Of all the different choices you have to make when starting a new business, arguably none is more critical or has a more significant impact on your success or failure than your choice of business entity structure. The entity you choose will affect everything from the amount of taxes you pay and the type of records you are required to keep, to how vulnerable your personal assets are to the legal and financial liabilities incurred by your company, and even your ability to finance your venture.
When choosing between the different entity types, you will be contemplating one of the following structures: a sole proprietorship or partnership (the default choice if you do nothing), a corporation, or a limited liability company (LLC). You may notice that we did not mention an S-corporation, B-corporation, public-benefit corporation, nonprofit, or even a trust here. That is because S-corporations, B-corporations, public-benefit corporations, and nonprofits are all types of corporations, and while a trust can be an owner of an entity, it is not the entity itself.
You can think of the legal entity you choose for your business as the container for your business, which is distinct from how that container is owned (which could be through a trust), and it is also distinct from how that entity is taxed (which could be as an S-corporation or as a nonprofit).
Last week, in part one, we discussed the first two of five questions you should ask yourself when choosing the legal entity for your company, and here we’ll cover the three remaining questions.
3. How Would You Prefer To Be Taxed?
Similar to your liability exposure, your choice of entity also helps to determine how your business is taxed. If your business is a sole proprietorship or a partnership, you and the other owners are legally the same as your business, so your share of the company’s profits or losses are reported on your personal income tax return and taxed at your personal income tax rate.
In contrast, as a C-corporation, your business is considered a separate legal entity from you and the other owners for both liability and taxation purposes. As a result, the corporation pays taxes at the new flat corporate tax rate of 21% established by the Tax Cuts and Jobs Act. Then, after-tax profits are distributed to the shareholders, and those profits are taxed at the personal rate of each of the shareholders. This system of “double taxation” means the corporation first pays tax at its rate, and then the shareholders pay tax at their own individual tax rates.
However, due to the expense and complexity of creating and maintaining a traditional corporation, very few small or mid-sized businesses are set up as C-corporations. Fortunately, you can still obtain the liability protection and tax advantages offered by a C-corporation by setting your business up as an LLC.
As an LLC, you have flexibility in choosing how you’ll be taxed. Unless you choose to be taxed as a corporation, single-member LLCs are automatically taxed as sole proprietorships, while multi-member LLCs are taxed as partnerships. In either case, your company doesn’t pay any taxes on its profits itself. Instead, your share of the net business income is taxed on your personal tax return, and you’ll pay taxes based on your personal income tax rate.
Alternatively, you can also elect for your LLC to be taxed as an S-corporation and in this case, you will file a tax return on behalf of the corporation, reporting all income and expenses on that return. But the entity will not pay taxes. Instead, the business will issue you a K-1, indicating the net profit, which will be taxed as ordinary income on your personal return.
The main advantage of choosing to be taxed as an S-corporation is that you only pay payroll taxes on your payroll, not on your profit distributions from the company. Whereas, if you are taxed as a sole proprietorship, all profits are considered payroll and subject to payroll taxes. In addition, the audit risk for S-corporations is typically less than the audit risk for companies taxed as sole proprietors, where income and expenses are reported on your personal Schedule C.
If your business is taxed as an S-corporation, you will pay income taxes on your profit distributions, but you would save roughly 15% in payroll taxes on distributions taken as profits, rather than as payroll since you don’t pay payroll taxes on income taken as profit distributions. In contrast, when using an LLC taxed as a partnership or sole proprietorship, you will pay payroll taxes on all distributions to you from the LLC up to the payroll tax limits.
That said, for an S-corporation election to make sense, you’ll probably want to have at least $60,000 or so of net income per year. If you are close to that amount and have not yet filed an S-corporation election, we encourage you to meet with a Certified Public Accountant (CPA) to discuss all of your options.
4. What Kind Of Records Are You Willing To Maintain?
While sole proprietorships and partnerships don’t offer any liability protection from the liabilities or activities of the business, both entities are extremely simple to set up and maintain. For example, if you start a new business and are the only owner, you are automatically a sole proprietorship in the eyes of the law, and you are automatically a partnership if you have more than one owner. In either case, there’s no need for you to register your business with the state, file any paperwork, pay any fees, and there are no special rules to follow.
