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Protect Your Family & Your Business with the Right Legal Entity

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One of the most common mistakes entrepreneurs make when starting a small business is selecting the wrong kind of legal entity for their business.

It’s common to think, “I’ll wait until we grow some before I spend the money to form a corporation or LLC.” But delay in selecting the right legal entity when starting a small business can wind up costing a lot of money in higher taxes, as well as creating a potential legal disaster for the entrepreneur’s family.
An entrepreneur who doesn’t take steps to set up a legal entity when starting a small business is automatically treated as a sole proprietorship. This means that the business isn’t eligible for many of the tax deductions available to other kinds of business, and the business owner can be held personally liable for the debts of the business, or any legal judgments against it.
Also, sole proprietorships are nearly 3 times as likely to be audited by the Internal Revenue Service as are other kinds of business tax returns—even though nearly 72% of all business tax returns filed each year are from unincorporated businesses.
There are three primary major types of business entities, including a Limited Liability Company (LLC), S Corporation (S-Corp), or C Corporation (C-Corp). There are also several kinds of business partnerships that are the best choice for some entrepreneurs.
Regardless of the kind of business entity that’s right for your new business, the benefits are clear:
  • Secure and protect your personal and family assets
  • Gain access to valuable tax deductions
  • Generate credibility among clients and potential partners
The LLC: Pass-Through Taxes & Flexibility
A Limited Liability Company (LLC) provides limited liability protection to its members. In most circumstances, members of an LLC are not personally responsible for debts and liabilities incurred by the company. This limits the ability of a creditor to pursue the personal assets of the member(s) to repay business debts. These protections are not typically afforded to sole proprietorship or general partnership. A limited liability company (LLC) also has certain tax advantages.
The advantages of an LLC include:
  • Limited liability protection. Owners typically are not held personally responsible for business debts and liabilities.
  • No residency requirement. Owners are not required to be U.S. citizens or permanent residents.
  • Pass-through taxation. Typically an LLC does not pay taxes at the business level. The profit or loss is reported on the owners’ personal tax returns and any taxes due are paid at owner’s individual tax rate.
  • Flexible management. Limited liability company owners have flexibility in structuring company management.
  • Fewer ongoing formalities. Compared to a Corporation, LLCs have less stringent annual paperwork requirements.
  • Lower audit risk. Typically an LLC is audited less frequently than a sole proprietorship.
  • Consent to add additional members. Written consent of LLC members must be obtained prior to increasing ownership in the company or adding new owners.
The disadvantages of an LLC include:
  • Limited taxation control. An LLC cannot engage in corporate income splitting to lower tax liability.
  • An LLC cannot issue stock. By issuing stock you could potentially attract investors.
The S-Corp: Pass-Through Taxes & No Double Taxation
S Corporations (S-Corp) are Corporations that have elected a special “Sub Chapter” tax election with the IRS. S Corporations provide the same limited liability to shareholders as Corporations; however, S Corporations are taxed as a pass-through entity. S Corporations do not pay taxes at the corporate tax rates; they are instead required to file only an informational tax return while any profit or loss is reported on the shareholder’s personal tax return, which is taxed at the personal income tax rates.
The advantages of an S Corporation include:
  • Limited liability protection. Owners typically are not held personally responsible for business debts and liabilities.
  • Easy transfer of ownership. Ownership is easily transferable through the sale of stock.
  • Pass-through taxation. Typically an S Corporation does not pay taxes at the business level. The profit or loss is reported on the owners’ personal tax returns and any taxes due are paid at the individual level.
  • Unlimited operations. When a corporation’s shareholder incurs a disabling illness or dies, the corporation can continue operations.
  • Elimination of double taxation of income. Income is taxed only once as a pass through entity; compared to a C Corporation, which is taxed once at the corporate income level and again as dividend income paid to the shareholder.
  • Raise capital. Additional capital can be raised by selling shares of stock to investors.
  • Credibility. Forming an S Corporation may help your business be perceived as a “professional” business than compared to a sole proprietorship or general partnership.
  • Lower audit risk. Typically an S Corporations is audited less frequently than a sole proprietorship.
  • Self-employment tax savings. An S Corporation can help minimize the self-employment tax, since owners who work for the business are classified as employees.
To qualify for as an S-Corp, the corporation must meet the following requirements:
  • Be a domestic corporation.
  • Have only allowable shareholders including individuals, certain trusts, and estates. Partnerships, corporations and non-resident alien shareholders are prohibited. (This means that an S-Corp cannot raise capital from a venture capital firm.)
  • Have no more than 100 shareholders.
  • Have one class of stock.
In addition, some kinds of corporations cannot be organized as an S-Corp, including certain financial institutions, insurance companies, and domestic international sales corporations.
The C-Corp: Tax Deductions & Paperwork
A C Corporation may not be the best choice for small or mid-size business owners, but they offer significant advantages in some circumstances, especially for start-up companies that are raising money through venture capital or angel investment.
The advantages of a C Corporation include:
  • Limited liability protection. Owners typically are not held personally responsible for business debts and liabilities.
  • Easy transfer of ownership. Ownership is easily transferable through the sale of stock.
  • Unlimited shareholders. A C Corporation is not limited to a certain number of shareholders, such as an S Corporation, which can have no more than 100 shareholders.
  • Unlimited operations. When a corporation’s shareholder incurs a disabling illness or dies, the corporation can continue operations.
  • Raise capital. Additional capital can be raised by selling shares of stock to investors.
  • Credibility. Forming a C Corporation may help your business be perceived as a “professional” business than compared to a sole proprietorship or general partnership.
  • Lower audit risk. Typically a C Corporations is audited less frequently than a sole proprietorship.
  • Self-employment tax savings. A C Corporation can help minimize the self-employment tax, since owners who work for the business are classified as employees.
The disadvantages of a C Corporation include:
  • C Corporations face the most extensive ongoing formalities of any business type.
  • A C Corporation’s profits are taxed when earned and taxed again when distributed as shareholders’ dividends, this is also known as “double taxation.”
  • Shareholders in a C Corporation are not eligible to deduct business losses, since a C Corporation is not a pass through entity.
  • Each Corporation must present financial statements to its shareholders. This is often done via a copy of the income tax filing for the corporation.
  • If a C Corporation is publicly traded, it must follow the requirements of the Sarbanes-Oxley Act.
This article was originally published by 1800 Accountant
Gary Milkwick is Vice President at 1800Accountant.com, a tax preparation and consulting firm based in New York City that serves thousands of small business owners.  Gary previously worked with Fortune 500 clients at PricewaterhouseCoopers, and with a regional accounting firm in Atlanta, Georgia that provides tax and consulting services to small business owners.
 
Gary earned B.S. of Accounting and Master of Accountancy degrees from Brigham Young University and an MBA from UCLA’s Anderson School.  He holds Series 7 and 66 securities licenses.  He is a licensed CPA with the Personal Financial Specialist designation in New York and Georgia.
Published: July 12, 2013
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