Starting a business is the dream of many. The easiest way to start is with a sole proprietorship; you don’t need to file any paperwork. However, if you want protection, separating your personal assets from your business assets, or if you want to hire others to work for you, and take advantage of certain tax benefits, you need a formal business organization.
There are three popular types of business organizations associated with small businesses, the main differences between them being how and when you files your taxes, as well as the level of protection the corporation provides to you. Before you put it down on paper, get an idea of the basics associated with each type of business, and figure out which would work best for you.
1. Limited Liability Company (LLC)
The LLC allows you a degree of separation between your personal and business assets, and offers you some protection. In many states (but not all), at least two people are required to form a LLC. You can hire employees to work at your LLC, and even set up retirement plans for owners/members and employees. With the LLC, you often see a managing member, and a general member. The managing member generally has more of the power, including to make decisions.
Instead of receiving a salary, the managing (or lead) member of the arrangement takes a distribution. The LLC is a “pass through” business, so the earnings move through to the members/owners, and the LLC itself isn’t taxed. The managing member must pay self-employment tax on the distributions from the LLC.
For the most part, the LLC is ideal for smaller businesses without too many employees. The paperwork is minimal, requiring articles of organization, and possibly an operating agreement. If you decide you want to incorporate later, it’s possible to convert a LLC to an S-Corp. or C-Corp.
The S-Corporation is sometimes considered a “corporation with privileges.” It’s a lot like a C-Corp., but it has a different tax status. The S-Corp. itself isn’t taxed, with all of the profits passing through to the owners. If you plan to issue stock, or if you want to pay yourself a regular salary, the S-Corp. can be a way to accomplish this without some of the hassles that come with a C-Corp. Here are some of the criteria associated with an S-Corp.:
- It must be domestic.
- You can only have up to 100 shareholders (although members of a family can be treated as a single shareholder).
- Only U.S. citizens or resident aliens can be shareholders, and shareholders are limited to individuals, estates, certain trusts, and some tax-exempt organizations.
- You can only issue one class of stock.
- You must file Form 2553 to inform the IRS of your intention to file as an S-Corp., and it should be signed by all shareholders.
Forming an S-Corp. requires articles of incorporation, resolutions, and by-laws in the state where you plan to do most of your business. With an S-Corp., it’s a good idea to set up payroll from the start, even if you have only a few employees.
An S-Corp. is great for a small business that plans to expand a little bit, but isn’t interested in expanding enough that a large number of shareholders is necessary.
If you have big plans to expand and take your company public, a C-Corp. might be the way to go at the outset. With the LLC and S-Corp., there is still an element of joining between the owners and the business. A C-Corp., though, is a completely different entity. A C-Corp. pays its own taxes, and then owners also pay taxes on what they receive as income.
The C-Corp. generally requires more paperwork in the setup phase, as well as throughout. A C-Corp. can receive some tax benefits and breaks, and the C-Corp. has the ability to carry losses forward — something that can’t be done with the LLC and S-Corp.
You can also have non-resident owners, and issue as much stock as you would like (although if you go public, stockholders can have a greater influence, depending on governance rules). Regular stockholder meetings, and the records that go with them, are a necessity.
Because a C-Corp. is so complex, many small businesses are reluctant to organize in this way. However, if you plan to expand, and what the ability to scale up more effectively, this can be a good option.