Picking a business structure is critical to setting up a business. You have 4 options that you can go by:
• Sole Proprietorship
Each one, comes with its own Pro’s and Con’s and we will give you a snapshot and you can decide which one would be best for your business.
It is the simplest and easiest way to set up your business. It is an “unincorporated” entity, owned and run by you, there is no distinction between you and your business.
You are personally entitled to all the profits and liable for all your business’s losses, liabilities, and debts.
Advantages of Sole Proprietorship:
• Full Control: Since you are the sole owner of the business, you have full control over all the business decisions.
• Easy & Inexpensive: It is the simplest & least expensive business structure to set up if you don’t want to spend money.
• Easy tax preparation: You and your business are the same, so it’s easier to fulfill tax reporting requirements.
Disadvantages of Sole Proprietorship:
• Unlimited personal liability: Since you and your business are the same and there is no legal separation between you and your business; you can be held personally liable for all debts and business obligations. Please note that this risk could also extend on liability incurred because of your employee’s actions.
• Raising Money: You will have a tough time raising money because there is no company stock to give away. Banks & investors would be hesitant to invest in a company with sole proprietorship business structure.
Business is not taxed separately since you and your business are the same. Whatever you earn from the business, it will be considered as your income. You can learn more about tax obligations here.
LLC (Limited Liability Company)
LLC is Limited Liability Company is typically most popular business structure when you are starting out. It provides limited liability protection of a corporation & tax/operational efficiencies of partnership.
What does it mean? It means that your house, car and personal assets are protected in case of problems with the business. If someone sues you or files complaint about your business, only the assets owned by the business are liable, your personal assets are protected.
Forming an LLC:
While each state might have some variations for forming an LLC but they stick to these general principles:
• Pick a business name:
You can use the business name you selected in Step 1. There are 3 rules that an LLC should typically follow:
1, Your LLC’s name should be unique within your state. i.e. there should not be another LLC by a similar name in your state.
2, It must not include any words that might be restricted in your state eg: “banks” or “insurance.”
3, It must indicate that it is an LLC after the company name. eg: YourBusinesName LLC (or “Limited Liability Company”).
• File your Articles of Organization:
When you set up your LLC, you must file “articles of organization” which is a simple document that legitimizes your LLC. It will include information about the LLC, such as business name, mailing address, members names.
For most of the states, you will file it with Secretary of State but some states might ask you to file with different department eg: Dept. of Commerce and Consumer affairs, State Corporation Commission, etc. Check your state’s requirements and file accordingly.
• Obtain Licenses and permits
You must obtain licenses and permits for your business. e.g.: Sellers permit, business license etc. We will cover that in Step 4.
• Operating Agreement within LLC’s members
A majority of the states do not require you to file operating agreements but you must have an operating agreement for your company especially if there are more than 1 member in LLC. Operating agreement lays out your LLC’s structure i.e. equity distribution among its members, distribution of profits/losses, member’s rights, operational rules, and regulations etc.
Operating agreement will serve as guidelines when you get into disagreements with your members or if a member leaves.
• Announce your Business
Some states might require you to announce your business name in a local newspaper. Check with your state’s filing office to see if you need do this.
Advantages of LLC:
LLC protects its members from personal liability for any business decisions or actions. It means that if LLC gets sued, has debts etc. its member’s personal assets are protected and not liable. Please note that it means “limited” liability protection, even though its members are protected in general but they might not be protected from “wrongful acts.”
• Less Paperwork
The cost and paperwork to set up an LLC are much less as compared to setting up a corporation.
• Profit sharing
There are much fewer restrictions on profit sharing within LLC members and they can distribute profits as they see fit. Basically, it’s up to the members to decide who has earned what percentage of profits depending on how much work or capital that member has put in.
Disadvantages of LLC:
• Shorter life span:
If members of LLC leave the business, the business is dissolved and members must fulfill remaining legal and business obligations. You can prolong the life of your LLC by adding provisions in your operating agreement that clearly states, what will happen if a member decides to leave.
• Self-employment taxes
Since members of LLC are considered self-employed, they must pay the self-employment tax contributions. Check with your tax accountant to make sure you are following all tax rules.
The government does not consider LLC as a ‘separate tax entity,’ so the business itself is not taxed.
LLC is considered a pass thru tax entity, which means that you are only taxed on profits that you personally receive.
Learn more about tax obligations of an LLC here.
A C-Corporation is an independent legal entity i.e. the corporation itself owns it, and not the shareholders.
The biggest advantage & reason for creating a C-Corporation is if you are planning on raising outside capital and taking the company public.
Corporations are much more complex to create and manage because they have expensive admin fees and complex tax & legal requirements.
