In recent years the Limited Liability Company, which is typically referred to simply as an LLC, has become the darling of entrepreneurs and small businesses around the country. But the LLC is not always the best choice. Sometimes a Subchapter S corporation or another structure is preferable. This article helps you choose the right structure for your new business.
Determine Your Long Term Goals
Is your goal to create a company that will grow and then go public, or be sold to a larger company for millions of dollars, or do you intend to run a small family business where you, members of your family, and perhaps a few trusted associates will be involved? Will you operate primarily in your home state, or will your focus be national or international? These questions are critical in deciding how to organize your new business. For example, if your goal is to be acquired or go public, you probably want to create a “C corp.” If you and a few friends or family members are creating a business that will not expand, at least in terms of owners, an LLC may be perfect. On the other hand, you may want the formalities of a Subchapter S corporation.
When to Use an LLC
LLC’s and corporations both insulate the owners from liability. An LLC has “members” rather than shareholders. The members can run the company or have one or more “managing members” do so. The LLC is an excellent tool for holding rental property–I recommend that each building be held by a separate LLC so that any liability is limited to that building. If your company is going to have only a few owners or members, an LLC may be ideal. The paperwork is somewhat simpler than a corporation (though many states allow “close corporations” in which the shareholders run the organization just like members of an LLC). The LLC is usually a good substitute for a sole proprietorship. Note that all income from the LLC will be treated as ordinary income and subject to FICA and income tax. Although you can elect to have an LLC taxed as a corporation, generally the LLC is taxed like a partnership or sole proprietorship and profits are distributed to the members and taxed as ordinary income. The LLC also offers the benefit of shielding owners from direct, personal liabilities, which is a benefit any properly formed and run LLC or corporation provides, an important reason many elect to stay away from a partnership and sole proprietorship.
When to Use a C Corporation
A C Corporation is a garden variety corporation with no limits on the number of shareholders it can have. If you want to grow your shareholders and maybe go public or be acquired, a C Corporation is generally the best choice. The local XYZ Store can be a C Corp, and IBM is a C corp. When creating a C Corporation, you will need guidance on how many shares to authorize and how many shares to issue. This is true for both a C corp and a Subchapter S Corp
When to Use a Subchapter S Corporation
If you create a corporation, you may file a form with the IRS asking to be treated as a Subchapter S Corporation. In order to qualify, the number of shareholders must be limited and no shareholder can be a corporation. The advantage of the Subchapter S Corporation is that profits or losses are passed directly to the shareholders and the corporation itself is not taxed. With a Subchapter S, you can pay yourself a salary but distribute some profits as dividends, possibly avoiding self employment tax on some income..
Where Should I Organize My Business?
Generally speaking, you can organize your business in any state where you have an actual presence. That can be the state where you live or it can be a state where you have an office. Many companies organize in Delaware, because Delaware does not require companies to have a physical office in Delaware. You can have your registered agent there serve as your office. There are three things to consider: First, where do you have a physical presence. Second, what are the franchise or similar fees charged in the states you are considering. For example, CA charges $800 a year, while Delaware charges less than $200 for a small company. Finally, in what state will your business be taxed and what are the tax rates there? If you can organize and operate your business in a state with lower tax rates, that is usually an advantage.
So What Should I Do?
Unfortunately, there are no hard and fast rules with respect to what is right in all cases. Speaking with an attorney or an accountant, or preferably both, is something entrepreneurs should budget. There are fees up front to seek professional advice, but these fees are usually quite small in the greater scheme of things, and competent advice will prevent you from making mistakes, or picking the wrong path for your situation. The inevitable truth is that spending some money up front to ensure you follow the appropriate path is far more economical than making a mistake and needing to fix things later.
About the Author
Ken Sprang is a corporate and transactional lawyer with special expertise in labor and employment law. He represents business clients throughout the United States and in Europe.