Business Entity Selection

One important consideration when starting your business is determining the best legal structure of your business. Your selection of legal structure will affect operating efficiency, transferability, control, the way you report income, the taxes you pay, and your personal liability.

Here is the comparison of some of the basic considerations while selecting one of the five most common structures for your business entity:

  Sole Proprietorship(SP) Limited Liability Partnership (LLP) Limited Liability Company (LLC) S Corporation C Corporation
Limited liability No Yes (for LPs only) Yes Yes Yes
Perpetual life No No Yes Yes Yes
Eligibility Physical persons No limitation No limitation (Limited if “S” election is made) U.S. citizens or permanent residents No limitation
Maximum shareholders Single owner Unlimited Unlimited members 100 Unlimited
Minimum ownership 1 2 or more 1 in many states 1 1
Ownership by other corporate entities N/A Yes Yes No Yes
Classes of stocks No No No Yes Yes
Flow through entity N/A Yes Yes (if treated as SP, Partnership or S Corp) Yes No
Double taxation No No No(unless treated as a C Corp) No Yes
Tax flexibility Medium Medium Highest Medium-high Low
Federal tax forms 1040 (Schedule C) 1065 1040, 1065, 1120S or 1120 1120S 1120

The choice of a legal structure can be complicated and errors can be costly. In addition, current tax laws make it difficult to change your legal structure after you begin operating. Making the right decision before you open for business is very important.

Consult with a CPA who can help you decide what type of entity and structure is best for your situation and type of business, explain how business structure affects your organization’s bottom line, and file the necessary paperwork to start your business.

LLC vs. S Corporation – Which One Is Better?

The main similarity between Limited Liability Company (LLC) and Subchapter S Corporation (S Corp) entity types is that they both allow the benefits of limited liability protection and pass-through taxation. However, both these entity types have their unique set of advantages and disadvantages that you should be aware of, while deciding which one of the two types is more beneficial for your unique circumstances.

An LLC offers ease of creation, less restrictions on ownership structure, and fewer reporting requirements and corporate formalities. An LLC allows profits and losses to be shared among its members in a manner other than member’s pro-rata ownership in business. Also, a single-member LLC is permitted to report business activities on owner’s personal income tax return rather than filing a separate tax return. A couple of potential downsides of an LLC in comparison to an S Corporation is that you may potentially pay more in employment taxes, and there are some restrictions regarding whom you can sell your business ownership interests to.

An S corporation has restrictions as to who can be an owner and the number of owners there can be. An S corporation requires its profits and losses to be shared in proportion to each shareholder’s ownership in business. In addition, an S Corporation is always required to file a tax return, regardless of income or loss. Shareholders of an S Corporation are required to pay estimated taxes on their income from S Corporation on their own returns. A couple of potential benefits of an S Corporation in comparison to an LLC is that you may potentially pay less in employment taxes, and there are generally no restrictions regarding whom you can sell your business ownership interests to.

The biggest consideration in deciding between an LLC and an S corporation is employment taxes.

An LLC owner is considered self-employed and not required to withdraw a salary. An S corporation shareholder, on the other hand, is not considered self-employed, and is required to withdraw a reasonable salary for his/her time and efforts devoted to the business. In essence, an LLC owner pays self-employment taxes on all profits distributed to him/her, whereas, an S corporation shareholder pays self-employment taxes only on the reasonable salary he/she is required to withdraw. S corporation profits, net of the reasonable salaries paid to the shareholders, are not subject to self-employment taxes.

IRS does not provide specific guidelines as to what is considered as reasonable salary. It is the responsibility of taxpayer to determine that. Factors considered by the courts in determining reasonable salary for employees or officers of an S corporation include duties and responsibilities, training and experience, time and efforts devoted to the business, dividend history, amounts that comparable businesses pay for similar services, etc.

In the end, there is no single right answer to the question as to which one is better – LLC or S corporation. The answer depends on your unique circumstances. Consult your CPA to weigh pros and cons of each entity type and select the one that is best for your situation.

Protecting Corporate Veil

Many owners of incorporated business entities believe that their personal assets are protected against the debts or obligations of their business, no matter what. While limited liability is one of the principal characteristics of business entities, simply incorporating a business is not enough to protect against personal liability. Once a business is properly incorporated as a separate legal entity, business owners must operate their business as such and follow all the required corporate formalities throughout its existence in order to create a shield, known as “corporate veil”, against personal liability.

