Once the decision to form a business has been made, the founders must consider the type of business they wish to form, such as an LLC, sole proprietorship, S corporation or C corporation. While state law governs the formation and operation of these business types, several of these entities have basic characteristics that are the same from state to state. In addition to determining in which state you wish to create your business, there are several factors to consider - like liability and taxation – when deciding the best form for your business.
A limited liability company, or LLC, is a business entity that features limited liability for its owners, called members. LLCs are created when the members follow the protocol for the state in which the LLC is formed. This typically occurs with the filing of a certificate or articles of organization with the state agency that oversees businesses as well as paying of the filing costs. LLCs are similar to a corporation in that the members’ liability is limited with respect to the actions and debts of the LLC, but the LLC elects how it will be taxed. It can be taxed as a partnership where its income, expenses and losses are reported on the members’ individual tax filing, or it can be taxed as a corporation where the business itself will report the income earned, expenses and losses.
A sole proprietor is a much simpler business form as it is created by an individual’s decision to go into business for himself. There can only be one owner in a sole proprietorship; therefore, the sole proprietor can never raise capital by offering shares in the business. Typically, it is not required for a sole proprietor to register with the state as one must do for an LLC or corporation. The biggest difference from other business entities is there is unlimited personal liability as a sole proprietor for actions taken on behalf of the business as well as for business debts. Sole proprietorships are taxed on a “flow-through” basis, which means business income or losses are taxable at the individual level rather than at the business organization level. Therefore, the owner includes the business's financial data on his personal income tax return.
Read More: Can an LLC Be an Individual or Sole Proprietor?
A corporation is a legal entity separate from its owners, called shareholders. As a separate legal entity, corporations are liable for their actions and debts, rather than shareholders, who are liable only to the extent of their investment. Centralized management is a key feature of corporations; shareholders elect a corporation’s directors who manage the business. Formed in accordance with state law, a corporation is established when a filing fee is paid and articles of incorporation filed with the appropriate state agency, typically the Secretary of State. To maintain good standing, the corporation must meet ongoing obligations, such as filing annual reports. In addition to earning income from its business activities, a corporation can raise capital by becoming a publicly-traded company, which means it sells stock on stock exchanges. The corporate form also allows its owners to transfer their ownership interests. Finally, corporations are taxed at federal, state and sometimes local levels. Corporations pay income taxes on their profits and if they share those profits with shareholders, shareholders also pay taxes on that income, which is why corporations are said to face “double taxation.”
While S corporations are very similar to C corporations, the reason a corporation would elect S corporation treatment is for tax purposes. S corporations are taxed similar to partnerships and are “flow-through” organizations; owners reflect the business's income, expenses and losses on their personal income taxes. S corporations are created when a company elects S corporation treatment by filing Form 2553 with the IRS. There are several requirements in order to qualify for S corporation status. The corporation must be domestic, have no more than 100 shareholders who are not business entities, and only have one class of stock. Additionally, the corporation must not fall into prohibited regulated categories, such as financial institutions and insurance companies.
Kay Lee began freelance writing for Answerbag and eHow in 2010. She is an attorney in Washington, DC, practicing since 2006. Lee specializes in employee benefits and executive compensation. She holds a Juris Doctor from the Columbus School of Law and a Master of Laws from Georgetown University Law Center.