When planning their business, a question that has concerned many entrepreneurs is how they can protect themselves if the company fails. While they may not have much in the way of personal assets, they certainly do not want to be named in a lawsuit. Faced with such a dire prospect, how can a person efficiently run a business?
One of the simplest ways to protect yourself is to form a separate business entity. That way, the entity (not you, personally) takes the "hit" from any lawsuit that might occur in the course of your business. That's also why they are called "limited liability entities," because they limit your personal liability. Limited liability entities come in many forms including the C-corporation, S-corporation, limited liability company, limited partnership, professional corporation (or, in some states, professional association), limited liability partnership, and professional limited liability company. Like the dessert tray at a buffet, all will meet a particular need, but are slightly different in their form and composition, and some aren't right for everyone.
Many business owners opt for the S-Corp (named after Subchapter S of the Internal Revenue Code) for its special tax treatment or the limited liability company. Which will work best for you? Here is a review of some of the considerations that go into making the right decision.
1. Who will own the business? Some forms have restrictions on who, or how many, people can own it. For example, in many states, professional corporations can be owned only by people who are licensed members of the company's profession (e.g., only architects can own an architecture firm). Also, an S-Corp cannot be owned by foreign nationals who are not resident aliens in the U.S., so you could not use that form with overseas investors. An S-Corp can have as few as one, but no more than 100 owners (called "shareholders"). By contrast, a limited liability company (LLC) does not have these limitations, although in a few states, there need to be at least two owners. So ask yourself: Can I own the company by myself? Will others own it with me? Will I have investors (even family or friends) who are not U.S. residents? Am I a licensed professional? Your answer may rule out the choice of certain business forms.
2. Here, the important issue is whether you require any flexibility in distributing profits. If there is more one owner, and you are putting in the sweat equity and the other is the financial investor, questions arise as to how profits will be shared, and management control split. If you need flexibility in profit sharing, a limited liability company is best. The percentage of ownership or management control is not directly tied to the profit distribution. If you have a two person LLC, you can structure it such that you control 75% of the limited liability company but choose to receive only one quarter of the profits (for example, where the other owner is a substantial financial investor). This kind of flexibility is not available in an S-Corp as there is only one shareholder class and your share of the firm represents your share of the profits.
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3. Many small business owners pick the S-Corp because, under US tax law, it passes tax advantages through to the owner. The limited liability company (LLC) gets the same treatment. What does this mean? Very simply, any profits or losses earned by your business are "passed through" to you and you pay personal income taxes for these profits. The S-Corp and the LLC differ markedly from the C-Corp, which is subject to double taxation. Be mindful of state and local laws when you are making your choices. Some states do not allow a complete pass through and you have to pay state and local taxes. A limited liability company gets the same taxation treatment as a partnership. Profits pass through entirely to your personal income tax. Ask your accountant to run through different tax scenarios before finalizing your decision. You might find pretty marked differences from one type of business structure to another.
4. How much does the business structure cost? When you start a company, you need to file in the state of incorporation and pay a fee to the Secretary of State. However, the costs of maintaining a company can vary greatly from one structure to another. An S-Corp has more document and accounting requirements necessitating accounting fees, the appointment of company officials, and records of shareholder's meetings. An LLC has fewer regulatory requirements and is generally cheaper to maintain. Costs can vary greatly from state to state. In New York, for example, forming a LLC is markedly more expensive than the S-Corp.
It is important to pick the right business structure as it is difficulty and costly to change it later. It is advisable to consult with an attorney as well as an accountant before finalizing your decision.
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