Although LLCs and corporations offer liability protection and tax advantages, those benefits do come with specific administrative and reporting requirements known as corporate formalities. These formalities dictate how the entity must be structured, maintained, and managed. If you fail to adhere to these formalities, the court could remove the protective barrier shielding your personal assets, known as “piercing the veil,” leaving you personally liable to creditors in the event of a judgment.
C-corporations come with the most stringent and most extensive administrative formalities. For example, you must file articles of incorporation with the state, hold a regular board of directors and shareholder meetings, create and enact corporate bylaws, and maintain detailed record-keeping requirements, such as keeping meeting minutes. Beyond that, you must also file annual financial reports with the state and pay yearly fees to maintain your corporate status.
LLCs have administrative formalities, but they aren’t nearly as burdensome as those for C-corporations. As the owner of an LLC, for instance, you must file certificate of formation with the State and create an operating agreement, which governs how your LLC is structured and run. In addition, Texas requires LLCs to file an annual report with the state agency responsible for registering business organizations.
Although there’s no statutory requirement for LLCs to hold owner meetings or keep minutes, doing so provides strong evidence that you’re abiding by corporate formalities. And by combining diligent record-keeping with a clear separation of your personal and business finances, you can give your LLC extra protection from creditors.
Should you choose to set up as an LLC or corporation, we can offer you support with maintaining your business records and keeping up with the required corporate formalities. In fact, we offer special maintenance packages that make meeting these requirements a snap, while maintaining the maximum level of protection for your personal assets.
5. How Do you Plan To Finance Your Business?
One final issue that your choice of entity will affect is your ability to finance your business. When securing funding, you must first decide what form of investment is right for your company: equity or debt. Specifically, are you looking for an investment in exchange for an equity stake in your company (equity), or would you be better off getting a loan to fund your business (debt)?
That said, if you choose to set up your company as a sole proprietorship or partnership, you will most likely be limited to financing your business with a debt investment, since most investors—banks included—will be extremely reluctant to invest in businesses set up using these entities. And once again, this is mainly due to the lack of liability protection offered by sole proprietorship and partnerships.
When funding a business, investors want to minimize their risk and maximize their return. Investors typically prefer to fund business entities that offer their owners liability protection, because in those cases, they wouldn’t have to go after your personal assets if you are unable to pay back the loan. Personal assets are generally harder to seize than business assets in case of a default.
In addition to liability protection, entities like corporations and LLCs offer your company enhanced credibility and legitimacy, which is another attractive feature for investors. Given the financial investment and administrative formalities that are required to set up and maintain these entities, corporations and LLCs show that you take your operation seriously, and you are willing to invest both money and time to structure your business properly.
Owners of C-corporations and S-corporations, aptly known as shareholders, can sell shares of stock in their company to outside investors. By purchasing shares of a company's stock, investors offer financing in exchange for a share in the percentage of your company’s profits. Shareholders may also be granted voting rights, which gives them a role in decisions on key issues, such as membership and positions on your board of directors, management decisions, and other corporate actions.
C-corporations can have an unlimited number of shareholders, and can issue different types, or classes, of stock. In contrast, S-corporations can have no more than 100 shareholders and are only allowed to issue a single class of stock. Given these restrictions, C-corporations are the most attractive entity for equity investors. However, as we mentioned earlier, due to the expense and complexity required to set up and maintain, very few small- and mid-sized companies are set up as C-corporations.
Get Professional Assistance
Properly selecting, setting up, and maintaining your business entity is far too important for you to try to handle everything on your own. At Davidek Law Firm, PLLC, we will offer you trusted advice on choosing the entity that is best suited for your particular business, while also helping to ensure that your entity is properly set up, with all of the necessary agreements and other resources in place.
Additionally, we can provide you with a variety of business systems, which will not only make your operation more efficient but also establish a clear separation between your business and personal finances, which is a vital part of maintaining your entity’s liability protection. Finally, we will also make sure that you are in full compliance with the various state laws and administrative formalities required to maintain your entity and safeguard your personal assets.
With all of these tedious—yet critically important—matters are taken care of, you can devote all of your energy and passion to growing your business into something truly meaningful for yourself, your clients, and your family.
This article is a service of Davidek Law Firm, PLLC. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business.