Blog articles tagged "incorporation"

An LLC can be treated as an S-Corporation for tax purposes if it makes an S-Corporation election as long as the entity meets the IRS criteria to be taxed as an S-Corp, files an S-Corp election and gets approved by the IRS to be taxed as an S-Corporation. Without an S-Corporation election, single member LLCs default to be taxed as sole proprietors and a multi-member LLCs defaults to be taxes as partnership since they are considered “disregarded entities”. However, if a single or multiple member LLC agreement meets the IRS criteria to be classified as a small business corporation, the S-corporation election is filed and gets approved by the IRS, then for tax purposes, not legal purposes the entity is an S Corp not a LLC.

Many small business owners incorporate their businesses not only for legal protection, but also to reduce owners’ payroll taxes through S-Corp tax election with the IRS. One advantage of an S-Corp is that it gives business owners the ability to reduce their self employment taxes. Any small business owner who has not made an S-Corp election and uses Schedule C for their personal tax return for 2010 is subject to both employer and employee FICA and Medicare payroll taxes at 15.3% up to $106,800, 2.9% Medicare for Schedule C net income greater than $106,800, and California SDI for 1.1% up to 93,316. If a business owner pays himself/herself a “reasonable salary”, the rest of the net income is not subject to these payroll taxes.

Whenever a corporation or limited liability company does business (i.e. enters contracts or agreements) in a state other than the state in which they are domiciled, they are required to do a foreign filing in that state. For example, if a business is incorporated in Delaware, but has an office and/or employees based in California, that business needs to do a foreign filing in California. In such a situation the corporation will need to pay franchise taxes in both Delaware and California.

In a pass-through (or flow-through) entity, the entity’s income and expenses “pass through” the entity and are treated as the income and expenses of its owners. LLCs and S-Corporations are pass-through entities. This differs from a C-Corpoartion (which is the default form of corporation) which is taxed a corporate income tax at the end of the fiscal year in addition to the personal income taxes and dividend taxes that its owners and employees pay. Federal corporate income tax is about 15% to 35% of profits, and most states also have corporate income tax. This means after a C-Corporation has paid its expenses for the year, it will be taxed at least 15%-35% of whatever is left above the amount the company started with that year. If the company is an LLC or an S-Corporation, there is no corporate tax, and indeed the owners can even apply losses of the company against their personal income.

If your business only has a few investors and you do not anticipate receiving outside financing in the near future, an LLC is probably best for you because of its flexibility, simplicity, and pass-through taxation (see blog entry on pass-through taxation). However, if you want a board of directors that is distinct from the officers and/or shareholders of the company, or if you are looking for institutional investors, then a corporation is probably a better form of entity because of its more organized and established structure of governance.

A corporation is made up of three groups of people – the shareholders, the board of directors and the officers, although the same person can hold multiple positions. The board of directors is formally elected by the shareholders and represents their interests. It is the board of directors that hires the officers of the company, also known as the management. The management’s job is to oversee the day-to-day operations of the company. Major decisions, however, require the approval of both the shareholders and the board of directors. A corporate structure is thus a highly organized and rigid structure of governance that can often be quite burdensome. A corporation requires a slew of corporate governance documents that must be frequently updated. It also requires that annual meetings be held for shareholders and the board of directors.

LLC stands for “limited liability company”. Generally it provides the same legal protections from personal liability as a corporation, however it is governed more like a partnership than a corporation. Whereas a corporation’s owners are called shareholders, the owners of an LLC are known as members. An LLC does not require a board of directors or even officers and can simply be managed directly by its members, if so desired. It can also be structured more like a corporation, with managers that are distinct from its owners. LLCs allow for significantly more flexibility than do corporations. For instance, the owners of an LLC can allocate distributions in whichever way they see fit. Even if the ownership of an LLC is split 60/40, the owners can decide to split the profits 50/50 – something that is not possible in a corporation without a significantly more complicated structure.

A limited liability entity (a corporation or an LLC) provides both financial and liability benefits. The financial benefits include the ability to deduct more business expenses from annual revenue when calculating taxable income than would be possible without an entity. Forming a limited liability entity also helps protect your personal assets in the event of a lawsuit or from debtors in a situation where your business’s liabilities exceed its assets. This means that as the owner of limited liability company, your personal assets will not be placed at risk because of the actions of your company, as long as the company is kept separate from your personal assets. This requires the corporation or LLC to: 1) make sure the company is adequately capitalized (it has the money necessary to cover the reasonably predictable legal and business responsibilities of the business); 2) that the company keeps clean accounting books and has accounts that are separate from the personal accounts of its owners or employees; and 3) that all legal documents are adequately maintained and the company complies with corporate governance laws.

Also, forming a corporation or llc usually makes it easier for a business to borrow money and to sell all or parts of the business in the future. It is important to note that the longer a business operates without a legal entity, the more complicated and expensive it becomes to transform it into one. For this reason it is very important to form a legal entity as soon as feasible.