When starting a business or even after operating for several years, many entrepreneurs will ask which legal entity is right for their business model. The motivation for forming an entity is primarily to avoid personal liability by limiting liability to the entity itself. Given that the limited liability protection is the same regardless of whether you select an S-Corp, LLC, or C-Corp, the question then is which entity is right for your business?
A major consideration in selecting the business entity is taxes.
A C-Corp is taxed twice as revenues come into the business entity and again when dividends are paid to the shareholders. Salaries, however, are deductible by the corporation.
Because of the double taxation on C-Corps, many small business owners prefer a pass-through entity such as an S-Corp or LLC to offset other ordinary income (such as a salary) against the losses of the business. However, if the profits of the C-Corp are not expected to be large and will not be paid out as dividends, certain business owners with high ordinary income from other sources will not want the profits of the business to be taxed at the same high rate as the rest of their income.
In addition to the tax considerations above, S-Corps and LLCs are not taxed identically in California. Although these entities “pass-through” to your individual taxes, you must pay a minimum $800 tax which increases on a sliding scale for LLC revenue above $250,000 regardless of whether the LLC is profitable. S-Corps, on the other hand, must pay 1.5% tax on profits in addition to the minimum franchise tax of $800. S-Corps do not have the same flexibility as LLCs in allocating profits and losses among the owners. However, with an S-Corp, you have the flexibility of taxing a portion of the gross profits as dividends as opposed to purely wages which are subject to self-employment tax. That said, LLCs also give you the option to elect to be taxed as an S-Corp to take advantage of the different tax treatment of dividends versus wages.
Because tax considerations vary depending on your individual circumstances, it is always best to discuss with your CPA how the varying entities will impact your specific tax circumstances.
Taxation is not the only key concern when selecting an entity. If you plan to seek venture capital or angel funding, the most favored business entity by investors is the Delaware C-Corp. Why? Many investors do not want the complications of a pass-through entity, and Delaware’s caselaw is most favorable to management. However, if you are a Delaware corporation operating in California, take note that your business may still be governed by many of California’s laws as a “quasi-Californian” entity.
California-based entrepreneurs have often asked whether it is sufficient to incorporate in Nevada or Delaware without qualifying in California to avoid the high $800 annual minimum tax. Although some internet sites advocate incorporating in Nevada, if you are operating out of California (i.e. your offices, employees are in the state, etc.), you must also qualify in California. If you do not, you cannot bring a lawsuit in California as a plaintiff. For example, if someone owes you money, and you need to sue in California, you cannot until the entity exists; and, you may be subject to other late fees and penalties for failing to register on time. By incorporating in Nevada but operating in California, you will end up paying taxes in Nevada and California, when your franchise taxes would have otherwise been limited to California.
Another frequent question is whether to simply incorporate online rather than through an attorney. Online incorporation is certainly less expensive. However, without the oversight of an attorney, you may end up having to dissolve and reform the entity, amend the Articles of Organization and Incorporation, and revise a number of your formation documents with potentially unforeseen tax consequences as a result. I once reviewed a set of essentially fill-in-the-blank incorporation documents which a client had been relying upon for years (and for which he had paid $700, very expensive copying fees). He was trying to stage his company for an acquisition, and I explained that no one actually owned his company because no shares had been issued. You can imagine his surprise. My advice to any business owners when forming their entities is to do it right the first time. Fixing the problems later may be costly and result in unexpected consequences.
When selecting a business entity, surround yourself with your tax and legal team to ensure your company is headed in the right direction. If you select an entity that you later decide is no longer right for your business, conversion is possible, though it will involve additional accounting and legal time. Plus, the IRS will only let you change your mind every so often. The best course of action is to carefully map the tax considerations and funding objectives of your company before launching.