Though you can be in business without setting up a legal entity, we don’t recommend it. The following points will help you decide on the best entity for your operation.
1. Human Error
Carrying on business without a business entity means that each of the owners is 100% personally responsible for all of the business’s liabilities. That isn’t good.
A business entity [corporation, limited liability company (LLC), or limited liability partnership (LLP)] protects the owners from personal liabilities, except professional liabilities and personal wrongdoing.
2. Pass the Buck
The tax code divides corporations into C corporations and S corporations. The main difference is that with C corporations, the corporation pays income tax on its net income and the shareholders also pay income tax on dividends.
With S corporations, such as LLCs and LLPs, only the shareholders pay income tax on the corporation’s net income.
3. Exclusive Owners’ Club
S corporations have strict rules about who can be shareholders: no C corporations, LLCs, or LLPs; no trusts (with a few exceptions); no non-US residents.
S corporations may have a maximum of 100 shareholders. Even if you’re not planning to have these types of owners, the S corporation owner restrictions can limit (or make more costly) future opportunities to sell stock to new investors or take advantage of common estate planning techniques.
It is possible for creditors of a corporation’s shareholder to take the corporate stock in satisfaction of their debts. Generally, the same is not possible for interests in LLCs or LLPs. Creditors of an LLC member or LLP partner are limited to a charging order, which means that creditors can receive distributions from the LLC or LLP, but they do not get control.
5. Head of the Class
For C corporations, LLCs, and LLPs, it is possible to create different classes of stock or interest that entitle the owners to different rights. For instance, classes can differ on distributions, participation in management, and liquidation rights. S corporations cannot have different classes of stock, other than voting and non-voting stock.
6. All Good Things
Every partner in a partnership (whether LLP or general partnership) has the right to withdraw from the partnership at any time. It may be a breach of the partnership agreement, but a partner’s withdrawal might still result in the dissolution of the partnership. Corporation shareholders and LLCs members do not have the right to withdraw unless this right is provided in an owners’ agreement.
7. Gainful Employment
Profit distributions from an S corporation are not subject to employment taxes, provided owners who work in the business are also paid a reasonable (taxable) wage. Profit distributions to the working owners of an LLC or an LLP are subject to employment taxes, whether or not the owners also receive wages.
8. Healthy, Wealthy and Wise
Payments for health insurance and other fringe benefits are generally deductible by a C corporation, regardless of the recipients. Health insurance and fringe benefits provided to the owners of an S corporation, LLC, or LLP are not deductible generally.
9. Keep it Simple
A separate income tax return must be filed for each separate business (except a sole proprietorship or 100% subsidiary), even though S corporations, LLCs, and LLPs generally do not pay taxes themselves. The corporate income tax returns are relatively simpler than the LLC and LLP income tax returns because LLCs and LLPs are governed by complicated rules about the allocation of profits and losses.
10. Changing Course
If circumstances require a change in the choice of entity, it’s almost always possible, at a price. The laws in most states now have simple filing procedures for converting from one type of entity to another. That’s the easy part. But conversion might trigger taxes, especially when converting from a corporation to another entity.