When you decide to start a small business, your first concern should be to select the right corporate structure. You may be surprised to learn that there is no clear-cut choice, but rather, a number of different considerations to take into account. It is important to talk with many people before you decide, including an accountant, your mentor or a trusted adviser, your spouse, and of course, a lawyer, who will advise you on legal loopholes and state laws that could affect the amount of tax you pay, the extent of your liability, and the time you need to invest on bureaucratic tasks.
Subchapter S Corporations (S-Corps)
Many small business owners opt for an S-Corp Structure. The latter is a pass-through entity (meaning that profits, credits, losses, etc. are passed to members’ tax return, and the company avoids being taxed a second time through the corporation). Since an S-Corp is a corporation, it must comply with a number of bureaucratic duties, including passing bylaws, holding shareholder and director meetings, etc.
S-Corps are more attractive for small business owners than C-Corps in terms of sale of the business. Proceeds from C-Corp sales are seen as income, which is taxed higher than capital gains transactions. S-Corp owners only have to pay an individual capital gains tax if they sell their business.
S-Corps also have specific requirements regarding shareholders; there can be no more than 100. If you eventually see your business expanding, an S-Corp may not be the right structure for you.
Limited Liability Companies
An LLC also affords the pass-through benefits of an S-Corp, but dissolving this type of company is even more advantageous, since asset distribution among members is not classed as a taxable transaction by the IRS (tax is paid only if assets are sold further down the line).
An LLC affords greater flexibility in terms of members as well, since there can be as many owners as necessary. This structure will also allow you to distribute income as you see fit; a corporation, on the other hand, distributes income equally among investors.
The downside of an LLC is that you have to pay self-employment tax, which can amount to over 15% of the income that passes through the company; profit, too, falls under this tax.
Some states also require LLC companies to have an Operating Agreement, which will determine shareholders’ right to sell their stake. When you set up an LLC California and other states deem membership interests to be non-transferable, so if you wish to change this, you will need to do so in your Operating Agreement. The latter may specify that an outgoing member must offer other shareholders a fair market percentage for his/her shares, etc., and should foresee sales, dissolution and other matters of vital interest for the company.
Limited/Limited Liability Partnerships (LLPs)
LLPs have a small projection; indeed, they are mainly used by licensed professionals such as doctors and lawyers and some states to not allow anyone else other than licensed professionals to form an LLP. Therefore, if your services lie outside one of these established professions, you might consider an LLC or S-Corp structure.
Since each company structure has stringent legal requirements, make sure to discuss your options with legal advisers as well as successful business people and mentors who can steer you in the right direction. While LLPs work well for a specific list of professionals, small businesses falling outside these services can consider the pros and cons of S-Corps and LLCs, bearing in mind both bureaucratic requirements and possible losses through tax.