For all the time and energy it takes to set up an ugly entity, you might as well set up a good one.
Corporations
Now let’s get into the good entities, the ones that limit your liability and offer asset protection. Corporations, first chartered by the English Crown in the 1500’s, are the oldest good entities, so we will start with them.
When you set up a corporation, you are creating a new legal person. Upon being chartered by the state, a corporation establishes its own legal identity. No matter how passionate you feel about your business, no matter how personal it is to you, you are not your corporation. This separation offers a big benefit. Because a corporation has its own legal presence and its own tax identity with the IRS, the corporation acts as a shield for the owners, whose liability is limited to the money they invested to start the corporation. If the corporation is sued, it is the corporation itself, as a separate legal entity, that is sued, not the owners, whose personal assets are not part of the company and are protected by the corporate veil. (That is, unless you sign a separate Personal Guarantee agreeing to be personally responsible for the debt if your entity doesn’t pay it.) And because the corporation is its own separate legal entity the death of a shareholder doesn’t mean death of the corporation. In a corporation, ownership comes in the form of shares, and those shares can be transferred.
Starting a corporation (whether taxed as an S or a C corporation) requires some paperwork preparation, including:
• Organizational documents filed with the Secretary of State’s office in the state in which you wish to incorporate. For a corporation these are called Articles of Incorporation, which set out the company name, initial Board of Directors and authorized shares of the company.
• Because Articles of Incorporation become a public record, nothing proprietary or confidential should be included.
• In some states, a list of corporate officers (which may just be you) are filed with the Secretary of State.
• Bylaws of the corporation are the rules of the corporation and are not filed with the state. (They really don’t want all that much paperwork.)
C Corporations
Incorporating offers protection of your business and personal assets. However, a regular C corporation does feature double taxation. (Both the C and the S refer to the IRS code sections on corporate taxation.) In fact, the main drawback of a C corporation is that earnings are taxed twice. When the corporation makes a profit the corporation pays tax on the gain; when dividends are paid to shareholders (owners) they’re taxed as well. As such, you are taxed twice on the same dollar of income.
One way around this is to choose a corporate structure that allows for flow-through taxation, as illustrated here:
S Corporations
By filing IRS Form 2553, Election by a Small Business Corporation, right after setting up your corporation, you can become an S corporation. The advantage to the S corporation is that it’s a flow-through taxation entity. Essentially, when profits are made by the corporation, they are not taxed at the corporate level but rather flow through to the shareholder’s personal tax return, meaning they are only taxed once.
There are a few drawbacks to an S corporation. If you’re interested in taking your company public and publicly trading shares, you’ll have to be a C corporation, but you can always elect to switch from S corporation to C corporation status once you’re ready to go public. Another drawback is that once a corporation has elected to convert to a C corporation, there’s no way to revert back to an S corporation again for five years. An S corporation can’t have more than 100 shareholders or any nonresident shareholders. As well, an S corporation can’t be owned by a traditional C corporation, a multimember LLC or many types of trusts.
But for minimizing payroll taxes, as discussed ahead, S corporation taxation is superior. And know that you can have an LLC taxed as an S corporation.
Limited Liability Companies (LLCs)
The LLC is a newer entity that combines the flow-through taxation of a partnership with the limited liability aspects of a corporation. Like an S corporation, LLCs offer flow-through taxation. They also offer superior asset protection benefits.
LLCs are chartered with the state and thus provide limited liability to the owners (known as “members”). Like a corporation, members are protected from personal liability for business debts or legal claims against the business (unless, as with any other entity, they sign a personal guarantee). And, as in a corporate structure, members must remember to sign contracts and obligations as members of the company rather than putting themselves at risk by signing individually.
LLCs allow for flexible management. Either the members (owners) or the managers (the president, etc.) can run the company. They also offer flexibility in division of profits and losses. In a corporation, dividends are allocated according to percentage ownership. In an LLC, members can utilize special allocations to divide profits between members. So, for example, profits in an LLC owned 50/50 can be allocated on a 70/30 basis.
With an LLC, Articles of Organization are filed with the Secretary of State. Instead of bylaws, an operating agreement is created. As with a corporation, to avoid personal liability in an LLC you must:
• Maintain timely filings with the state.
• Prepare entity tax returns.
• Maintain a separate bank account for the business.
• Separate personal and business matters.
• Have adequate capitalization (funding) of the business.
• Hold annual meetings of managers and members.
From being brand new in the 1980’s, LLCs are now one of the most popular ways to do business and hold real estate.
Limited Partnerships (LP’s)
A limited partnership is akin to a general partnership, but offers more protection. Instead of just general partners in a general partnership, in a limited partnership there are general and limited partners. General partners (as in a general partnership) are personally exposed. A creditor can go after each and every general partner and all of their personal assets. As well, general partners face personal liability for partnership debt. Limited partners are only liable to the point of their contribution of capital to the partnership. To deal with the risk of being a general partner, an LLC or corporation can be set up to serve as the general partner in a limited partnership, thus encapsulating unlimited liability in another limited liability entity.
But, as the chart below indicates, you will need to set up two entities to be completely protected in an LP arrangement. With an LLC, everyone is protected in one entity.
When you elect to form as an LP, you’ll file a certificate of limited partnership with the Secretary of State’s office, and a limited partnership agreement will serve as the operational road map for the entity.
A chart of the good entities helps to explain the differences and similarities:
Where to Incorporate
Many people incorporate in the state where they do most of their business. And sometimes