If you are one of the 27 million Americans starting or running a business, you might have some questions on how to keep your venture from going under. One way to ensure success is to think critically about which business structure is right for you. New businesses are often formed as an S corporation (Inc.) or a Limited Liability Company (LLC), with the LLC being the more popular choice. According to the United States Small Business Association (SBA), “LLCs increased by 11.3 percent over the previous year for a total of 1.6 million of these entities for 2006 (the most recent year for statistics)."
There are quite a few similarities between the two, but the differences are distinct and can have a huge impact on your operations; When you’re laying the foundation for your new business venture, don’t skip over the details.
“You should have good legal, tax, accounting, financial advice any time you’re building a business,” advises Richard Lieberman, a business organizations attorney with Jennings, Strouss & Salmon. “Plan for change, plan for growth, plan for your exit. Because if you take spend time setting up your company up right in the beginning, you can maximize your return at the end.”
Selecting the appropriate structure for your business is crucial. For this reason, an experienced business attorney may be useful in determining what option is best for your unique needs.
Similarities between structures
Both LLCs and S corporations offer limited liability protection. In layman’s terms, your personal assets have some protection if your business is ever sued. In contrast, if you chose to run your business as a sole proprietor, those assets would be fair game. The other main similarity is that both LLCs and S corporations offer pass-through taxation. Business income and losses “pass through” to the business owners rather than getting taxed at company level.
Navigating the tax benefits of each structure is something you would do with your attorney when deciding how to file.
“There are ways for corporations to avoid paying capital gains taxes on a large portion of their gain, not just getting it at a lower tax rate but not having to pay any tax under certain government programs or being able to defer the tax in other circumstances,” says Lieberman. “But the choices they make at the beginning can impact their ability to take advantage of those programs.”
Benefits of an LLC
LLCs offer more flexibility when it comes to allocation of business income and losses, as well as the overall management of the business. For example, LLC profits and losses can be allocated disproportionately among owners, whereas the profits and losses in an S corporation must be based on ownership percentage. Single-owned businesses can also benefit from the LLC structure because the business owner can include profits and losses on the Form 1040 individual tax return.
If you decide to form an LLC, it is in your best interest to hire legal counsel to assist you with the process. Setting up an LLC involves:
- Selecting an available and compliant name for your LLC. In addition to not being in use by another LLC and ending with an LLC designator (such as Limited Liability Company), your chosen name must also comply with your state’s rules.
- File the articles of organization. This is the general term given to the formal paperwork that must be filed, along with payment of your filing fee, which typically ranges from $100 to $800.
- Create your LLC operating agreement. This important document establishments the rights and responsibilities of all members of the LLC.
- Obtain required licenses and permits. This varies widely from state to state.
Benefits of an S-Corp
While there are many benefits to forming an LLC, that particular business structure is not without its shortcomings. Venture capitalists and angel investors often prefer investing in corporations over LLCs. As such, if you think you’ll ever want to seek additional funding for your business, you may be better off forming an S corporation from the start. But the primary advantage of forming an S corporation is that it enables the business to reduce its tax bill through the payment of both salary and dividends. And if you anticipate ever going public, switching from an S corporation to a C corporation is easier than converting from an LLC. That said, not all businesses will qualify for S corporation status.
In order to be eligible to set up an S corporation, your business must:
- Be domestic
- Only have allowable shareholders
- Only include individuals, certain trusts, and estates and
- Not include partnerships, corporations or non-resident alien shareholders
- Have a max of 100 shareholders
- Have no more than one class of stock
- Not be ineligible based on certain criteria
Setting up an S corporation is similar to an LLC in that you must first make sure your chosen business name is available, prepare articles of incorporation, and prepare corporate bylaws. Corporate bylaws serve to lay out your company’s rules, and the positions and duties of each officer. Even if bylaws are not required in your state, it is in your best interest to maintain them for your own business needs. They can be extremely useful if, and when, disputes arise. Finally, you will need to obtain required state and local permits and licenses. Filing an S corporation is not difficult, but resolving mistakes you made in the process can be.
Contact a professional
While there are many areas you might skimp and save on when you’re in the frugal stages of launching your business, professional legal advice is not one of them. A qualified business attorney can be invaluable in offering insight to areas you had no idea you needed to know. Lieberman says that a good attorney will help you determine the structure of your business by “working with a client in terms of their proposed projected income and the tax impact of that, their financial arrangements and their anticipated investors, how long they intend to be operating the business, whether they expect to have losses in the early years or will be earning income rapidly, liability protection, and whether they’re dealing with international investors. Those things all impact the choice of entity.”
Choosing the right business structure from the start will save you countless headaches—and money. Don’t attempt to navigate this complex process on your own. A skilled tax or business organizations attorney can help you determine what options are best for you.