As small business attorneys, the question we get asked the most is: which type of business should I choose? LLC, S Corp, and C Corp are often considered the most common entity types. But before answering the question of “which type of business”, though, we find it helpful to go over why we recommend setting up an entity at all.
This article was derived from a livestream with G & G Law, LLC founder Michelle Green.
Why Should I Form A Business?
From a legal standpoint, setting up an entity for your business provides great liability protection. It limits your liability by creating a shield between your personal assets and your business assets. You could form an LLC, form a PLLC, form a C Corp – all offer the same liability protection.
This means that if someone were to get a judgment of some sort against your business, the creditor or claimant would be unlikely to reach your personal assets, like your personal savings, house, car, or future wages. They’d only easily be able to collect against your business assets, like your business bank account.
Every type of business that we’ll discuss – LLC, S Corp, and C Corp – provide this liability protection. If you do nothing, you’ll default to a sole proprietorship or partnership, and you WON’T have this liability protection.
As you make the decision about what type of business is right for you, keep in mind that procrastination is the worst option. Any entity at all is better than no entity.
What Is A Corporation?
We’ll begin by describing Corporations.
Corporations are the traditional type of business, but they have one big problem that makes them less than ideal for most business owners: double taxation. Corporations default to a C Corp tax status with the IRS, which means they default to this tax status.
Double taxation means that the C Corp has to pay taxes on any profits at the corporate level AND that the individual shareholders, which is what the owners or partners in a C Corp are called, also have to pay taxes on the money they make from the C Corp.
Additionally, corporations have to observe many formal requirements to maintain C Corp status. For example, they are required to hold an annual meeting each year and keep organized meeting minutes. They also have to have a board of directors and name officers.
However, C Corporations have several large advantages as well. Venture capital firms strongly prefer and may even require that any business they invest in be structured as a C Corp. If your business needs venture funding to survive, you should definitely be considering a C Corp. However, in our experience, this applies to only a small number of businesses.
Next, LLCs. LLCs are our personal favorite entity type because LLCs are simple.
First, they escape the double taxation trap. The IRS considers LLCs to be disregarded entities when it comes to taxes. This means that “LLC” isn’t an IRS tax classification – LLCs are taxed as either a sole proprietorship or partnership depending on how many members, what partners or owners of an LLC are called, are in the LLC.
Second, LLCs have fewer legal formalities than C Corps do. You don’t have to have annual meetings, keep minutes, or appoint a board of directors. You certainly can if you want to, though.
Additionally, LLCs can be flexible when it comes to profit or loss distribution. In C Corps, this distribution HAS to be in proportion to the amount of shares owned by each shareholder or stockholder. In LLCs, the members are not required to distribute profits and losses in proportion to their membership interest.
Overall, LLC’s are the “easy button” of entity type.
Either a C Corp or an LLC can elect to be taxed as an S Corp.
An S Corporation is an IRStax classification rather than a legal type of business that you file with the Secretary of State. To tell the IRS you want to be taxed as an S Corp, you have to send them a form (Form 2553).
Businesses often choose to be taxed as S Corporations to avoid double taxation, and there may be other tax benefits as well.
Whether S Corporation taxation is beneficial for a business depends on a lot of variables individual to that business. Plus, the laws surrounding this continually change. You should discuss this with your accountant, CPA, or tax attorney. We also have blog posts and livestreams about S Corp taxation if you’re interested in learning more.
You should be aware that there are requirements to qualify as an S Corp, making them less flexible than LLCs and in some ways less flexible than C Corporations. For example:
S Corporations can’t have non-resident aliens, partnerships, or corporations as owners;
There can only be up to 100 owners;
They can only have one class of stock (or membership interest);
They can’t be an ineligible corporation;
S Corp owners must pay themselves as employees, which means you have to set up payroll;
Certain business owners find the tax benefits to be worth this loss in flexibility, though.
It is possible to form an LLC (or C Corp) right away, and then elect to be taxed as an S-Corp down the line. The IRS has a window each year when businesses can make this election.
Again, we highly recommend talking with an accountant or CPA to determine the best tax status for your business.
You can make an S-Corp election by Form 2553 with the IRS.
Do I Need A Lawyer?
Can you set up an entity by yourself, or do you need a lawyer?
We highly recommend having a lawyer set up your entity for you or several reasons.
Deciding An Entity Type
A lawyer can help you determine the best type of business for you. We’ve already discussed the basics, but there are more, including PLLCs, Professional Corporations, and B Corporations. For example, there was a recent change in the law regarding PLLCs. As a result, MANY people formed LLCs when they were required to form PLLCs instead. Now these people have to spend more money and time to fix this error and convert their entities. With a lawyer on board, they would have known about the law and known to form as PLLCs instead.
Drafting An Operating Agreement
A lawyer can also help by drafting your Operating Agreement (or bylaws, for a corporation). An Operating Agreement is a document that outlines the operations and management of your business. It’s especially important for multi-owner businesses because it serves as the partnership agreement – it outlines how decisions are made, what each partner’s obligations are, what happens if someone becomes disabled or dies, etc. Often, when we talk to people who formed their business through Legal Zoom and ask whether they have an Operating Agreement, they ask “What’s that?” When we form an entity, part of our mission is to educate and empower our clients to know what their Operating Agreement says and know how to follow it.
Start A Long-Term Legal Relationship
Finally, it’s smart to involve a lawyer in your business from the get-go so you can start a long-term professional relationship. After helping a client form their business, we often go on to help with contracts, leases, employment issues, and all other sorts of legal issues.
We hope that helped clear up some of the differences between LLC, S Corp, Corporations, and other entity types. If you have more questions or are ready to get started, our website has a lot of information about LLCs, S Corps, PLLCs, and more. You can also get in touch to set up a consultation with one of our attorneys. We’d be honored to help you and your business get going and keep growing.