What form should your business take?
Here are two helpful articles about LLCs and C or S corporations.
While you think you and your friend are the only partners in your business, you do have other silent but highly compensated partners who will share in your potential success. Let me introduce you to your new lifelong partners Uncle Sam and your state Legislature.
One question that may make your decision easy is this: Do you want to pay your taxing partners once or twice on the same amount of profits every year? Most startup entrepreneurs would want to keep as much of their hard earned profits as possible by organizing as a limited liability company or “LLC”, general partnership or “S corporation”, rather than as a standard “C corporation.”
Here’s how it works. A limited liability company or LLC allows business profits to bypass traditional corporate taxes and pass through to the LLC’s owners or “members.” You would report your LLC-related income on your personal income tax return. Equally, you would be able to apply any startup LLC-related losses on your personal income tax return.
In contrast, business profits in a standard C corp are taxed by the federal government and again by most states. Then to the extent that you and your partner take out the profits in the form of dividends or bonuses, you have to pay Uncle Sam and possibly your state once again. Nasty isn’t it!
Both LLC’s and C corps provide owners with some limitations of liability. For example, if your business obtains debt without signing a personal guarantee, you and your friend would generally not be personally liability for missed payments. It’s important to note that exceptions to liability limitations may exist in tort claims involving negligence or fraud.
Big concept entrepreneurs seeking angel or venture funding should just organize a C corp. Multiple rounds of venture funding often involve the issuance of several classes of common and preferred stock – which is easily handled in a C corp structure. Many sophisticated investors crinkle their noses at LLC’s and won’t invest until the structure is changed – at the entrepreneur’s expense. Employee stock options are also easily administered in C corps.
The set up and ongoing administrative requirements of an LLC are easier than a C corp. For example, Washington State provides an online tool to register the business name and develop an LLC’s “Articles of Organization.”
If you decide to organize an LLC, I strongly recommend that you hire a seasoned business-oriented attorney to develop your LLC’s “operating agreement.” This agreement should carefully define voting rights, responsibilities of the owners, the procedures for buying or selling member shares in the business, or even how to one day dissolve the business.
Given the high potential of your business, it is best to talk to your accountants too. Ask probing questions, including if your personal situation may require you to pay self-employment tax on your share of LLC profits.
I never mind paying for skilled accounting and
legal guidance. When embarking on a new venture, it’s reassuring to know the
first steps forward are in the right direction. Go make your million!
Pros and Cons of S Corporations
By Susan Schreter
I read your article on limited liability companies, but what should I know about S corporations?
Decisions. Decisions. Decisions. When entrepreneurs make the big decision to leave a 9 to 5 job, they often say they made the leap for the opportunity to be the top decision maker. At last, they can devote more of their work day to their innovative pursuits.
Unfortunately, the entrepreneurial dream doesn’t always match up to startup reality. During their first months of freedom, entrepreneurs find they are consumed with a wide range of dry, administrative tasks. It’s why discouraged readers ask, “When does it get fun?” “When will I have a chance to make a difference?”
Call me odd, but I do think selecting the structure of a startup business is interesting and fun. It’s an entrepreneur’s first big decision with strategic consequences.
Since 1997, S corporations have been the most popular form of corporate tax return filed with the IRS. There are a number of reasons why over 3 million US companies “elect” S corporation status instead of filing as a standard C corporation.
Like standard C corporations, S corporations shield owners’ personal assets from unpaid debts (provided they are not personally guaranteed) and other business liabilities. Businesses that operate in traditionally litigious industries such as heavy manufacturing, food or consumer products often seek the limited liability benefits of a standard C corporation, S corporation or a limited liability company (“LLC”).
Perhaps the best part about an S corporation is its favorable tax status. With the exception of taxes on certain capital gains and passive income, an S corporation is exempt from federal income tax. This means that most S corporation profits and losses are “passed through” to the individual shareholders.
Owners of small profitable companies may be able to save thousands of dollars in taxes, providing more money for business expansion. Of course, this added cash flow can also be paid to shareholders in the form of dividend distributions.
Here’s another fine point about corporate taxation. Dividend distributions to shareholders of standard C corporations are not deductible for federal income tax purposes. As such, the IRS collects a double tax on dividends: once at the corporate level and then again when individual shareholders report dividend income on their personal tax returns. Organizers of S corporations can avoid this nasty double tax hit.
Sounds great doesn’t it! But S corporations may not be right for venture capital bound businesses because of the “one class of stock” requirement. Angel investors and venture funds generally insist on receiving a separate “preferred” class of stock with benefits over common shareholders.
There are other restrictions too. Whereas standard C corporations and LLC’s can have an unlimited number of shareholders, S corporations are limited to 75 shareholders. These shareholders must be US residents, estates or certain trusts and partnerships. Ambitious entrepreneurs who may solicit Canadian angels or corporate investors won’t meet IRS criteria.
S corporations are perhaps most viable for businesses that are organized by one or a small number of individuals. In addition to the other tax saving benefits, S corporations have been used to reduce owner-manager employment taxes. Instead of paying compensation in the form of a salary, owner-managers paid themselves in the form of low tax dividend distributions. To close this loophole, the IRS now requires owner-managers to pay themselves a “market salary” before distributing dividends. Still, owners of very profitable S companies can save by dividing up their compensation.
So, what is the best structure for your business? As the founder of your new enterprise, the joy of making the decision is all yours.