Legal Entities – Finding the “Perfect Fit” for Your Business

FeetIn a previous blog post, we discussed the importance of structuring your business as a separate legal entity. Doing so helps protect personal assets from creditors, and it influences the amount you pay in taxes. There are different entity structures; each serves a purpose, and that purpose may or may not align with your business needs. It isn’t always obvious which entity structure best suits your business. While legal counsel can help you determine which entity formation will best complement your business operation, weighing the advantages and disadvantages of each can guide you towards the perfect fit between an LLC and a corporation.

A limited liability company (LLC) has the compositional qualities of a partnership, with the limited liability benefits of a corporation. LLC owners (or members) are only liable to creditors for the amount they individually invest. If you have a small, upstart company, forming an LLC might be the most attractive option, because it offers the most tax flexibility and structural flexibility, and least administrative formalities. First, owners can choose how they wish to be taxed, selecting from different subtypes of LLC’s. They can be taxed as a single-member LLC, where the company will be taxed like a sole proprietorship and not treated as a separate entity. Instead of the company being taxed directly, the IRS will tax based off of the single member’s federal tax return. They can be taxed as a multi-member LLC, in which all involved members choose to be taxed as if they were operating a partnership. Further, members can choose to be taxed as a corporation. In addition to tax flexibility, the eligibility requirements are more relaxed for LLCs, with low start-up costs and minimal paperwork. Paired with less mandated recordkeeping, lower administrative costs are favorable.

Despite these benefits, LLCs are not immune to disadvantages. In fact, most of these disadvantages arise because an LLC’s identity is tied so closely to its members. First, the departure of any member can terminate the LLC, requiring the company to file for LLC status again. For this reason, LLCs are said to have a limited life, unlike more durable corporations, whose existence is not tied to the presence and absence of shareholders. Second, unless members choose to be taxed as a corporation, they will be treated as self-employed, owing Social Security and Medicare taxes to be paid by their share of income.

However, LLCs are not always a sure fit for many companies who prefer the traditional corporation structure. Some benefits of small business incorporation include extensive personal asset protection and a complete legal separation between owner identity and company identity. The costs of operating flexibly can be prohibitive, as an LLC’s entire net income is subject to a hefty self-employment tax. Plus, to maintain its LLC status, an LLC has the (counterintuitively) difficult task of appearing as dissimilar from a corporation as possible. The IRS has listed four characteristics that define a corporation, and prohibits an LLC from possessing more than two. Exceeding two requires the business to refile as a corporation. Corporations are subject to formal obligations, which can be burdensome and often require additional administrative support. However, some of these obligations behoove corporations and help them to keep organized – a department in which many LLCs struggle. Unlike LLCs, corporations mandate that members be assigned specific roles, which can cause some organizational difficulties when it is unclear who has managing power, contracting power, etc.

Corporations tend to be a better fit for larger business, with the exception of S Corporations. Check out our next entry, where we’ll dig into the distinctions between different corporation structures, and see how they align with your business needs.

Bexley Law Firm, LLC