When starting a business, many decisions must be made early in the process. The biggest consideration, one that should be at the forefront of your planning, is what form of entity is most suitable for the business. A business is generally structured as a partnership, a limited liability company (LLC) or a corporation. All of these entity forms have pros and cons, in terms of tax treatment and for other non-tax reasons. Each form is well-suited for particular business goals, both short and long term, so take time to make sure you choose the entity form that is most appropriate for your business. Here are some pros and cons that you should discuss with your business attorney before making a final decision.
Corporations offer limited liability, meaning that if the corporation is sued, the individual stockholders generally are not liable for paying the judgment. A corporation can have many stockholders or just one, and certain “corporate formalities” must be followed, such as keeping minutes from annual stockholders’ meetings. Specific documents must be filed with the state, both at start up and at dissolution, and must be maintained during the life of the corporation. State laws govern the operation of a corporation, giving stockholders little flexibility in structuring the company.
A partnership is a more flexible structure where two or more people join together for a business venture. Partnerships are simple and, other than reserving a business name for your company, require very little paperwork to be legal. Partnerships do not require written agreements, although they are strongly recommended, and they do not require annual meetings. However, most partnerships offer no protection from liability, so the individual partners (at least one) will be responsible for a judgment against the partnership, and their personal assets could be at risk, even after dissolution of the partnership.
Limited liability companies have gained popularity, mainly due to the flexibility they offer while still limiting liability. LLCs can have one member or many, and membership interests need not be equal. They also offer the type of flexibility that permits one member to contribute money while another member contributes services, such as building a house or providing accounting or legal services. In fact, distributions and allocations of profit and loss need not be equal; for example, the “money” member can be paid back his investment before anyone else gets paid anything at all. This allows incredible flexibility in structuring and operating the business.
There are some big differences in the tax treatment of corporations and partnerships or LLCs. For example, corporations pay tax at the company level whereas partnerships and LLCs do not. But partnership and LLC income may be taxed to the individual partners or members even if it’s not distributed to them, unlike corporate shareholders. Partners or members may owe self-employment taxes as well, whereas withholding taxes are paid by the corporation for shareholders who are also employees of a corporation. It is important to understand the differences in tax treatment between the entities since taxes can have a big impact on your business. But tax treatment is just one aspect of the business to consider. You may find that one option is much better than another, or you may decide that other non-tax factors are more important to you.
With the diverse options available, it is important to weigh all the variables and decide which factors are most significant for your business needs and goals. Paying less (or more) taxes, flexibility regarding everyday operations and allocation of profits and losses, limited liability and even the dissolution process are all important issues, and one or the other may or may not be enough of a reason to choose a particular form. Not every entity form is right for every business, so it is crucial to get professional advice from an experienced business attorney so you understand all the implications of your choice and can succeed in reaching your goals.