It’s a question nearly every small business owner or entrepreneur has asked: Should I choose an S-Corp? A C-Corp? What about an LLC for my company? What are the differences between an LLC vs. a corporation? An S-Corporation vs. an LLC? Choosing your legal entity is a crucial choice when starting your new business and you should give it the consideration it deserves. And there’s no black and white answer either; the right choice varies by business.
Which entity you choose will have a big effect on your exposure to legal liability as the owner of the company, and will also help determine how much you and your company will pay in taxes come tax season. Another aspect your liability can affect? How much your business grows, and how much money you can raise. Read on to help make the best possible entity decision for you and your growing company, plus some other legal aspects to consider.
Should I Choose an LLC, a Corp, a C-Corp or an S-Corp?
There are three major kinds of entities that you will likely be choosing from for your business: a Limited Liability Company (LLC), a C-Corporation (C-Corp) or an S-Corporation (S-Corp). As with anything, there are pros and cons to each. We break it down below.
This is a traditional corporation, in which you can have unlimited shareholders, as well as varying classes of stock. With a C-Corp, there are unlimited fundraising options, and you can also go public, which gives you the benefit of a limited personal liability for business activities.
So what are the downsides? With a C-Corp, all net revenues are taxes twice, which is called “double taxation” – once on the corporate level and once on the individual shareholder’s tax return. Double taxation was, for many years, viewed as a sizeable burden for small business owners, which led to the formation of the LLC.
An LLC is a great choice for many small business owners. Here’s why: It protects the business owners from the liabilities and debts just like a C-Corp, but also provides many tax benefits. Like what? Well, you avoid double taxation, for one, and your net revenue is only taxed once on your individual income tax level.
An LLC also allows your business to grow and allows you to add additional members to your company as needed. You can also use different classes of ownership, (also called membership in an LLC), so you are able to have non-voting or non-managing members of your LLC. This allows you to build equity as you build your company.
A state classification, an LLC will usually act as a barrier between your personal and business assets should an issue arise. Worth noting: You must have a bank account set up for your business for this to happen and cannot combine your business and personal funds. And let’s face it: that isn’t a good idea, anyway.
One potential downside of an LLC: Not all liabilities and debts actually belong to the LLC. Many young businesses get credit or loans by providing a personal guarantee for that debt. So, if you’re a small business owner and provide your Social Security number or personal information to get financing, you will be personally liable for that debt, even if your LLC can’t pay it back.
Other downsides of an LLC are that if you plan to raise money or get investors, you will likely have to convert your LLC to a C-Corp. Overall, an LLC is probably the easiest business entity to set up, manage, and maintain.
Another option to choose from when forming your business, an S-Corp is essentially a tax election that arises when a business elects to be taxed under Subchapter S or Chapter 1 of the IRS code. Before electing for an S-Corp status with the IRS, you have to first have another entity for your company, called the “underlying entity.” In other words: You have to start off as either a sole proprietor or a partnership, an LLC or a traditional C-Corp. Then, you can make the leap to the S-Corp.
You might select an S-Corp because it provides many of the same tax benefits of an LLC, plus more. An S-Corp can save a business owner a significant amount of money in self-employment taxes, while with an LLC, all revenue is subject to self-employment taxes.
While each entity has its pros and cons, be sure to do your research and consult a CPA before making your final determination.
Additional Requirements for S-Corps
Worth noting: maintaining an S-Corp does take some extra work. There are several requirements one must fulfill in order to have an S-Corp status.
Number one: Shareholders must adhere to corporate formalities, such as holding both regular and special meetings, keeping minutes at said meetings, and using a written (and formal) corporate resolution to document all significant decisions made on behalf the business.
If you don’t maintain these corporate formalities, it can result in a whole host of tax ramifications, some of which are significant. They include double taxation, possible back taxes, and penalties, even being barred from using an S-Corp distinction for five years.
What many business owners don’t realize about S-Corps is that you will only really see significant financial benefits if you’re revenue is high enough – usually in the upper six figures. Be sure to talk to your CPA before opting for this designation.
Other considerations to weigh when deciding whether to use an S-Corp: there are limitations on the number of shareholders allowed, and you can only issue one class of stock to these shareholders. Shareholders also cannot receive special allocations of profits and losses, which could present difficulties when trying to raise capital from investors.
