How Do I Choose the Right Legal Entity for My Startup Business?
If you’re starting a new business, one of your earliest, and most important considerations is picking the legal entity that best suits your endeavor. There are a handful of options available, each of which comes with distinct compliance requirements, tax considerations, and overall levels of flexibility. Here are three of the most common – LLCs, S corporations, and C corporations – each of which should be examined with your unique business and tax goals in mind.
Limited Liability Companies – A Popular Choice for Startups
One of the most popular structures chosen by startups is an LLC, where all income and expenses are passed through to the owners. This means that the LLC is not subject to tax on its business income. Instead, the owners report their share of income and expenses from the LLC on their personal tax returns and pay tax from there. In addition to the simple flow of income and expenses to owners, this structure also protects owners in case of a legal dispute. Should one arise, an owner’s personal assets are protected, and creditors are only entitled to their share of capital in the LLC to settle disputes and liabilities.
S Corporations – Numerous Advantages Including Pass-Through Taxation
Another option is starting up as a corporation that elects to be taxed as an S corporation, which is often a good option for startups that plan on converting to a C corporation in the future, or ones that plan to raise more capital from outside investors. Startups can attain S corporation status if they’re a domestic corporation with no more than 100 shareholders, and only one class of stock. Like an LLC, S corporations pass through all income, losses, and deductions to their shareholders, who then report the net income on their personal tax returns. This provides limited liability to shareholders and avoids the double taxation that is inherent in C corporations.
C Corporations – Benefits for Growth Minded Businesses
A C corporation is a legal entity that is separate from its owners/shareholders and like other structures, provides limited liability. One benefit of a C corporation is there are no limitations on who can be a shareholder, the number of shareholders, or the number of classes of stock. Another benefit is something called perpetual existence, which basically means the corporation will continue to exist until it is dissolved. In addition, investors can freely transfer shares, a feature that is attractive for startups that plan on going after venture capital. You should also consider forming a C Corporation if you don’t want to be subject to self-employment tax. However, a C corporation is subject to double taxation, which means the corporation is first taxed on its business income, and any leftover profits are distributed as dividends to shareholders, who then report the income on their personal tax return. This has an impact on dividend declaration because C corporations can retain income in the form of retained earnings, as opposed to distributing dividends to shareholders to avoid double taxation.
Article by Muhammad Junaid, Senior Tax Manager