Business Entity Formation
The experienced team at Foley Freeman can assist you in selecting the appropriate way to structure your new business to help you maximize your chances of success. There are various pros and cons to each of the most common business structures/entities.
Limited Liability Companies (LLC’s)
- Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC.
- Tax Status. Taxed similarly to a sole proprietorship (if one owner) or a partnership (if multiple owners).
- Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and services. Consequently, it is up to the members themselves to decide who has earned what percentage of the profits or losses.
- Less Required Recordkeeping. No requirement to hold annual meetings or record minutes.
- Self-Employment Taxes. Members of an LLC are usually considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
- Limited Liability. The shareholders’ personal assets are protected from business debts and actions of a corporation, Shareholders can generally only be held accountable for their investment in stock of the company.
- Generation of Capital. Corporations have an advantage when it comes to raising capital for their business — the ability to raise funds through the sale of stock.
- Corporate Tax Treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.
- Time and Money. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating and tax costs that many other business structures do not require.
- Double Taxing. In some cases, corporations are taxed twice – first, when the company makes a profit, and again when dividends are paid to shareholders.
- Additional Paperwork. Because corporations are highly regulated by federal, state, and in some cases, local agencies, there are increased paperwork and recordkeeping obligations. For instance, Corporations must hold annual meetings and record meeting minutes.
- Tax Savings. One of the best features of the S Corporation is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corporation shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which can be taxed at a lower rate.
- Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more of the total shares, then benefits like health and life insurance are deemed taxable income.
- Independent Life. An S corporation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corporation can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.
- Additional Paperwork. S corporations are required to hold annual director and shareholder meetings, maintain minutes from those meetings, adopt by-laws, and maintain records of stock transfers and various records.
- Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.
- Limits on Shareholders. There are limits on the number of shareholders. S Corporations cannot have more than 100 shareholders.
- Easy to Create. The majority of time spent starting a partnership often focuses on developing the partnership agreement.
- Partners have a Shared Financial Commitment. In a partnership, each partner is equally invested in the success of the business. Partnerships have the advantage of pooling resources to obtain capital. This could be beneficial in terms of securing credit and paying start-up costs.
- Complementary Skills. A good partnership has the benefit of utilizing the strengths, resources and expertise of each partner.
- Partnership Incentives for Employees. Partnerships can have an employment advantage over other entities if they offer employees the opportunity to become a partner.
- Joint and Individual Liability. Partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy partnership debt.
- Disagreements Among Partners. The more partners the more opportunities for disagreement. Partners should consult each other on all important decisions.
- Shared Profits. Because partnerships are jointly owned, each partner must share the successes and profits of their business with the other partners. An unequal contribution of time, effort, or resources can be a source of discord among partners.
- Easy to Create. A sole proprietorship is the simplest and least expensive business structure to establish. Costs are minimal, with costs limited to obtaining the necessary license or permits. If you intend to operate a sole proprietorship under a different name than your own, you are required to file for an Assumed Business Name.
- Total Control. Because you are the sole owner of the business, you have complete control over all decisions. You are not required to consult with anyone else when you need to make decisions or changes.
- Easy Tax Reporting. Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship.
- Unlimited Personal Liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.
- Difficulty Obtaining Funding. Sole proprietors often face challenges when trying to raise money. The inability to sell stock can hamper third-party investment. Banks may also be hesitant to lend to a sole proprietorship because of a perceived lack of credibility when it comes to repayment if the business fails.