By: Allan Thompson | Chief Operating Officer
As the dust settles on this tax season, it is a good time to review the business structure of your company. While many small businesses start out as a sole proprietorship or partnerships, eventually success and growth may lead to the need to convert to a Limited Liability Company (LLC) or a corporation. Every business is different, so finding the best fit requires understanding each type of structure and how it would serve your business – now and in the future.
Two key considerations for forming an LLC or a corporation are how liability and taxes are handled. Both sole proprietors and members of a partnership report profit or loss on their personal tax returns. Furthermore, sole proprietors and members of partnerships are personally liable for business debts and court decisions. As a business grows or assumes more risk, these factors can put too much direct personal responsibility on owners. It might be time to set up the protections provided by a corporate structure.
There are limits to the liability protection offered by forming an LLC or corporation,1 but if the business structure is respected it will protect personal assets. If you have heard of the ‘corporate veil’, this is the basic tenant. If you respect the separation between the corporation and its actions and your personal finances and actions, you will be protected.
If you decide that the time is right to start or convert to a LLC or create a corporation, you will need the help of your tax advisor. The business and tax laws are extremely detailed and complicated. Furthermore, if your business has multiple owners with their own personal tax situations, a tax expert can help each owner plan for changes. Retirement plans, medical expenses and coverage, and business tax deductions should all be carefully reviewed with your advisor.
Understanding the basic structure and the pros and cons of Limited Liability Companies, C Corporations, and S Corporations can help you decide which might be the best for your small business as it moves forward.
Limited Liability Company (LLC)
A Limited Liability Company, or LLC, is perhaps the simplest choice for a small business structure from a paperwork standpoint. The requirements for forming and running an LLC are determined at the state level, so you will need to check with your state’s requirements. Paperwork usually requires creating articles of organization and a certificate of formation, which many states even offer as fill-in-the-blank forms. According to the IRS, most states allow for a single member LLC.2 Keep in mind that you will probably need to include something in your business name that indicates it is an LLC, for example Smith Dry Cleaning, LLC or Smith Dry Cleaning Limited Liability Company, so a business name change may be required. Permits and licenses will also be required.
The benefits of LLC include limiting personal liability for owners and flexibility with taxation. LLCs can choose to be taxed as either a partnership or a corporation. Profits and losses can be declared outside of ownership.
The downside for members of an LLC is that the entire share of a member’s profits may be subject to self-employment taxes. Furthermore, additional tax paperwork is required if the LLC wishes to be taxed as a corporation. Otherwise, the taxes are ‘passed-through’ to the member’s individual returns. The LLC must maintain separate bank accounts and insurance. Bookkeeping must be kept in order to prove the LLC is faithfully treated as a separate entity from its members. Day to day operations might not change much, but the IRS will expect the LLC to be treated as a separate financial entity.
LLCs are not able to sell shares, so they must find other ways to raise capital.3 Many LLCs rely on small business loans or merchant cash advance funding to raise capital when necessary.
Corporations are also governed by state law. Each state will have its own set of requirements and forms. Thankfully, Nolo.com keeps an updated list for all 50 states here. Many states will require some indication in the business name that the company is set up as a corporation, for example Smith Dry Cleaning, Inc. or Smith Dry Cleaning Incorporated.
The benefits of a C Corporation include limited personal liability for business debts, flexibility with how corporate profits can be divided among owners and the corporation which can lower the overall tax rate, and expanded tax deductions for the business. Corporations can also issue stock to reward employees or raise funds. The name C Corporation comes from filing under subchapter C of the IRS code.4
The cons of a corporation for a small business are the burden of increased paperwork, the expense of filing paperwork, and filing taxes as a separate entity. Becoming a corporation requires quite a lot of initial paperwork, but it also requires ongoing maintenance. The IRS will expect your corporation to be run as a corporation with the election of directors, regular meetings, an updated records book, and compliance with paperwork requirements like filing stock registration certificates, annual statements of domestic stock, and annual reports. Again, each state will have its own requirements on top of the requirements of the IRS. Some of this paperwork will require fees, which range from state to state. Your business will also need to obtain all necessary permits and licenses.
While a corporation may opt to sell shares to raise funds, small business loans or merchant advance funding can also raise capital without diluting ownership. When considering a business structure, think carefully about how you plan on approaching stock ownership and distribution.
An S Corporation is very similar to the structure of a C Corporation with one very important distinction, namely that an S Corporation elects to be taxed as a partnership.5 In operational terms, this means that the members of the S Corporation can be paid a fair market salary which is taxed through their personal tax returns. All shareholders of the must sign and file IRS Form 2553, Election by a Small Business Corporation.
There are time limits on when a corporation can elect to become an S Corporation. At the moment, you need to file Form 2553 before the 15th day of the third month of your tax year. For a new corporation, your tax year might start when you begin doing business.
Take time to review how filing taxes separately as a corporation will work out for you and all other members of the proposed corporation.
If you are interested in learning more about these business structures and how they might improve your small business, please check out the resources offered by the Small Business Administration and the resources offered at NOLO.com. Knowing more about each of these structures will help you and your tax professional make smart decisions that will set your small business up for a great future.
4. Steingold, F.S. (2015) Legal Guide for Starting & Running a Small Business. 14th Edition, Berkeley, CA: NOLO
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