Congratulations! You have decided to follow the entrepreneurial path and start your own business. The first step in setting up your business is deciding what legal operating structure to use. Do you go corporate or keep things simple?
You could stick with a sole proprietor or partnership method, which keeps operations and taxes relatively simple. In either case, you can avoid the fees and extensive recordkeeping required of corporations, but either structure opens you up to personal liability through your business dealings. Your personal assets, including your home, could be used to pay off debts incurred by your business. Partnerships are equally messy with respect to liability and debts, as you are held liable for business debts according to your percent stake in the company.
However, going corporate with either an S or a C corporation involves a significant amount of time and paperwork that is not often practical or useful for a small business. The Limited Liability Corporation (LLC) attempts to strike a balance between the two structures.
The LLC establishes a separate business entity to shield your personal assets from any claims on your business, but the profits and losses from your business are reported on your personal tax return as with sole proprietorship and partnerships. The IRS refers to these structures as "pass-through entities" since the cash passes through directly to your tax return. Other forms of corporations are separate tax entities and must file their own corporate returns separate from owner's personal returns.
LLCs are formed by filing documentation with the Secretary of State's office in your state. You need to supply articles of organization (name, address, and purpose of the organization) and an operating agreement (the rules under which the LLC will operate). There are no required regular meetings or restrictions on corporate structure.
If your business owns real estate or other property that is likely to increase in value over time, an LLC is preferable to a C corporation, because LLCs avoid double taxation on the appreciation of the property upon liquidation or sale. Owners of a C corporation are taxed once through the corporation and again as a shareholder.
S corporations avoid the double taxation of a C corporation by taxing only the salary received from the corporation. Since LLC owners are frequently self-employed, they must pay self-employment tax — and within an LLC structure, owners would be subject to the self-employment tax on the entire profit or loss from the business and not just the salary paid.
Why don't larger corporations take advantage of these rules? One of the largest reasons is that LLCs cannot issue stock or sell shares of the business to raise capital. By definition, that prohibits LLCs from using stock options as incentives to retain employees.
For smaller businesses, the question is usually whether it is worth the extra time and management issues to potentially gain the tax tradeoffs of an S corporation or acquire liability protection through a simpler LLC. It may be worth a quick tax calculation to estimate the effect based on your expected profit level.
In general, a LLC offers independent contractors and small businesses the best balance of limited paperwork and liability protection. However, if you are not sure which is the best for you, start small with a sole proprietorship or partnership and convert the structure to a corporate format later if you find you need the protection of a corporation and that the potential benefits outweigh the potential costs.