Courts across the country recognize a doctrine known as “piercing the corporate veil” which most often arises in connection with a creditor’s attempt to hold corporate shareholders or LLC members personally liable for the debts of their business entity. Courts are likely to allow the piercing of corporate veil and hold the business owners personally liable, if the business entity is found to be simply the “alter ego” of the owners, or when owners disregard the required corporate formalities to the extent that the business entity is no longer distinguishable from its owners.

Here are some practical tips to reduce the likelihood that the corporate veil of your business entity will be pierced:

  1. Make sure your business is incorporated correctly.
  2. Have a separate bank account for your business on its name.
  3. Do not commingle or freely transfer funds between your business account and your personal account, or between your parent company and its subsidiaries.
  4. Do not pay your personal expenses out of the business checking account.
  5. Capitalize your business adequately.
  6. Do not hold the business assets in your name. Hold them in the name of your company.
  7. Do not provide personal guarantees.
  8. Sign contracts and other legal documents as an agent for your business entity. Do not simply sign your name without reference to your business entity.
  9. Observe required corporate formalities such as conducting shareholder and Board of Directors meetings after giving proper notice, keeping minutes of the meetings, issuing stock certificates, etc.
  10. Follow formalities regarding loans to shareholders; have them properly authorized and documented, have arms-length interest rate and terms, and require repayment.
  11. Do not pay loans from shareholders before unrelated creditors.
  12. Make the type of your business entity known via business card, website, invoices, letterhead, etc.
  13. Do not let Parent Corporation control a subsidiary’s operations. Have separate officers and directors for each.
  14. Timely file the annual report with the Secretary of State.
  15. File corporate income tax returns.

Basically, if a court cannot separate what belongs to your business from your personal belongings, and if you cannot provide any proof that all the required corporate and other formalities have been followed, it may be deemed that you are acting more like a sole proprietorship than as a corporation or an LLC, and therefore, you may lose your limited liability protection. Consult with a CPA or an attorney to ensure that your corporate veil is strong. 

Operating Your S Corporation

After your business is allowed to be treated as an S Corporation by the IRS for tax purposes, it is important for you to observe certain corporate formalities and meet specific reporting requirements. This is for you to maintain your S corporation status in good standing and continue to receive the asset protection and tax benefits afforded by the S corporation status.

Here is a list of some of the tasks throughout the year to operate your S corporation properly:

  • Draft and follow bylaws: Bylaws are the rules for the operation and interactions between shareholders. You will need a set of bylaws to show the IRS that your S corporation is distinct from the shareholder as an individual. You should know what your bylaws require, and comply with them before taking any action. 
  • Hold meetings: Generally, S corporations are required to have at least one meeting of stockholders and one meeting of the board of directors each year. Elect directors and officers, issue stocks, and adopt bylaws at initial shareholders meeting.
  • Keep minutes: Draft minutes from the meetings and file them in your corporate book. It is important you hold meetings and keep minutes even if you are the only shareholder in your corporation.
  • Create a stock ledger and a corporate book: A stock ledger is a document that keeps records of the issuance and transfer of all shares, the names and addresses of all current shareholders, the number of shares held by each shareholder, etc. A corporate book houses all corporate documents including your bylaws, meeting minutes, and notices.
  • Setup payroll: S corporation status requires shareholders to determine and withdraw a reasonable salary. Shareholders are required to pay estimated taxes on their income from S corporation on their own personal tax returns. Setup your payroll system to file quarterly payroll reports and make deposits.
  • File tax returns: S corporations are required to file an annual corporate tax return (Form 1120S) even if there was no business activity during the year.
  • File annual reports: This is an annual filing required by the secretary of state to update the information on file for your S corporation. An accompanying fee is required to be paid on an annual basis.

S corporation can be a powerful tool for asset protection and tax savings. However, it comes with additional corporate formalities and administrative costs. Operating your S corporation can be time-consuming and maybe even a distraction from your focus of growing your business. Ask your CPA to help you operate your S corporation properly and handle most of the procedural work.