As a business attorney in the Sarasota County, Florida, I often help new business owners on set up their corporate entities. One of the first questions asked is, “Which entity is right for me and my business?”
The answer is, invariably, it depends. This is a complicated question for many reasons, but it’s one that is well worth answering because establishing a corporate entity is important. There are 3 major reasons why people incorporate their businesses:
- Incorporating your business can limit your personal liability;
- Incorporating your business can limit your tax exposure; and
- Incorporating your business can allow you to divide the ownership of your business easily.
These are the major benefits to operating your business under some form of corporate entity, and these 3 reasons should play heavily into your decision to selecting which entity is right for you. However, there is a fourth factor, and that is the amount of red tape and overhead attached to operating your new entity. As a new business owner you will have a lot of aspects of the business to manage, and you will have to attend to everything with limited time and limited funds. The ideal business entity protects the owners from liability, limits tax exposure, allows ownership to be divided easily, and doesn’t require a ton of time or money to maintain.
The purpose of this article is to run through the three major types of business entities you will encounter, and to list some of the differences between the entity types, as well as the pros and cons of each entity.
The LLC
The LLC or Limited Liability Company is the simplest form of corporate entity. The LLC has only recently become popular in the United States, but has become a favorable choice for small businesses because they are inexpensive to establish, easy to manage, and still offer protection from liability stemming from actions of the company.
LLCs are pass through entities, meaning that the profits from the company pass directly through the company to the owners. Instead of the company itself being taxed and having to file a tax return, the individuals who own the LLC receive a percentage of the profits based on their ownership share (their “pro rata” share), and then they report that income (less deductible business expenses) on their personal income taxes. Of course, if the business is losing money the owners report that loss. The bottom line is that everything flows from the LLC to the business owner and the profits get taxed one time at the individual level.
LLCs are nice because they are inexpensive to form and can be operated with few corporate formalities. Used properly, they can insulate you from personal liability and allow you to divide ownership between multiple parties without an excessive amount of red tape. However, if the business starts generating a lot of money, it is all reported as ordinary income and subject to self employment tax.
The S Corporation
An S Corporation is best described as a hybrid between an LLC and C Corporation. Like the LLC, it is a pass through entity where all of the profits and losses flow to the owners of the company, but like a C Corporation the company is owned by shareholders. The key advantage to an S Corp over an LLC is that the owners of the S Corp can pay themselves a reasonable salary (subject to FICA tax and other withholding requirements), but the remaining net earnings can be distributed as passive dividend income not subject to self employment tax. The advantage of an LLC over an S Corp is that there is less paperwork and corporate formalities with establishing and maintaining an LLC.
However, to make matters even more interesting, LLCs can elect to be classified as a S Corporation in the eyes of the IRS to avail themselves the tax benefits of an S Corp. That provides the business owner with the flexibility of administration that comes with an LLC, and the flexibility of tax treatment of business income with the S Corp.
The C Corporation
When you think of a C Corporation, think of your traditional big business that is listed on a public stock exchange. Like an S Corporation, the C Corporation is organized by shares and allows for sophisticated options when it comes to dividing ownership. The key difference with a C Corp is that its income is taxed on two levels: the company is taxed on the corporate level, and then the profits that get distributed to the shareholders get taxed on the shareholder level. From a corporate housekeeping standpoint, C Corporations have more formalities than a LLC and S Corporation, and are more expensive to maintain.
Most small to midsize business clients that I work with end up taking the S-Corp or LLC route.
Corporate Entity Selection – Final Thoughts
Selecting the appropriate entity is an important part of beginning any new business venture. You need to carefully consider the pros and cons of the legal, tax, and operational aspects of each business entity when deciding. You will want to work closely with both your lawyer and CPA to determine the best fit for your business.
If you have any questions regarding establishing a business entity in Florida, please feel free to contact me. It would be my pleasure to discuss your business and your needs in determining the appropriate entity.