Forming a C-Corporation:
• Pick a business name:
Establish a business name and register the name with your state government.
If you choose to operate under the different name, you would need to file fictitious name or DBA (Doing Business As). Please note that it varies based on each state, so make sure you check requirements for your state.
• File Articles of Incorporation
Use online services or fashion lawyer to file Articles of Incorporation with your Secretary of State.
This would legitimize your corporation with the state.
• Create By-laws
By-laws are not required to be filed with the state but are required for you to have. They govern as rules/laws/guidelines that your corporation will abide by. e.g. it states how you will handle conflicts, what will happen if shareholders leave and/or share vesting schedule structure.
Basically, think of by-laws as laws your corporation will abide by when things go bad. You must give good thought to by-laws because it will save you lot of headache when there is conflict or things go bad.
You should have all the members/shareholders sign and agree to the by-laws.
• Licenses & permits
We will discuss that in next section.
Advantages of C-Corporation:
Your personal assets are protected from any liabilities incurred by the corporation.
• Raising money
Investors prefer corporations when they are funding a company because it is easy to distribute shares to different investors based on their investment.
• Corporate tax
Corporations are considered independent entity and they file taxes separately from their owners. Owners only pay taxes on corporate profits that they receive in form of dividends, salaries, bonuses etc.
Profits typically go thru corporate taxes which are usually lower than personal income tax.
• Attracting new employees
Corporations are more attractive to new employees because most companies will give stock options to employees. It enables them to attract high caliber employees.
Disadvantages of C-Corporation:
• Double Taxation
In most cases, corporations are taxed twice. First, when a company makes a profit and secondly, owners pay taxes on dividends/bonuses they receive.
• Expensive to maintain
Corporations are costly and time consuming to maintain. There is lot paperwork that needs to be maintained, e.g.: corporate meetings, meeting minutes, quarterly taxes etc.
Corporations can be taxed twice. First, when they make a profit and secondly, the owners are taxed on salaries/dividends/bonuses they receive.
Corporations are required to pay federal, state and in some cases, local taxes. You can read more about tax requirements here.
If you are starting out and not planning on raising money anytime soon, creating a corporation might be too much for you and LLC could be better option.
In simplest terms, S-Corp is an amalgamation of LLC and C-corp. Before LLC was created, S-Corp used to be the preferred structure for businesses especially when they were starting out.
The biggest benefit of S-Corp is it help you avoid the double taxation that C-Corps can be exposed to.
What makes S-Corp different from C-corp is that profit/losses can pass thru to your personal taxes and business is not taxed itself, only the shareholders are taxed.
But, there is one caveat, any shareholder that works for the S-corp must pay themselves a “reasonable compensation” which must be fair market value. Because if not, then IRS might reclassify any additional corporate earnings as “wages.”
Forming an S-Corp
Typically, steps are same as you did in C-corp. You file it as a corporation and after you are established as a corporation, you must sign & file Form 2553 to become an S-Corporation.
Once you are registered, you must get your licenses, permits, by-laws etc. as you would in the case of C-Corporation.
Advantages of S-Corporation
• Tax savings
One of the biggest advantages of S-corporation is tax savings. First, you don’t get charged double tax as in the case of C-corporation. Secondly, as members of LLC are subject to employment tax on the entire business income. The salary/wages of the S-Corp shareholder (aka employee) are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at lower rate.
• Business expense tax credits
You can write off your expenses as ‘business expense.’
• Prolonged life
S-Corp as an entity has a prolonged life. If a shareholder leaves the company or sells their share, the S-Corp continues to keep doing its business.
Disadvantages of S-Corporation:
• Limited shareholders
You can only have up to 100 shareholders under S-Corp.
• Strict operational process
Since S-Corp is a separate entity, it requires owners to have regular director & shareholder meetings, meeting minutes, a record of changes to by-laws, stock transfer etc.
• Shareholder compensation
As mentioned earlier, as a shareholder you must pay yourself “reasonable compensation.” IRS keeps an eye on it and if it is not executed properly, it can raise a red flag for IRS and you could get audited.
All states tax S-corps differently, so check with your accountant about requirements about your state. You can visit IRS page to learn more about tax obligations of S-corp.
As you can see, there are multiple structures when starting a company and each offers different advantages & disadvantages.
If you are starting out, LLC might be the best bet for your because it is easy to set up and maintain. This is our recommendation but you should always do your due diligence to determine what is best for you.
There are various ways to register your company and our goal is to provide best possible resources for you.
Company Registration Services & Lawyers:
Disclaimer: This information is provided to serve as a guideline for you. We are not a law firm and are not offering legal advice. We highly recommend you should do your own due diligence and consult a lawyer if you need to make sure your business is set up correctly.