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Every business owner asks these questions at some point: “I am starting a new business. Should I form an LLC or a Corporation? Do I even need to incorporate at all?”
If you’re even thinking about starting a business, you should seriously consider incorporating.
There are two major reasons to form a business entity:
For most new business owners, protecting personal assets is the major reason to incorporate. It is inexpensive, relatively easy, and can help shield you from lawsuits. For instance, if someone sues your company and it is not incorporated, they will be able to go after your personal assets, bank accounts, car, or even your home. If you are incorporated, personal assets that do not belong to the company are generally protected.
This is not a free pass for illegal activity, however. A business owner may still have personal liability if he or she does something fraudulent or fails to maintain a legal separation between their business and personal financial affairs. For example, if a business owner pays personal bills from a business checking account or ignores the legal formalities of the corporation, a court may set aside the corporate protection and personal assets may be at stake.
That’s why most businesses buy a commercial liability insurance policy. The right insurance policy will help protect you and your business.
The second major reason to incorporate is sharing equity in the business between two or more owners. Without an entity, such as an LLC or a Corporation, operating a business with more than one person creates a “partnership.” Generally, you don’t want to be in a “partnership” without another form of corporate protection. That’s because in a traditional partnership, all of the “partners” are personally liable for each other and for the business. So if your partner gets sued for breaching a contract, you could be on the hook.
Secondly, it is often difficult to resolve disputes in a partnership. Without bylaws or rules on voting rights, it can be difficult or impossible for the business to take action. When there is a dispute, it can lead to dissolution of the partnership—a messy and expensive process.
Great move. Now it’s time to choose a corporate structure.
The most common types of corporations are Limited Liability Companies (LLC) and Corporations (C-Corp). The biggest differences between the two are the tax consequences and operating rules.
Corporations are what most people think of when they hear the word “incorporate.” Wal-Mart, Exxon, and General Motors are all corporations. Corporations are business entities that are created by registering with the state and letting them know that you’re operating a business as a corporation. These types of businesses issue stock, have boards, and must abide by internal rules.
Corporations work best when there are a large number of owners and investors. Traditionally, a “corporation” allows people or other companies to invest or own part of the corporation without assuming any risk for the company’s conduct. If the company gets sued or loses all its money, the investor is only liable for the money they have invested. All other personal assets are protected.
Corporations require 3 main types of people:
Owners are the individuals or companies who own stock in the corporation. They share in the profits/losses of the company, but do not necessarily run it.
Directors act as representatives of the shareholders and are responsible for managing the company. They hire managers and make executive level decisions about what the company will do.
Finally, officers run the day-to-day operations of the organization. Typically, the president, vice president, secretary and treasurer are all officers of the company.
In some companies, especially smaller companies, a single person can hold multiple roles. For example, if you are the sole owner of a business, you might be the sole shareholder, single director, president, treasurer, and secretary.
In the most basic sense, each “share” entitles the shareholder to 1 vote. So, if a shareholder owns 51% of the company stock, that shareholder can effectively control the company’s actions by outvoting everyone else. However, shareholders will often agree to vote together and “pool” their votes for a desired outcome.
For example, if your company has 3 equal shareholders, two of them can vote together to block the third shareholder from taking any action, such as appointing a new board member. Two owners may also be able push the third out of the company.
Shareholder disputes can get complicated very quickly, especially for larger companies or companies with different classes of stock. That’s why most Corporations will hire an attorney to draft a “shareholder agreement” to protect the rights of all shareholders.
If you do form a Corporation, you will need to comply with corporate formalities. This means coming up with company bylaws, holding annual shareholder meetings, complying with corporate voting rules, and holding board meetings. If you fail to follow the corporate formalities, you could be personally liable for the actions of the business. It can also cause issues with the IRS.
The LLC is the most common type of corporate entity, and with good reason. An LLC is a separate legal entity which offers protections like a corporation, but without all the formalities. Generally speaking, LLCs can dispense with formal meetings, the board of directors, and some record-keeping requirements.
LLCs are also easy to form. Most states allow you to file articles of organization online. There is no specific form to follow and many states even automate the process via their online filing system.
Another advantage of the LLC is the flexibility of initial ownership percentages and organizational structure. You can allocate some shareholders to those who will profit or lose more than others depending on the success of the business. A Corporation, by contrast, will allocate profits and losses according to the percentage of ownership (shares).
A drawback of the LLC is that ownership rights cannot be transferred as easily as those in a Corporation. In fact, many LLCs have operating agreements that restrict the transfer of ownership. As a result, the LLC is often disfavored by investors.
One of the biggest drawbacks of a traditional Corporation is “double taxation.”
In simple terms, a traditional Corporation is considered a separate legal entity from its shareholders. Corporations pay taxes on their annual earnings, just like individuals. When Corporations pay out dividends to their shareholders, those payments are subject to income tax liabilities. So, if you’re the sole owner of a traditional Corporation, the business is taxed on its income and you are taxed again on payouts to you.
To get around this, you can form your company as a Corporation, but ask the IRS to tax it like a Partnership (Subchapter S of Chapter 1 of the IRS code). These are commonly referred to as “S-Corps.” The S-Corp election is only available to certain businesses who meet IRS criteria:
If your company is owned by another company, has more than one class of stock, has a lot of shareholders, or has foreign shareholders, an S-Corp is not available.
If you do take the S election, the Corporation is treated as a “pass-through” entity for tax purposes. This means that the owners report their share of the profits/losses on their individual tax returns and double taxation is eliminated.
However, S-Corps are often the subject of closer IRS scrutiny and must still comply with all the formalities of a traditional Corporation.
On the other hand, an LLC is automatically treated as a pass-through entity by the IRS. The owners of the LLC report their share of the LLC’s profits/losses on their personal tax return and double taxation is avoided.
LLCs can have foreign shareholders and are not subject to all the formalities of a Corporation. Keep in mind there are still rules that need to be followed to retain the protections of incorporating.
It is always best to consult with an experienced lawyer about issues you may face. If you are doing it yourself, you can often find free forms online from the Secretary of State’s website. You can quickly obtain a FEIN number for your business from the IRS website.
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Michael Levenson has extensive experience working for insurance companies and in the health care field. Prior to joining InsureYourCompany.com, Michael was an attorney with one of the largest insurance defense firms in the country where he specialized in health care law and previously served as the judicial law clerk to a judge presiding in the New Jersey State Superior Court.
Mr. Levenson earned his Juris Doctor degree from Albany Law School with honors. While in law school, he served as a Constitutional Law Teaching Fellow and worked at Albany Law School’s Civil Rights and Disabilities Law Clinic, where he dealt with a myriad of health care law issues.
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