings until the corporation pays the shareholders in a form of a dividend. This dividend is taxable to the shareholder at the shareholder’s personal tax rate. Thus, since the corporation’s income is taxed at the corporation level and the dividend is taxed at the shareholder level, the income is double-taxed. This is not always bad, and can be used to a shareholder’s advantage in certain situations. However, most of the time, double-taxation is best avoided.
Some types of corporations avoid taxation at the corporate level. These are corporations that are allowed to make an election under subchapter S of the Internal Revenue Code. There are many restrictions on so-called “S” corporations, including limitations on the number of shareholders, the types of shareholders, etc.
LIMITED LIABILITY COMPANIES
Limited liability companies (“LLCs”) are a relatively new form of legal entity. They offer liability protection for the owners (“members”), and they can be taxed as a pure “pass-through” entity in which the business itself pays no taxes—only the individual members do. Because of this, LLCs have become extremely popular in the past couple decades.
The liability protection for LLCs is generally regarded as being equal to that of corporations. However, to benefit from the liability protection of an LLC, the business must be structured correctly. The business should have its own bank account. There should be a process for transferring money in and out of the account. Employees should be paid using a payroll system and payroll taxes must be paid accordingly. So long as procedures are installed and followed, the members of the LLC should be completely safe from any liability incurred by the business itself.
The biggest benefit of an LLC is the ability for it to be taxed as a partnership under Subchapter K of the Internal Revenue Code. This allows for the LLC to be a pure pass-through entity in which the LLC itself will not incur income tax. Additionally, setting itself apart from S corporations that are mentioned above, there is much more flexibility in the types of members, the number of members, and different tax strategies that may be used in an LLC compared to the S corporation.
In summation, there are many factors to consider in choosing a business entity type. For that reason, it is better to seek the advice of legal counsel in making such an important determination. If you or someone you know is considering starting a business, feel free to contact our team at Russell Law Offices, S.C. to set up a consultation and help decide what entity is best for you.