Corporation, LLC, or Neither:
What is right for my business?
I usually recommend that a new business with only one owner (a husband and wife count as one owner) begin his/her business as a sole proprietorship. Check with your attorney about your need for liability protection, but you must obtain sufficient insurance regardless of what kind of business you are starting. And since lenders and lessors require personal guarantees from business owners, forming a corporation or LLC rarely gives you the ability to walk away from significant business debts.
But there are good reasons for moving past the sole proprietorship and creating a corporation or LLC (limited liability company.) Choosing the best tax entity for your business involves balancing the advantages and disadvantages (both tax and non-tax) of each alternative. Each has its pros and cons. Here are some common situations which will point you toward the best choice for your business:
Whenever the business is owned by more than one person, it is important to have a written agreement which spells out many things. How will income and expenses be divided? Will the owners draw salaries? If so, how will the salaries be determined? What happens if an owner dies or becomes disabled? What if one owner needs health insurance but another does not? What if one owner wants to contribute part of his compensation to a retirement plan but another does not? What if the business needs more capital? These and other questions should be answered at the very beginning of the business, before misunderstandings arise. Consult a good business attorney, like Janet Fogarty in Millbrae, or the appropriate book from Nolo Press. This written agreement should be prepared as part of forming a partnership, corporation or LLC. Also, requiared recordkeeping for corporations is much stricter for corporations than LLCs, which may become an issue, especially if there are minority shareholders.
Flexibility of Allocation of Income & Expenses
Suppose that two people create a business, and one owner supplies more capital than another. This could be cash, equipment, etc. The owners may want to distribute unequal amounts of profit, or allocate depreciation of equipment to the owner who contributed it. Special allocations are permitted with a partnership or an LLC, but are discouraged in an S corporation. It is required that all shareholders of an S corporation have identical rights to distribution and liquidation proceeds.
Possible Reduction of Payroll Taxes
Owners of S corporations pay payroll taxes plus income taxes on their salaries, but only income taxes on any remaining profit. But see my separate page comparing S corporations and LLCs.
Liability for Partners' Acts
In a general partnership, you may be personally liable for the acts of your partners.
Long-term Goal: Going Public or Sale of the Business
In this case, a C corporation is probably the way to go. Investors are comfortable with C corporations. And there are tax breaks for owners who sell their qualifying corporate stock. If you think that you may eventually sell your business, be sure to consult an experienced tax accountant to insure that your stock will qualify for special tax treatment. Also, there is the possibility of double taxation when liquidating a C corporation. Update: the recent tax law changes have made the C corporation much less attractive for small businesses because they receive no Section 199A deduction, and the 21% flat tax rate is significantly higher than the 15% previously paid by many small businesses.
Restrictions on Which Businesses Can Form LLCs
In California, a business which requires a state license is not permitted to form an LLC. The state has never issued a list of which licenses are considered "professional" and which are "nonprofessional." So, if your business requires a state license, and your type of license has not been specifically ruled on, you are taking a chance that your LLC will be invalidated later, which will complicate matters if you are in a lawsuit, which is when this issue is usually discovered. The Contractor State License Board can issue a contractor's license to an LLC. However, the company is required to either carry $1 million of liability insurance or have $500,000 of liquid assets, so it is likely than only larger contractor companies will take advantage of the opportunity to operate as LLCs.
Deductible Business Losses
In a partnership, LLC, or S corporation, business losses (and profits) flow onto the owners' personal tax returns, where they are deductible if the owner has enough basis in the business. Basis can be thought of as the amount invested in the business. Partners and LLC members may include their shares of company debt in their basis, and so may claim more losses. Shareholders in S corporations cannot include their portion of company debt, unless the debt is a loan from the shareholder. This is one reason why it is usually inadvisable to hold rental real estate inside an S corporation.
Gross Receipts Fee
California LLCs with gross receipts of $250,000 or more are subject to an additional fee, which ranges from $900 to $11,790. Corporations do not pay a gross receipts fee. So entities with sales of more than $250,000 tend to favor corporations over LLCs.
Many other factors will also influence your choice of entity, including fringe benefit considerations, potential personal service corporation status, personal holding company status, non-US owners, advantages of having a year-end other than December 31st, the desire to build up cash within the company, and estate planning considerations.
Here is more information on the differences between LLCs and S corporations.
The purpose of this information is to help you be aware of the common concerns to be considered and to begin the conversation with your tax accountant and attorney.
Bess Kane, CPA