Along with naming your company, deciding which entity your business should become is one of the first decisions you'll ever make.
The decision to start your own business all comes down to a series of three little letters: Inc, LLC and LLP. Along with naming your company, deciding which entity your business should become is one of the first decisions you'll ever make. And it's an important one. "You really want to think it through and understand what's right for you," says Mark Williams, director of operations at Business Filings, a company that provides incorporation services for small businesses.
The differences among the three business structures -- corporations, limited liability companies and limited liability partnerships -- are worth pouring over because they will determine how your business evolves -- the way in which you structure ownership, whether you can raise capital and, of course most importantly, how much you pay Uncle Sam on tax day.
Inc. -- Setting up as a corporation
The majority of businesses in the United States (both small and large) are formed as standard C corporations and have the Inc. moniker following their names. And there's good reason for this. C Corporations give their owners enormous flexibility in how they operate their businesses, the way they distribute ownership and how they raise capital. They also afford owners and managers significant protection from legal liability. If someone sues your business, generally speaking, your house and livelihood won't be on the line. And vice versa. If you get into trouble with personal debt, creditors, by and large, won't be able to come after your business.
But corporations aren't for the slight of heart. They're complicated structures that require a lot of paperwork and organizational discipline. Chip McClelland, a business, tax and financial consultant in Honolulu, says he's had to undo incorporation for more than a few small business clients who didn't know what they were getting into.
One way to make the process of being a corporation a little simpler is to convert it to an S corporation. This is done by filing Form 2553 with the IRS by March 15 of the year in which you want to be eligible. As an S corporation you will not have to pay taxes on the earnings of your business, avoiding the double taxation whammy of C corporations. Since the income of an S corporation is "passed-through" to shareholders, you pay taxes only on this personal income. Yet, keep in mind that S corporations still require all the formality of C corporations -- by-laws, articles of incorporation, boards of directors, annual meetings, and required employment contracts for officers and owners.
There are also specific rules and restrictions involved in being a tax-free S corporation. Much of the flexibility you get with a C corporation is gone. You can't have more than 75 shareholders, and these shareholders must be individuals (not other corporations or trusts) and can't be non-resident aliens. You also can't do anything fancy with your company's stock; only one class of stock is allowed -- no preferred shares with special liquidation, dividend, or conversion rights.
LLC -- Limited Liability Company
If these S corporations restrictions seem too limiting but you like the tax advantages, you might want to think about incorporating your business as an LLC. A business classification that's been gaining popularity in the last 10 years, LLCs offer many advantages to small business owners. Business Filings reports that half their clients choose to incorporate as LLCs.
A slimmed-down alternative to the corporation, LLCs have the same so-called "limited liability" protection as corporations, but none of the costly bureaucratic hurdles. In many states LLCs also have lower formation and renewal fees.
Similar to S corporations, income generated by an LLC flows to its owners, who are referred to as "members." However, there are no limits on the numbers of such members or the company's organizational structure. LLCs can form subsidiaries and offer several classes of "membership interest," or stock. And last year LLCs became eligible for the deduction of 100% of health insurance premiums, just as corporations have been able to do for years.
The main disadvantage of LLCs is that raising capital isn't easy. Doing a public offering, for instance, is nearly impossible. This is because ownership interest in an LLC is not freely transferable. Owners must obtain approval of the other owners before interest can be sold. If you're a business owner with dreams of one day pulling off an IPO, forming a C corporation is probably your best bet.
LLP -- Limited Liability Partnership
Historically partnerships have been the province of law and accounting firms, and today that's still largely the case. Yet because of emergence of LLCs there are few advantages these days to being an LLP. The pass-through tax advantages of partnerships can now be found in both LLCs and S corporations, yet LLPs lack the liability shield afforded by LLCs and corporations. In a partnership every owner, or partner, is legally responsible for the actions of the company.
LLPs are, however, ideal for short-term projects, like a condo development with multiple investors, since they can be disbanded easily.
Much of the decision over business entities comes down to what you want your company to be when it grows up. Deciding that at the start can set your business off on the right track and prevent a lot of headaches down the road.