Your business entity structure is one of, if not the most consequential, decisions you make when starting a company. It can shape everything from how much taxes you pay to what kind of records you're required to keep and even your ability to finance your enterprise.
If you are unsure of what business entity type to choose, consider these four options: a sole proprietorship, partnership, corporation, or limited liability company (LLC). Keep in mind that a sole proprietorship or partnership is the default choice if you take no action. We have not mentioned an S-corporation, B-corporation, public-benefit corporation, or nonprofit, nor a trust here. And that is because these are all types of corporations. While a trust can own an entity, it is not the entity itself.
The business legal entity you choose shelters your company, similar to how a container protects its contents. This decision is unrelated to who owns the business (it could be through a trust or by you individually) and also distinct from how that entity is taxed (which could be as an S-corporation or as a tax-exempt nonprofit).
In last week's post, we went over the first two out of five questions to ask yourself before settling on a legal entity for your company. This week, we'll finish going over the remaining three questions. These queries can assist you in choosing Your Company's Entity, but you should always confer with us—Your Family Business Lawyer™—before making your final decision.
3. In What Manner Would You Like To Be Taxed?
The way your business is taxed also corresponds with how much liability exposure your company has. As we discussed previously, if you run a sole proprietorship or partnership, you and the other owners are one and the same as your business, legally speaking. Therefore, whatever percentage of profits or losses your company garners is reported on your personal income tax return and taxed at whichever rate that may be.
In comparison, your business is considered a separate legal entity under C-corporation for both liability and taxation purposes. As a result, the corporation pays taxes at 21%, the new flat corporate tax rate set by the Tax Cuts and Jobs Act. Then after-tax profits are distributed to shareholders, who will be taxed again at their personal rate. This system of "double taxation" means that not only does the corporation have to pay tax first, but then so do the shareholders -- essentially being taxed twice.
Fortunately, you can still obtain the liability protection and tax advantages offered by a C-corporation by setting your business up as an LLC, even though very few small or mid-sized businesses are set up as C-corporations.
LLCs have the advantage of flexibility when it comes to taxes. If you don't choose to be taxed as a corporation, single-member LLCs are automatically taxed as sole proprietorships, while multi-member LLCs are taxed as partnerships. In any case, your company won't pay taxes on its profits. Your share of the net business income is what will be taxed on your personal tax return. You'll end up paying taxes based on your personal income tax rate."
You can also choose to have your LLC taxed as an S-corporation. In this case, you will file a tax return for the corporation and include all income and expenses from that return. The company does not pay taxes but instead gives shareholders a K-1 form with the net profit. Shareholders then report that amount on their personal tax returns as ordinary income.
The most significant perks of being taxed as an S-corporation only have to pay payroll taxes on your income and reduced audit risk in comparison to a sole proprietorship. With the latter, all profits are considered part of your payroll and, therefore, subject to taxation. Lastly, since expenses and income from an S-corp are reported separately from personal entities, there is less chance for an IRS audit.
If your business is taxed as an S-corporation, you will pay income taxes on your profit distributions. Although, If you take the distributions as profits instead of payroll, you will save roughly 15% in payroll taxes because you don’t have to pay them on income from a profit distribution. On the other hand, if using an LLC taxed as a partnership or sole proprietorship, you will have to pay payroll taxes on all distributions to you from the LLC until reaching the limit for Payroll taxes.
In order for an S-corporation election to make sense, you’ll ideally have around $60,000 or more in net income per year. If you are close to that margin and have not filed an S-corporation election yet, reach out to us so we can get started on supporting you. Otherwise, if you want help choosing the entity that will offer the most tax advantages, set up a meeting with us—your Family Business Lawyer™ or Certified Public Accountant (CPA). We would be happy to discuss all of your options with you in detail.
4. What Type of Records Are You Willing to Keep?
Although neither sole proprietorships nor partnerships provide any legal safeguard from the liabilities or activities of the business, both entities are incredibly easy to initiate and keep up with. For example, if you're starting a new business by yourself, by law, you are automatically classified as a sole proprietor. Similarly, if there's more than one owner for your enterprise, then it is legally seen as a partnership. In either situation, you don't need to register your venture with the state government, nor do you have to file any documentation. You also won't be charged any fees, and there aren’t rules...
The liability protection and tax advantages of an LLC or corporation come with several corporate formalities that you must complete. If these are not followed, the court could lift the protective barrier around your personal assets in a legal process known as “piercing the veil.” This would make you personally responsible to creditors if they file a lawsuit and win.
Administrative formalities for C-corporations are usually more strict and extensive. For example, you would need to file articles of incorporation with the state, have regular meetings with shareholders and directors, create corporate bylaws, as well as maintain records such as meeting minutes. In addition to that, annual financial reports must be filed with the state every year, and there are also yearly fees payable to keep your corporation status active.
LLCs have some administrative formalities, but they are much less strenuous than those of C-corporations. For example, as the owner of an LLC, you must submit articles of organization to the state and draft an operating agreement, which outlines how your LLC will be constructed and operated. Plus, every state necessitates that LLCs file either an annual or semi-annual report with the agency in charge of registering business organizations.
