Choosing the Right Business Form

Date: October 16, 2018

Whether you are already running a successful business or just getting started, it’s a good idea to think about incorporating. And depending on your circumstances, it may be prudent consider switching corporate forms if you are already incorporated. Yet of course, there are many factors to consider.

Each corporate form offers advantages and disadvantages that may have a huge impact down the road. This article highlights key points about each business form, discussing: (1) ease of formation; (2) how the business is controlled; (3) how the business is taxed, and; (4) whether the owners are shielded from liability.

Sole Proprietorship and Partnerships

Formation: Sole proprietorships and partnerships are the easiest types of business to form. You may start a sole proprietorship without any formality simply by holding your services out to the world. Similarly, a partnership is formed automatically as soon as two or more people begin operating a business for profit. All that is needed is an oral agreement to work together with your business partner. That said, its a good idea to have a written partnership agreement to make clear everyone’s expectations from the start.

Control
: By default, partners are co-managers of the business. If there is a significant dispute, a simple majority vote controls. However, partnership agreements give partners significant freedom to vary the structure of the partnership. Generally, the terms of the partnership agreement will override default partnership rules—including agreements on how profits are to be divided.

Taxation
: Sole proprietorships and partnerships are pass-through entities. The individual partners report income and losses from the partnership as ordinary income on their personal taxes.

Liability
: Sole proprietors and partners are fully liable for the debts and liabilities of the partnership. This means your personal assets are vulnerable when operating as an unincorporated sole proprietor or partnership.

Limited Liability Company (LLC)

Formation: An LLC is created by filing articles of organization and paying a filing fee—usually with your Secretary of State. Although technically not required, most LLCs will also want to create an LLC operating agreement, which spells out everyone’s expectations about how the company will be run.

Control
: Most LLCs are member-managed. In case of a dispute, a majority vote controls. However, LLCs have considerable freedom to define their management structure in the LLC operating agreement. The terms of the LLC operating agreement override default statutory rules, which may otherwise apply.

Taxation
: LLCs are pass-through entities. LLC members report income and losses from the LLC as ordinary income in their individual tax filings.

Liability
: LLCs shield the members from individual liability. Members are only liable to the extent of their investment in the LLC. For example, if Bob invests $100 into Bob’s Burgers, LLC, the most that he could lose is his $100 membership interest.

Corporations

Formation: Creating a corporation is significantly more complicated. The corporation must appoint an initial board of directors and file articles of incorporation, along with a filing payment. The corporation then creates corporate bylaws with the operating rules for the corporation. Finally, the corporation issues shares of stock.

Control
: A corporation is managed by its board of directors. The relationship between the board of directors and the shareholders is detailed in the corporate bylaws. Most corporations have board-appointed officers (e.g. CEO, CIO, etc.) to handle daily operation of the company. Accordingly, a shareholder may also be appointed as an officer with a set salary.

Taxation
: Corporations are taxed twice. First, they pay a corporate tax on earnings. Second, these earnings are taxed (again) when distributed to shareholders via dividends. That said, there may still be important tax benefits, which you should discuss with your CPA or tax counsel. For example, the federal tax reform of 2017 lowered the tax rate for c-corporations.

Liability
: Shareholders are shielded from individual liability. Directors and officers are shielded as well, but may be liable if they breach their fiduciary duty to the corporation, or if they commit fraud or for wasting company resources.

S Corporations (S corps)

S corporations are a special form of corporation. Unlike normal corporations, the IRS allows S corps to be taxed as pass-through entities—meaning that individual shareholders are taxed on the gains and losses of the S corp at ordinary income tax rates, i.e., with their personal tax filings. In exchange, S corps are strictly monitored and have some additional restrictions. For example, they must have fewer than 100 members, they may only have one class of stock, and only US citizens and permanent residents may be members.

For more information about S corps, consult this IRS guide.

Observing Corporate Formalities

One final note about LLCs and Corporations: the liability shield applies only if the company observes corporate formalities. As a rule, the business owner should not treat the company as an “alter ego.” For example, you can get into trouble comingling company and personal finances, for failing to hold board meetings, or by failing to comply with your operating agreement or bylaws. Courts may “pierce the corporate veil” and hold business owners liable if they do not observe these corporate formalities.

Get Expert Help

While this article was intended to be as general as possible, it is important to bear in mind that business law varies state-by-state. Accordingly, it is highly advisable to work with a trusted CPA or tax attorney licensed in your state. While it may be possible to go it alone, its always prudent to work with a professional to ensure that you are choosing the best corporate form and that you are covering all your bases with the required filings.

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