So What’s The Best Option?
Even though an LLC is not the ideal entity to use when fundraising, for many business owners, its advantages outweigh other options. For example, in an LLC business debt generally increases the membership tax basis, which means that members can deduct more business losses on their individual tax returns.
Additionally, the higher the investor or member’s basis, the less capital gains are possible, which translates into less tax when they sell their interest or sell the business.
So while an S-Corp provides lower self-employment taxes for its members, its inability to utilize business debts and losses may offset the benefit of a reduced self-employment tax. Plus, once you factor in its other limitations, it becomes clear that an S-Corp is only ideal or a small sector of business.
A good rule of thumb? When in doubt, an LLC is a good choice.
As a business owner or aspiring entrepreneur, you probably know you need to consider the legal aspects of business ownership. Yet many business owners invest in a business coach, fancy website and social media promotions, and push the “legal stuff” to the side.
But what many people don’t realize is that not dealing with the legalities of business ownership could cost them a lot more down the road – even their business. Potential legal concerns include: protecting yourself if a client stops paying, what to do if a client demands a refund, or is someone steals your content. A lawyer can help protect you against these types of situations, and more.
Think of a lawyer as insurance. Like you have health insurance to cover yourself if you in an accident or suffer an unexpected illness, having legal contracts and support in place before something happens can protect you – and your business.
Below are some things to have in place before going pro with your business.
You may be wondering exactly what an entity is: Essentially, it’s a type of business you are running, whether it’s a corporation, LLC, or sole proprietor. We’ve all heard of the terms: sole-proprietor, LLC, and Corporation — but what do they really mean?
If you are solely operating your business with your name (you = your business), then there is no need to involve the state at all. You can run the business with your Social Security number in lieu of a tax ID number, and simply add a separate Schedule C form when you file your taxes. (As always, be sure to discuss with your accountant first.)
While not dealing with the state sounds great, consider the following: This also provides you no protection, meaning there is no separation between your business and personal assets.
Let’s say you open your own business and provide a service to a new customer. Then something goes terribly wrong, and that customer sues you for $20,000 – and wins. Your business is worth $5,000, so they can collect that. As for the remaining $15,000? That comes from your personal assets – house, car, shoe collection, you get the idea.
If you had obtained some sort of business protection, such as liability insurance, you may have been able to protect your personal assets.
Where Should I Form My Business?
The answer to this one is relatively straightforward: You form the business in the state where you are going to operate said business.
In the era of working remotely and operating a business from home, it’s increasingly common for your home base to be more fluid. But, do yourself a favor and register your business in the state in which you operate. It will cut down on a lot of confusion.
In today’s world, a necessary part of running a business is your website. It’s your virtual storefront, where customers come to find you, and where you conduct your business. And with websites come a lot of copy, menus, and pages. Here’s what you really need.
Terms & Conditions
If your website is missing a terms and conditions page, you’re asking for trouble. Here’s why: The terms and conditions page acts as a contract between your business and all site visitors.
While it varies, basically, it protects you from potential legal action from site visitors and lets them know that you own all the content on your site.
Other Legal Assets You Need
Client or customer contracts are hugely important in the world of entrepreneurs, as they set the parameters for your relationship between you and your clients.
These agreements cover everything from the length of the relationship to the cost of the program or amount paid for work, what happens if payment is not made, dispute resolution, and governing law, among others.
Pro tip: Send the document in PDF form, that way you can be sure it wasn’t altered.
Independent Contractor Agreements
You may not want to have all workers as full-time employees since you will then be responsible for things like benefits and taxes.
An independent contractor relationship spells out that there is no employment relationship between you and the contractor, and they are responsible for filing their own taxes, and obtaining their own benefits, among others.
Independent contractors also cannot act as an agent of the company, meaning that they can’t enter into agreements with another person on your company’s behalf.
These are necessary for those individuals you plan on having a long-term working relationship with and want as representatives of your business.
As the business owner, you are then responsible for your taxes, and potentially their health benefits. This also means that they can represent your company in a public capacity and you have more control over their work schedule, location, and how work is completed.
Employees also should receive an employee handbook, which denotes their compensation, vacation and sick days, and company policies, among others.