Starting your own business is easy. It is an automatic process from a legal perspective: as soon as you start trading, you have a sole proprietorship. Setting up a company so that your assets are separate from those of the business… that is another story. There are various types of business entities to choose from, each with their own implications for how your business is owned, managed, and taxed.
Choosing the right form of business for your unique circumstances has far-reaching consequences. Use this guide as a guide to help you choose between the most common types of business entity: the Limited Liability Company (LLC), the C-Corporation, and the S-Corporation.
The Limited Liability Company
An LLC is a relatively simple company structure, and very popular for that reason. It is a separate legal entity in the eyes of the law (in other words, its assets and liabilities are separate from those of its owners). The LLC is owned by its members (or by only one member), and membership is expressed in the membership agreement (either as a percentage or as membership units).
The income of the LLC flows directly to its members. They are then taxed on that income. The benefit here is simplicity: no need for the LLC to file its own tax returns. The disadvantage, of course, is that the members have this additional tax liability to take account of and deal with.
The LLC offers several significant advantages. First, the simplicity and ease with which it can be formed. Secondly, the protection that it offers members: they are not personally liable for the company’s liabilities and obligations. Thirdly, there is no residency requirement to form an LLC – you can form an LLC even if you are not a resident of the United States. Fourthly, the LLC itself is not subject to federal income tax.
Finally, there are very little rules and requirements for how an LLC is to be run day to day. All of this can be determined in the membership agreement. It makes the LLC flexible, and allows you to run your business without too much concern for corporate governance reporting requirements.
However, the simplicity and relatively little regulatory and reporting requirements associated with the LLC is also the source of its disadvantages. This business structure does not have to pay tax, but its members do. This means that the company often has the obligation to pay cash to members to cover tax obligations – it limits the entity’s ability to reinvest cash. It also means that any tax exempt entity (for example, public funds that invest in VCs) can’t be members, because they are not allowed to receive business income. Finally, ownership of the LLC is not flexible and scalable in the same way as as that of a corporation. A corporation can easily issue and sell shares. If you are planning to seek investment, therefore, an LLC is probably not your best option.
The C Corporation
A Corporation is a legal entity that has, similar to an LLC, a separate legal existence from that of its owners. It differs from an LLC in two main respects: firstly, it is subject to federal income tax. Secondly, it is owned by shareholders (who each own a percentage of the total shares of the company), and managed by a board of directors. Its biggest advantage is that it is the ideal business entity type to use if you are interested in raising funds by issuing equity.
The fact that a C-Corp’s ownership is attached to shareholding makes it easy and simple to distribute equity in exchange for investments. Shareholding and shareholders’ rights also allow for the creation of preferred shares (and different classes of shares) that can carry specific rights and protections.
Another reason why investors prefer the C-Corp is that it is itself subject to federal income tax. This means that the shareholders are not taxed on business income. Finally, a C-Corporation’s separate existence from its owners and managers also ensures its continuity.
As for the disadvantages: the benefits of a C Corp comes at the cost of increased regulatory scrutiny. It is much more complex and expensive to form a corporation, and the reporting requirements that corporations face are much more extensive than those imposed on simpler business structures. This means increased requirements for how the business is run, including board meetings, shareholder meetings, keeping meeting minutes, and creating bylaws.
All corporations share the same basic structure set out above for C Corps. There is one further refinement on the corporations structure: S-Corps.
S-Corps are essentially C-Corps that are owned by a relatively small number of investors, all of them natural persons. An S-Corp can function as a corporation whilst its shareholders are taxed for its income (similar to the tax arrangement we saw for LLCs).
Any C Corp can file IRS Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS). If the corporation meets the requirements, it will be taxed as a partnership. The most important requirements are that all shareholders are natural persons (i.e. not business entities) and that there are no more than 100 shareholders.
If you are a relatively small business, an S-Corp allows the benefit of simplified tax returns (you are taxed on the income in your own hands, and the business is not subject to income tax). This is the biggest advantage that this business structure offers.
The disadvantage is that S-Corps are, by nature, not very scalable. You cannot have more than 100 shareholders. In addition, the fact that those shareholders must be natural persons excludes any potential commercial investors and VC funds from investing in your company.
How to Choose
The most important question to ask, is: do you want to engage in equity fundraising in the future? If so, you should definitely incorporate as a C-Corp, for all the reasons mentioned above. If not, you might be better off with an LLC or S-Corp. This will depend on how dispersed ownership is (if you are only a few owners, consider an LLC), and how much you rely on the continuity of your company (if you place a lot of value on continuity, opt for an S-Corp).
Business Formation Lawyers at LawTrades
Finalize your company’s legal business structure without delay. You can do it today, with accessible, affordable, and convenient legal assistance from LawTrades. Setting up a company has never been this seamless. Talk to one of our experts today!