If you're starting a business, you have likely contemplated which legal entity formation to choose. While there are not an endless amount of options (there's really only 3 big ones), it's important to carefully weigh the advantages and tax ramifications of each, and choose the best legal and tax structure for your business needs. Typically, the legal formation you choose also comes with a default tax structure, so you will want to be aware of this and make sure no other elections are needed for your desired tax status.
Sole proprietorship
The most basic (and most popular), and yet the least advised form of start up entity, is the sole proprietorship. By default, if you do not choose any form of legal entity (i.e. LLC or incorporation under state laws), your form of organization will be considered a sole proprietorship. While the intention of the sole proprietorship is to make it administratively easy to start a business, it comes with serious drawbacks, primarily the lack of legal protection. Without a corporate or LLC shield, your assets will be at risk in the event of a legal suit. You may, however, be able to mitigate this risk with a business owner's liability policy that would protect your personal assets in the event of a lawsuit. For tax purposes, a sole proprietorship will report its profit and loss on schedule C of the owner's Form 1040.
LLC
Widely becoming accepted as a comparable alternative to a corporate entity, an LLC typically presents a legal formation process that is less burdensome and also allows more flexibility in regards to how owners can participate in the profits and losses of their business. An operating agreement can be devised that spells out how the business will be run, how income will be distributed, and the roles and responsibilities of the owners or members.
It is important to distinguish between a single-member LLC and a multi-party LLC.
Single-member LLC
A single-member LLC (SMLLC) is an LLC created with only one owner/member. By default, an SMLLC will be taxed like a sole proprietorship, with all your income and expenses reported on Form 1040 Schedule C. However, at your discretion, and provided you meet the requirements, you may elect to be taxed as an S corporation. Many small business startups will benefit from the tax structure of an S corporation which allows you to limit your self-employment tax to the wages you pay to yourself. In other words, the profits of the business itself, is not subject to payroll taxes, just federal and state marginal tax rates. For certain corporate pay structures and higher business income levels, this benefit can be significant.
On the legal side, because an SMLLC is you and only you, there is also much less professional advising needed on the legal agreement. A typical registered agent service will provide state entity formation, an operating agreement template, and registered agent service for a year for $200-300.
Multi-member LLC
A multi-member LLC, i.e. an LLC in which more than one person or entity make up the members of the LLC, will default to the partnership taxation rules of Subchapter K of the Internal Revenue Code. Not only are the tax consequences of partnerships unique, having a multi-member LLC will force you to have a very clearly defined business plan with roles and responsibilities assigned to each partner. A lawyer should be consulted for the formation of a multi-member LLC, as there is much more information that needs to be analyzed and determined if it is a suitable agreement for you and the other parties.
As noted, a multi-member LLC is taxed as a partnership, and with it comes rigorous tax complexities, as well as the challenges of navigating a business with multiple parties. On the upside, a partnership offers a great deal of flexibility for allocating the profit and losses of the business. For example, if you would like to open a cost-intensive business such as a restaurant, a financier can ensure that all of their money is recouped before profits are allocated to other parties. You will not have such flexibility under corporate rules, as all distributions and profit must be allocated pro-rata based on the shares owned in the company.
Incorporation
Another avenue to create a separate legal entity for your startup, other than an LLC, is to formally incorporate under state laws. The corporation is the most formal of the legal structures and typically requires more administrative upkeep and documentation than an LLC. However, start up businesses that have the intention of seeking venture capital or going public can benefit from the rigidity of the corporate structure. Also, as a corporation, you will have the option of electing to be treated as an S corporation and avoid the double taxation of a C corporation. It's important to note, however, that you do not need to formally incorporate in order to be treated as an S corporation for tax purposes. As previously noted, an LLC may also elect to be treated as an S Corporation without the legal and maintenance requirements of maintaining a corporation.
Conclusion
For most small businesses, an LLC is the happy medium for a startup venture. It provides a legal shield and separation between your personal and business assets, as well as flexibility on how you may be taxed. Regardless of which legal formation you choose, one of the most important things to keep in mind is to separate your business and personal assets. Open a bank account in the business name, use accounting software to track expenses, and treat your business as separate from yourself. Not only is it a best practice for the success of your business, but it will also help ensure that you do not "pierce" the corporate or LLC veil and thereby expose your personal assets to legal risk.
Please consult your financial advisor, lawyer or accountant for financial, legal, and tax advice specific to your situation. Cedarmill Financial does not provide tax or legal services and any of the content on this website should not be construed as legal or tax advice.
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