Do I Need an LLC or a Corporation?
There are so many decisions to make when starting a new business. One of the most confusing for most fledgling business owners is whether they need to form a separate legal entity to operate the business, and if so, what type of entity. The most common business entities for small business are sole proprietor, LLC, and S Corp. Let’s run through each of these small business entities, so you will have an idea of which is the best fit for your new business.
A sole proprietor is not really a business entity at all. It just means that you started a business without a separate legal entity. As a sole proprietor, you can operate under your own name, or you can file a Doing Business As (DBA) form with your state for a small fee, which will allow you to operate a business under any name that you wish. If you are the only owner of the business, your income relatively low and you have no employees, you should probably be a sole proprietor. Taxes As a sole proprietor, you will report all your income and expenses on your personal tax return, on a Schedule C, but your business does not have to submit a separate return, and there are no special requirements for annual meetings or minutes. All profit in the business is reported and taxed as regular income. Liability As a sole proprietor, you are your business and your business is you. Therefore, you are liable for all debts, and claims against your business.
Limited Liability Company (LLC)
An LLC is a special type of business entity that offers some of the legal liability protection of a corporation, but is treated like a partnership for tax purposes. Limited liability companies are great for businesses with several owners, particularly if you may want to get creative with how profits are distributed. LLC’s can also be a good choice if you have employees because of the liability protection. You can set up a simple LLC through a site like LegalZoom, or you can even file the paperwork with the state by yourself, however, if there are multiple owners, or “members”, you should definitely have a lawyer draw up an operating agreement. Taxes LLC’s are a considered a “pass-through” entity for tax purposes. So all income is considered earned income, and is subject to both income tax and self employment tax. If you are the only owner of the LLC, you will report all your income and expenses on Schedule C of your personal return, just like a sole proprietor. If there are multiple owners, the LLC can elect to be taxed like a partnership or a corporation. Either a 1065 partnership return, or a 1120 corporate return will have to be filed, and each member of the LLC will get a statement for their portion of the profits. Liability A limited liability company can protect your personal assets against claims from creditors. If the LLC is sued, you will not personally be liable for any damages. LLC members also cannot be held responsible for any debts of the LLC, however, it is not very common for a small business to get a loan that does not also contain a personal guarantee.
A corporation is a legal entity that is independent from its owners. As a standalone entity, corporations must file and pay taxes, and are liable for claims against the organization. When profits are distributed to shareholders in the form of a dividend, they are taxed again. An S-Corp is a special IRS election that allows a corporation to be taxed at a personal level to avoid this double taxation. All corporate entities require considerably more legal and administrative maintenance than an LLC or sole proprietor. An S-Corp is a good choice for larger businesses, that have considerable profit beyond a reasonable salary for the owner, or for savvy business owners with significant income that want to use sophisticated retirement savings techniques. Taxes S-Corps have several tax advantages. All income from the entity flows through to the individual shareholders tax returns and is taxed at the shareholder’s rates. Payments to shareholders can be in the form of wages for any owners who are also employees, or distributions. Only the wage portion of earnings is subject to self employment tax, so any distributions above a fair salary save 15.3% in taxes. Corporations also allow for more creative retirement savings strategies that can further reduce your taxes.S-Corporations receive different tax status in different states, so be sure to talk to your CPA about tax treatment. Liability As a separate legal entity, a corporation protects its shareholders from the claims of creditors, similarly to an LLC. Shareholders are not responsible for the debts and other claims against the companies that they own.
Different types of legal entities exist to allow entrepreneurs some choices based on their needs. Choosing a business entity is an important decision for a small business, so seek the counsel of a trusted CPA or tax attorney.
You can read additional information about these business entities, and some others on the Small Business Administration website.
Derek Steinmetz is a Certified Public Accountant (CPA), as well as a financial planning and analysis consultant. Derek works with businesses of all sizes to streamline internal financial processes, identify key business metrics, and more. Find out more at www.thesteinmetzgroup.com or connect with Derek on Twitter.
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