Although LLCs aren't legally required to hold owner meetings or keep minutes, it's beneficial to do so since it demonstrates that you're following corporate formalities. Additionally, by keeping careful records and separating your personal and business finances, you can help protect your LLC from creditors.
If you would like to establish your business as an LLC or corporation, we can help you take care of the required paperwork and maintain your records. We offer special maintenance packages that make keeping up with these requirements easy and effortless while still providing maximum protection for your personal assets.
5. How Do You Plan to Pay for Your Business?
Your company's form will also affect your ability to finance it. Before securing funding, you must decide what type of investment is best for your business: equity or debt. In other words, are you looking for an investment that gives someone a partial ownership stake in return (equity), or getting a loan to be better suited to financing your needs (debt)?
In other words, if you don't set up your business as a corporation, you'll probably have to finance it solely through debt because most investors—including banks—are unwilling to invest in businesses that aren't corporations. The main reason for this is that sole proprietorships and partnerships offer little-to-no protection from liability.
When backing a business, investors want to lessen their risk and grow their return. Because of this, they will typically prefer to invest in companies that offer liability protection for the owners. This means that if you can't repay the loan, they wouldn't have to go after your personal assets- which are often more difficult to take than business assets.
Not only do corporations and LLCs offer liability protection, but these entities also give your company greater credibility and legitimacy- two qualities that potential investors find quite attractive. Unfortunately, setting up and maintaining a corporation or LLC requires significant financial investment as well as administrative formalities. However, this show of dedication on your part lets investors know that you are willing to invest both money and time into making sure your business is run properly.
If your company is a sole proprietorship or partnership, you'll probably have to take out loans from personal sources instead, such as loved ones, home equity, or credit cards. While LLCs provide their owners with protection from liabilities and increased credibility, they cannot issue shares of stock like corporations can. So even though an LLC might be a more appealing investment than sole proprietorships and partnerships, owners will probably have to finance their company through debt if they want to maintain control over it.
If your business isn't bringing in a consistent income, most banks won't give you a loan. But don't worry! Nowadays, there are many types of alternative financing for small businesses, including crowdsourcing, peer-to-peer lending, SAFE investments, SBA loan invoice financing, and credit card stacking. No matter what kind of company you have set up, if you need help securing funding, we're here to help. As your Family Business Lawyer ™, we'll go over all the options available to get you the money your business needs to succeed.
Outside investors can buy shares of stock from owners of C-corporations and S-corporations, who are known as shareholders. In exchange for a percentage of your company's profits, investors provide funding when they purchase shares of a company's stock. Shareholders may also have voting rights, which lets them play a role in decisions about key issues, such as members on your board of directors and management decisions.
Although C-corporations can have an unrestricted number of shareholders and issue various types of stock, S-corporations are only allowed 100 shareholders and one class of stock. Given these restrictions, C-corporations are more appealing to equity investors; however, due to the complexity and expense required for set up and maintenance, not many small or mid-sized companies elect this type of corporation.
If you want to issue shares of stock in your company, no matter what type it is, then you need an experienced business lawyer. The best-case scenario would be working with us; we're the Family Business Lawyer™ who has worked with companies that have raised venture capital before--specifically in your industry.
This post forms part of our Small Business Series and to access the other in-depth articles, please visit the links below.
7 Tips For Creating A Winning Business Plan
How To Choose The Right Entity Structure For Your Company—Part 1
How To Choose The Right Entity Structure For Your Company—Part 2
How to Grow Your Business for Sustainable Success in 2023
5 Best Practices For Establishing Healthy Boundaries With Clients
6 Essential Strategies For Starting A New Business
Putting Your Kids On The Payroll Can Benefit Your Business AND Help You Save Big Money On Your Taxes
3 Red Flags To Watch For When Dealing With Problem Clients
5 Strategies For Boosting Your Startup Business’s Cash Flow
Contact a Professional
Selecting, setting up, and maintaining your business entity on your own is a tall order. As your Family Business Lawyer™, we will help you choose the best entity for your particular business and ensure that it is properly set up with all of the necessary agreements and resources in place.
In other words, we can give you a bunch of systems that will help your company run more smoothly and also keep your business and personal finances separate. This is important for protecting yourself from liability issues. Also, as your Family Business Lawyer™, we will ensure you follow all the state laws and take care of the paperwork required to keep your company running safely while protecting your assets.
Wouldn't it be nice to have a team of professionals handle all the things you dread so that you can focus on turning your business into something great? Your clients and family deserve the best of you, don't they? Get in touch with us today to make it happen.
At Family Business Lawyer™, we want to help you make the best choices for your business throughout its lifetime and after your death. We offer a LIFT Start-Up Session™ or a LIFT Audit for established businesses that covers all the legal, financial, and tax concerns you may have. Contact us today to schedule an appointment.We provide business owners with a full scope of legal services and can assist you in choosing the best course of action for your business at any point during its lifespan or after your death. In addition, we offer Livestation Legal Planning sessions that encompass reviews of all the legal, insurance, financial, and tax systems necessary for protecting your business. Schedule online today.