Businesses may be organised in a number of ways. No entity type is ideal for every firm; each has advantages and disadvantages. The optimal form of company for your business will be determined by which of these benefits and drawbacks has the most influence on your firm.
This brief covers some of the factors to consider when deciding what form to choose when launching your firm. Before making a choice, you should consult with an attorney and your accountant in more depth; nonetheless, this will introduce you to some of the benefits and drawbacks involved in making your option.
Entities of many kinds
Limited liability companies, C corporations, S corporations, B corporations, sole proprietorships, general partnerships, and limited liability partnerships are all options for business entities. However, unless there are special state law concerns, only a handful of these forms provide characteristics that are appealing to most starting enterprises. Limited liability firms, C corporations, B corporations, and S corporations are examples.
If you run a business but fail to properly establish an organisation, your company will default to a general partnership if there are numerous owners or a sole proprietorship if there is just one owner. Neither structure protects your personal assets from creditors, and operating your company in this manner is not normally suggested since the risk does not balance the gain. As a result, before launching your firm, you should consider forming a legal structure such as an LLC or corporation.
Limited Liability Corporation (LLC)
LLCs are the most common kind of company for small enterprises that do not intend to seek outside funding from angel or venture capital groups.
An LLC is a distinct entity from its owners, and its ownership may be split in the same way that a corporation’s can. The LLC is accountable for its obligations and liabilities as a distinct company, and its members have no personal accountability. If the firm collapses or is exposed to claims that exceed the value of its assets, the members’ investment in the LLC may be lost, but their personal assets are usually secure.
An LLC is taxed in the same way as a general partnership. Single-member LLCs, on the other hand, are often treated as a “disregarded entity” for tax reasons. In any case, regardless of whether the revenue is held in the firm, all income or loss of an LLC is reported on the individual income tax returns of its members. This is referred to as “pass-through” taxes. If there are more members, the revenue or loss is distributed among them. If an LLC suffers losses, its members may credit these losses against other revenue. However, bear in mind that in certain cases, LLC owners who are not actively involved in the firm may be limited in their ability to use losses to offset other income.
The biggest downside of an LLC is that it is not the preferable form for startup firm outside investors. If you want to seek outside finance for your company, whether from venture capitalists, angel investors, or public offerings, you should probably avoid the LLC form. Although some angel investors may invest in LLCs, most investors would prefer that your firm become a Delaware corporation.
A limited liability company (LLC) is formed by submitting articles of incorporation with the state, and many states allow for online filing. Some states need yearly reports to be submitted in order for the LLC to continue to exist. An Operating Agreement, which regulates the company’s activities, is also required to incorporate an LLC. This might be a pretty basic document for a single owner LLC or a more complicated document for multi-member firms, but it is essential to preserve business formalities and personal liability protection.
It is feasible to establish an LLC that elects to be taxed as a S corporation. This entity combines some of the greatest characteristics of both kinds of entities: its management structure may be informal and flexible, similar to that of an LLC, while it benefits from the employment tax advantages of a S corporation.
Corporation under Subchapter S
An S corporation is a kind of tax shelter. An S corporation is formed by first forming a C Corporation or LLC with the state, followed by submitting a Form 2553 election as a S corporation with the IRS. S companies offer comparable benefits and downsides to LLCs. S companies and LLCs may both have one or more owners, both are liable for their own debts and obligations, allowing owners to have limited responsibility, and gains and losses both flow through and are recorded on the owners’ income tax returns.
Not every corporation or limited liability company may choose to be taxed as a S corporation. Several conditions must be completed, and these requirements impose constraints that may not be appealing to all businesses. To be eligible for S corporation status, the company must fulfil the following criteria: (1) Be a domestic corporation; (2) have only allowable shareholders (individuals, certain trusts, and estates are permitted, but partnerships, corporations, or non-resident alien shareholders are not permitted); (3) have no more than 100 shareholders; (4) have only one class of stock; and (5) cannot be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
As a result, S companies are only available to tightly held enterprises, and venture capital firms are normally barred from participating in S corporations since they are not deemed “allowable stockholders.” Because S companies may only have one class of stock, they have limited capital structure flexibility. An S company, on the other hand, may change to a C corporation if necessary.
The handling of employment taxes is the primary distinction between S companies and LLCs. Wages and wages paid by a S company to workers are subject to FICA tax. However, a S corporation’s income is not subject to employment taxes at the time it is earned. Furthermore, dividends issued from a S corporation’s current or accumulated profits are normally exempt from these taxes.
C corporations are the most prevalent company form used by startups seeking funding from angel and venture capital firms. They offer limited responsibility for its owners and, in terms of establishment and maintenance expenses, are equivalent to LLCs and S companies.
A C corporation has the distinct benefit of being the preferred form for outside investors and public offers. As a result, it is simpler for firms to participate in stock and debt financing. Delaware is the most popular state in which to incorporate a new business.
Another benefit that C companies provide for young firms that is sometimes neglected is reduced tax rates on the first $50,000 of yearly revenue as compared to LLCs. In addition, only employee wages are liable to employment taxes, while all revenue received by an LLC is subject to self-employment tax. A C company may also keep earnings in the firm without paying taxes on them to its shareholders.
The primary drawback of C companies is that their revenue and loss are taxed to the company and do not flow through to its shareholders. As a consequence, stockholders of a C company cannot deduct startup or other losses from other income. Furthermore, C corporation income may be taxed twice: once at the corporate level when received and again at the shareholder level when dispersed as dividends or when a shareholder sells shares at a profit due to the company’s accumulation or investment of its revenue. However, during stock transactions and mergers, double taxation may sometimes be avoided.
The B Corporation
The B Corp may be the ideal organisation for entrepreneurs whose ambitions are not primarily focused on maximising investor returns. Consider it a hybrid of for-profit and non-profit models. B Corps are required by law to be managed in a way that balances the financial interests of shareholders with the best interests of individuals significantly impacted by the corporation’s activity (i.e. environmentally responsible) or the public benefits stated as its overall objective. This structure enables a corporation to safeguard its purpose throughout time. Because removing a B Corp’s declared purpose normally requires a two-thirds super-majority shareholder vote, a firm may make actions that promote its growth and development without jeopardising its objective.
This is a relatively new corporate form that is gaining traction among individuals seeking to operate, work for, and invest in socially responsible businesses. B Corps, like standard businesses, may choose to have their profits taxed at the corporate level or to pass down their earnings to shareholders, who will be taxed at the individual level.
Because not every state allows you to form a B company, consult with an attorney if this structure appeals to you.
Selecting an Entity
No entity type is ideal for every firm; each has advantages and disadvantages. The optimal form of company for your business will be determined by which of these benefits and drawbacks has the most influence on your firm. For example, if you want to seek outside investors with varying tax and financial requirements, you should form a C company. On the other hand, if all of the business’s owners will actively engage in its management and a significant portion of the business’s revenue will be utilised to pay working capital or capital purchase requirements, a S corporation will be appealing due to its employment tax benefits. If you do not plan to seek outside funding but desire capital structure flexibility, an LLC may be the best option for you. If you are a socially concerned individual with a firm that serves a societal benefit but requires financing, a B corporation should be explored.
There may be concerns about your new company’s form that have not been covered in this overview; nonetheless, perhaps, this material has gotten you thinking about the most beneficial shape for your firm to adopt.