Whether you’re the next big thing in social gaming, affiliate marketing or location-based technology, every entrepreneur and business owner eventually faces the same gnawing questions: Should I Incorporate? Do I need to register a trademark? What’s a DBA?
These questions are only natural. After all, the legal and financial ramifications are significant. And your passion might be analyzing Twitter data or designing enterprise cloud-based apps, but I’m pretty confident it’s not tax law and legal fine print.
The sooner you address these legal matters, the better. As an entrepreneur myself, I know that when you’re putting in long days to release your new site or find new customers, working on legal paperwork doesn’t rank high on your priority list. But getting your legal ducks in a row will help you scale far more smoothly, avoid legal pitfalls in the coming years, and yes, even help you save money on taxes.
You might be wondering if you need to incorporate your business in the first place. Many entrepreneurs and small businesses consider themselves ‘too small’ to worry about incorporation. After all, having an Inc. after your name means you have a big staff and rows of cubicles, right? Well, actually, that couldn’t be further from the truth.
Even if you’re a freelance contractor, incorporating or forming an LLC can be a smart idea. Here’s why:
- Personal asset protection: Once your business is a corporation or LLC, it’s a separate legal entity. This means that the corporation (and not you) is responsible for its debts and liabilities. By contrast, without incorporation, your own personal savings and assets are at risk to settle any debts of the business. Of course, you don’t set out to anger clients or default on payments. And most likely, you’ll never encounter this kind of trouble. But things do happen. You might inadvertently expose sensitive customer data. Or accidentally infringe on another company’s IP. Or your main client may fail to pay their invoices, making it impossible for you to pay your own vendors. A legal business structure gives you peace of mind that your retirement savings won’t be wiped out by your business venture.
- Tax benefits: In many cases, corporate tax rates are lower than individual tax rates. Corporations and LLCs often qualify for additional tax benefits and deductions that aren’t available to individuals. Of course, specific circumstances vary, and you should consult with a CPA or tax advisor about your own particular tax situation.
So how do you decide which business structure is right for your company?
There are numerous legal business structures to choose from, but the three most popular forms are: the Limited Liability Company (LLC), S Corporation (S-Corp) and the C Corporation (C-Corp). In this article, I’ll cover the differences between the LLC and S-Corp, and stay tuned for a discussion on the S-Corp vs. C-Corp.
Let’s start with some basic definitions:
- Limited Liability Company (LLC): The LLC is hot among small businesses right now, and for good reason. It’s a hybrid of a partnership and corporation. There are no shares and minimal corporate formality. An LLC’s main benefit is to limit the liability of the owners. For example, your personal assets are separated from company property, and can’t be wiped out because your competitor sues you for IP infringement. An LLC does not file separate taxes (in the case of a single member LLC, the LLC’s taxes would be filed under the individual members’ tax returns; in the case of a multi-member LLC, the LLC would generally file a partnership tax return). All company profits flow through to the owners and are taxed at each individual’s personal income rate.
- S Corporation (S Corp): An S Corporation actually starts off as a C-Corp and then soon after incorporation, the owners submit Form 2553 to the IRS to be treated as a pass-through entity. Like a regular corporation, an S Corp is a collection of stockholders who share company ownership. But in this case, the income/loss of the company is passed through to each shareholder’s personal tax statement.
What does all this mean for you and your business? While circumstances vary among individuals and individual businesses, here are some general guidelines to help you understand the significant differences between these two structures.
Business Formality and Paperwork
The LLC is ideal for companies that want the liability protection, but would prefer to keep formalities to a minimum. In an S-Corp or C-Corp, Articles of Incorporation must be filed; bylaws have to be written; officers have to be named; a board of directors elected; and minutes must be filed and resolutions passed whenever you want to make changes to the company. In the LLC, this isn’t the case. LLCs just use an informal ‘operating agreement’. Depending on your particular type of business, this could either be a great time and money saver, or the gateway to potential conflict down the road.
Both LLCs and S-Corps are considered pass-through entities when it comes to federal income tax. This means the business itself is not taxed; rather, any business income or loss is reported on each individual owner’s tax return (please remember…it’s wise to consult with a tax advisor on your own situation…).
But here’s where the two structures differ. In an LLC, income and loss can be allocated disproportionately among the owners; in the S-Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership. So, if I own 50% of an LLC, my share of the tax burden doesn’t necessarily have to be 50% of the taxable income. But if I own 50% of an S-Corp and that company makes $100,000 in taxable income, I will be taxed on $50,000 of income…even if I never withdrew a cent from the corporate bank account.
Therefore, consider first whether you will make a profit soon after incorporation. If you are going to reinvest that profit back into your business, then an S-Corp might be right for you. However, if you’re going to distribute that profit to yourself and any shareholders, you should think about the LLC, or perhaps the C-Corp which is not a pass-through entity.
Of course, your decision will ultimately depend on all the unique aspects of your particular business needs, vision, and circumstances. But taking a serious look at your legal structure is important and will help you scale far more smoothly and avoid any legal pitfalls in years to come.
As you journey through the process, be sure to take each stage seriously. CorpNet.com’s professional staff is here to assist you every step of the way… And once you know what you’re required to file, we can take care of the details for you! If you have specific legal questions or concerns, you should consult an attorney for sound advice. After all, your business is worth it.
Please feel free to reach out to me with any questions to firstname.lastname@example.org.