Deciding to form a business is an exciting step. But then what? Do you incorporate or simply operate as a sole proprietorship? Before you can get your business off the ground, you'll need to evaluate these important questions before taking the next step.
Question #1: Do you need to protect your personal assets from the liabilities of the company?
If you're debating whether to form a legal entity or to be a sole proprietorship, one issue to consider is whether or not you need to protect your personal assets. The biggest benefit of formal entity formation is that the individual(s) owners of the corporation are shielded from the liabilities and debts of the entity. For some businesses, however, the cost of formation, including tax consequences, may outweigh the benefits, especially if the business can be thoroughly insured.
Professionals such as lawyers, doctors and veterinarians may opt not to form a legal entity, because professional liability insurance will cover the most likely type of action against the business. But it won't cover everything. For example, a slip and fall on the office premises, or an alleged employment discrimination suit would generally not be covered by professional liability insurance, but additional coverage is often available for these and other kinds of risks.
For small businesses, the protection from personal liability—especially for those without significant assets—may not be necessary. When you consider that sole proprietors can offset their personal income, including interest and dividends from all sources, against their business losses, a sole proprietorship can look attractive. Compare a thoroughly insured group of accountants with 5 employees to a restaurant with 50 employees and hundreds of patrons per day. The additional risks posed by a larger business would likely justify the small cost of incorporating to shield the owner(s) from liability.
Question #2: Should you choose a C corporation, S corporation or limited liability company?
If you decide you do want to shield yourself from the liabilities of the company, the question then becomes, should you choose a C corporation, S corporation or limited liability company (LLC)? A C corp. is a corporation that requires by-laws, a board of directors and the exercise of corporate formalities (board meetings, shareholder meetings). Most distinctively, however, it is subject to double taxation. That means C corps. are taxed at the entity level, and then when dividends are paid out, the shareholders are taxed at the individual level (hence the phrase “double taxation”). C corps. are typically only advisable under certain circumstances, such as if the answer to question #3 is “yes.”
By comparison, S corps. have many of the same restrictions as C corps., but they are not subject to double taxation. Instead, they offer pass-through taxation, which is advantageous for small businesses because the taxes incurred are frequently less than in a double tax situation.
LLC owners may elect either double or pass-through taxation. In addition, LLCs may require certain corporate formalities (this may include documenting company decisions and meeting minutes), as well as some additional business costs. It's important to note, all three entities offer liability protection.
Question #3: Will the business seek venture capital funding?
If you plan to seek venture capital funding for your new business, most investors like to see a C corp.—and not just any C corp., but a Delaware C corp. Delaware corporate law is highly developed and predictable as Delaware's Chancery Court is devoted solely to corporate law. High-tech companies often see themselves as candidates for venture capital, so if you have one of these companies, it is advisable to be realistic with yourself about the timeline for seeking this kind of funding. If you don't see the company in a position to ask for venture capital until year three, you may want to form an S corp. (which allows pass-through taxation, rather than double taxation), and then elect C corp. tax treatment when the company is ready for venture capital funding (if the founders want pass-through tax treatment prior to venture capital funding). The taxes and lack of flexibility in governance of a C corp. can be burdensome and costly during the early stages of the company.
Question #4: Do you want flexibility in the management and payment structures of the business?
If the answer is “yes,” and you want to also be shielded from personal liability, then you should probably form an LLC, which allows for such flexibility. By contrast, an S corp. requires shareholders to elect a board of directors, who make decisions about the company. While the formalities of an S corp. may be beneficial to save on Social Security taxes, Medicare taxes, payroll and unemployment taxes, it is advisable to speak with a professional and thoroughly crunch the numbers to determine if the tax savings would ultimately increase your bottom line.
When deciding which entity to select for your business, the decision depends on the unique circumstances of the founders of the business and the type of business to be formed. If you have additional questions you can consult a professional before making a final decision.