When you are starting a business the legal structure you choose for it is a critically important decision. It will affect things like the cost of operating the business, its taxes, the potential for you and any other owners of the business to be held financially liable for problems it may develop, as well as your business’ access to capital.
Many people opt to run their business as a sole proprietorship because it’s easy to set up and cheap to operate; and when more than one person is investing time or money in a business, the owners often decide to create a partnership because it too is simple to establish and inexpensive to run. However, both forms of business come with some big downsides. One of the most significant is that their owners are 100% legally liable for the business’s debts and other obligations. In other words, if the sole proprietorship or partnership fails (and a very high percentage of them do), the business’ creditors can try to collect the money they are owed by going after the owners’ personal assets assuming there are not sufficient business assets to pay the creditors what they are owned; and if the business ends up on the losing end of a lawsuit, the owners’ personal assets are at risk too. For these and other reasons, structuring a business as a corporation or a liability company (LLC) are far better options. The rest of this article explains how each of these two types of businesses work and highlights their pros and cons.
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A corporation is the most complex and costly form of business. In the eyes of the law, this form of business is a “person” that is birthed when its articles of incorporation and other required paperwork are filed and approved by the state where the business is formed. Ownership in the business is divided into shares of stocks and the owners or investors are referred to as shareholders or stockholders.
A corporation may be set up as a regular, or “C” corporation, or as an “S” corporation. Although both kinds of corporations share some common characteristics, there are important differences between the two. For example, there are no limits on who can own shares of a “C” corporation or on the number of shareholders this kind of corporation can have. Therefore, “C” corporations are ideal for large, public companies.
In contrast, there are limits on the number of shareholders an “S” corporation can have as well as on who can be a shareholder. For example, non-resident citizens of other countries and certain charitable entities cannot own shares of an “S” corporation.
Another key difference between the two relates to how they are taxed. A “C” corporation for example, pays income taxes on its profits and its shareholders are taxed on any dividends they may receive as a result of their investment in the business. This is referred to as “double taxation.”
An “S” Corporation on the other hand – and this is one of its beauties – is not taxed on its profits. Instead, they “pass-through” to the company’s shareholders, who in turn must claim the income they receive on their personal tax returns.
Limited Liability Company
Although corporations have been around for hundreds of years, LLCs are “the new kid on the block,” relatively speaking. The first such business was created by the state of Wyoming in 1977, and over time this form of business slowly spread throughout the rest of the country. Today every state has its own LLC statute and LLCs, not corporations, have become the business form of choice for most small business owners. Here are some of the reasons why:
- Ease of administration. An LLC is less formal than a corporation and therefore, less expensive to operate. For example, unlike a corporation, an LLC is not required to have officers – President, Vice-President, etc. – who run the company. Instead, it’s run by its “members” (owners) or by a “manager” who is selected by the other members. Also, an LLC does not have shareholders and so it’s not obligated as are corporations, to have an annual shareholder meeting and to ensure that there are formal minutes of that meeting.
- Tax advantages. Although a corporation must be treated as either a “C” Corporation or an “S” corporation for tax purposes, the creators of an LLC can choose to be taxed like either of those two kinds of corporations, as a partnership or as a sole proprietorship. Because each option has its own benefits and drawbacks in terms of reducing and controlling taxes, the creator/s of an LLC should always consult with their CPA prior to forming their company in order to determine which one is best.
- Asset protection. Every business owner should be concerned about limiting their personal exposure to their business’ creditors and to lawsuits, which is something that corporations do not do well because individually-owned stock is not protected under state exempt property laws. Depending on the amount and value of the stock a shareholder owns, its loss could be financially devastating.
With an LLC however, there is no stock. Instead, the owner/s of the business own a “membership interest” in the business, which cannot be seized by a plaintiff in a lawsuit. Instead, a the plaintiff must get from the court a Charging Order against an owner’s membership interest. The Charging Order requires an LLC to pay the plaintiff the amount of the judgment in a lawsuit should the business distribute any money to the member who was sued. However, if the member who was sued controls the LLC, it could be a very long time before the plaintiff receives any of that money. This means that members of an LLC rarely lose their interest in the business because of a lawsuit and for this reason, it’s extremely rare for a plaintiff to gain control of the business.
It’s likely that LLCs will remain the bedrock of business planning for the foreseeable future. Compared to a corporation, they are easier and cheaper to set up and manage and offer significant tax advantages. Most importantly, LLCs provide business owners with a more formidable wall against lawsuits compared to corporations.
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