Once you have decided that incorporation is right for your business, you will need to determine what type of legal entity you want your business to operate under. Most businesses will typically form either a corporation or an LLC. The main factors that usually play a role in this decision are tax issues and liability. Generally, by forming a corporation or an LLC, owners are not held personally responsible for the obligations and liabilities of the entity. However, there are exceptions under certain circumstances so it is always a good idea to consult with your attorney to discuss these matters.
Forming a corporation (either an S corporation or a C corporation) differs from forming an LLC because of the laws associated with each as well as the management structure and costs.
If you form a corporation, you will have:
- A separate legal entity created by a state filing.
- Liability protection for shareholders (owners). Shareholders are not usually responsible for the debts of the business.
- A management structure in which shareholders elect the board, who then appoint the officers. Shareholders can be involved in holding management roles, but it is not required. The directors elect officers to manage the day-to-day activities of the business.
- The option of easily transferring ownership without the consent of other shareholders.
- The same internal and external corporate laws and formalities. Because corporations have standardized laws, you are required to adopt certain bylaws, issue stock, keep record of meeting minutes with shareholders and directors, file annual reports, and pay annual fees when forming a corporation.
If you form an LLC, you will have:
- A flexible management structure.
- Voting and inspection rights of LLC members that are generally nontransferable and do not require that the majority of the other business members consent.
- Flexibility of what can legally be contributed in exchange for the ownership interest. With an LLC, membership interests can be purchased in exchange for assets.
Two types of corporations
When forming a corporation, you can either choose to from a C corporation or an S corporation. The differences between the two are as follows:
- C corporations are separate taxable entities that have the possibility of double taxation if shareholders report business profits that are distributed to them on their personal income tax return. Therefore, it is possible that the shareholders would have to pay taxes on the company twice. C corporations can have multiple classes of stock, as well as an unlimited number of shareholders, including non-US resident. In the event of the company being sold, a C corporation can only sell stock, as opposed to an S corporation, which can sell assets in addition to stock.
- S corporations are considered pass-through or flow-through entities because the income or losses of the company are divided and passed through its shareholders. Each shareholder must report the income or loss on their own individual tax return. An S corporation can only have U.S. shareholders and one class of stock.
Other types of legal entities
- A limited liability company (LLC) is a company formed under applicable state statute that offers its members a flexible management structure, as well as flexibility in regards to taxation. One main characteristic of an LLC is the availability of pass-through taxation, unless the LLC chooses to be taxed as a C corporation. LLC services can protect some liability for acts and debts of the LLC to its members; however, members are still responsible for debts beyond the fiscal capacity of the entity. An LLC is run by its Operating Agreement, which is a document that determines, defines, and allocates the rights of the members. With LLCs, owners have the ability to draft their own rules and bylaws (as opposed to corporations, that have rules set by state laws), so the Operating Agreement is a very important factor in forming a legal entity.
- A limited liability partnership (LLP) is similar to an LLC in that all partners have a form of limited liability for business debts. An LLP allows partners to have the right to directly manage the business. Similar to LLCs, LLPs allow for pass-through taxation and flexibility in management structure.
- Limited partnership is a partnership between owners where at least one partner must be a general partner and have unlimited liability and at least one partner must be a limited partner with liability limited to the amount of their investment. This type of legal entity also allows for pass-through taxation, and income is not taxed at the business level. With a limited partnership, not all members are granted limited liability.
- Sole proprietorship is formed when a separate existence from the business is not desired. The person setting up the company is completely responsible for its debts and reports all profits on their personal income tax. A sole proprietor has the option of forming a LLC, which would allow them some protection of limited liability, but could still operate as a sole proprietorship for income tax purposes.
Having a good understanding of each legal entity and its characteristics and factors is crucial so consult an attorney or CPA to help you identify and determine which type of corporation will best suit your business is highly recommended. The present size of your company and its potential growth are important factors that will be considered in this process.
After consulting with a professional regarding incorporation services, it is easy to form a corporation by utilizing one of the many online sources, or by seeking the help of an attorney. Regardless of whether you choose a corporation or a limited liability company, having a thorough understanding of each entity is imperative before making your final decision.
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