Thinking about starting a new business? Let’s pause for a minute and weigh some important considerations before you start the hiring process or sign that commercial lease. First, protect yourself by setting up an entity. In the unfortunate event a lawsuit is brought against your business, a company that is properly set-up and well-maintained can help keep you from being held personally liable.
Now, what type of company suits you? There are a few common choices: “C Corporations,” “S Corporations,” “Partnerships,” and, a favorite among lawyers, “Limited Liability Companies” (LLCs). Each organizational form has its advantages and disadvantages and understanding the key characteristics of each will help owners decide which form is best for their specific situation.
Before choosing an entity type, here are some things you should consider:
1. How is my company going to be taxed?
C Corporations are subject to what is called “double-taxation.” First, C Corporations pay taxes on all profits that are not considered business expenses. Second, if the corporation distributes dividends to its shareholders, the shareholders are then required to pay taxes on those dividends. In the end, the same income is being taxed twice, which may be unattractive to some business owners.
S Corporations, Partnerships, and LLCs, on the other hand, are “pass-through” or “flow-through” entities. This means that profits flow through the entity to the owners. In other words, the owners are taxed, and the entity is not, which avoids double taxation for the owners. Although S Corporations are pass-through entities, they must still file a business tax return. LLCs, on the other hand, must only file a business tax return if there is more than one owner. Similar to filing a tax return, a partnership must file an annual information return that reports the partnership’s total income, deductions, gains, and losses.
S Corporations can be advantageous for taxation in regard to self-employment. S Corporation owners can be considered employees and be paid a “reasonable salary.” After this salary is paid, corporate earnings can be treated as unearned income that will not be subject to self-employment taxes.
Eligible LLCs can elect to be taxed like an S Corporation if they meet the following requirements that grant them “S” status:
2. What types of investors and owners are involved?
Of all the entities, C Corporations grant the most flexibility in raising funds. C Corporations can raise capital by issuing a potentially unlimited number of shares to an unlimited number of investors. That’s because C Corporations have the unique ability to “go public.” If you’re planning on growing your company and taking its shares to be publicly traded on a stock exchange, then a C Corporation may be the right choice. This is one reason, among a multitude of others, that venture capital firms highly prefer investing into companies set up as C Corporations.
LLCs are more flexible than C Corporations in the types of owners they can have, but LLCs can’t go public. LLC owners can include individuals, corporations, other LLCs, and foreign investors. There is also an option to be single-member LLC, which are LLCs with only one owner.
Similarly, Partnerships are flexible in the types of owners they may. Partnerships may be made up of individuals, companies, or corporations.
S Corporations have many more restrictions on the types of owners they can have. Owners of an S corporation must all be US citizens or permanent residents, cannot be corporations or other partnerships, and must not exceed a total of 100. Additionally, S Corporations may only offer one class of ownership.
3. Why are LLCs so Popular?
LLCs are a popular business entity because of the following benefits they offer:
Tax Efficiency. LLC owners avoid double taxation because LLCs are “flow-through” entities, which means money flows through the LLC to the owners. Therefore, owners are only taxed at the individual level.
Limited Liability. The Owners of an LLC are not personally liable for the LLC’s debts or legal liabilities. While owners can lose the capital they invest into the company, personal assets typically cannot be used to collect on the LLC’s debts. However, it’s important for owners to keep their personal and business finances separate, as LLCs are not no-liability companies.
Flexibility. LLCs are more flexible than corporations in the ways they can manage the business. LLC members retain the flexibility to determine how profits and losses are distributed. This is most often reflected in an Operating Agreement, which lays out of the LLC is to be operated. Members are not required to distribute profits equally or according to ownership percentages.
Minimal administrative work and hassle. LLCs require significantly less paperwork and administrative procedures than other business entities. It is encouraged, however, for owners to document major business proceedings and formal procedures to protect the LLC.
Possibility of sole ownership. Sole owners of an LLC can make decisions on their own without having to consult and get approval from other members. However, if there are two or more owners in an LLC, they must follow the Operating Agreement (or other like controlling document) which should specify the obligations of each owner.
Minimal restrictions. LLCs are not restricted in the amount or types of owners they may have. There is no maximum number of owners for an LLC and owners can be individuals, partnerships, corporations, and even foreign individuals or entities.
Simple structure. The simple business structure can be easily adapted by many types of businesses.
4. How is an LLC formed?
Starting an LLC is a relatively simple process but the rules for formation vary from state to state. You should work with a legal team when forming an LLC to ensure all the requirements are met. Generally, these steps should be followed to form an LLC regardless of which state you are in:
Choose a name for the LLC. Most states will not allow you to use a name for your LLC that is already taken. It is important to be original and unique when choosing a name in order to avoid confusion and potential trademark infringement claims. If you have chosen a name that is available, but you are not yet ready to file the LLC documents, you may want to reserve the name you have chosen to ensure it is not taken before you file. This is often possible online at the Secretary of State or Division of Corporations website of the particular state you’re forming in. The length of the reservation period will vary from state to state. Keep in mind that in most states LLCs are required to designate that they are an LLC in the company name. The designations range by state, but business owners should think about whether they want “LLC,” “Limited Liability Company,” “L.L.C.,” etc. in the entity’s legal name.
Choose a Registered Agent. Most states will require you to choose a Registered Agent for your LLC. The Registered Agent is someone who will receive service of process and other official documents on behalf of the LLC and pass them on to the appropriate person at the company.
Prepare an LLC Operating Agreement. Though this may not be required in some states, you should draft an Operating Agreement for your LLC that will serve as a roadmap for how the LLC will be run. This agreement should include the business arrangement, authoritative figures, board of managers, voting requirements, restrictions on transferring and selling, how profits and losses will be divided and the way the company will be dissolved if needed.
File Articles of Organization with the State. This is often just a short form that requires elements such as the name and address of the company and the purpose for which the LLC is being formed. Filing the Articles of Organization will require a filing fee that varies from state to state.
Register to do Business in Other States (Optional). You may wish to register your LLC in other states if the LLC will do business in more than one state.
Consult an experienced Romano Law attorney to help plan and form the best business organization for you!