LLC or Corporation?

Choose the Right Form for Your Business

Anthony Mancuso

• Publisher: NOLO
• Year: 2020
• Print ISBN: 9781413328004
• eBook ISBN: 9781413328011
• Edition: 9
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

LLC vs. C-Corp vs. S-Corp: The most important business decision you'll make

Whether you are starting a new business or thinking about an existing one, the big question is "Which legal structure is best?" The answer has important legal and tax consequences. LLC or Corporation? explains:

• the basics of all business entities
• why sole proprietorships and partnerships are usually a poor choice
• how to avoid being personally liable for business debts
• how to pay less tax by choosing the right entity
• how to convert from one business entity to another, and
• requirements for doing business out of state.

LLC or Corporation? is packed with real-world examples to help you make the best choice for your company.

The 9th edition is updated with COVID-related information for small businesses.

PART

1

CHAPTER

1

Business Entity Basics

Why Your Choice of Entity Matters

Sole Proprietorships

Number of Owners

Liability for Business Debts

Income Tax Treatment

General Partnerships

Number of Partners

Personal Liability for Business Debts

General Partnership Income Taxation

Limited Liability Companies (LLCs)

Number of Owners

Limited Liability

Pass-Through Taxation

Management

Formation Requirements

Corporations

Number of Shareholders (Owners) and Directors

Limited Liability for Shareholders

C Corporation Income Taxation

Corporate Management

Corporate Capital and Stock Structure

Employee Fringe Benefits

. . . And the Runners-Up: Limited Partnerships, S Corporations, and RLLPs

Limited Partnerships

S Corporations

Registered Limited Liability Partnerships (RLLPs)

Do you really have time to read this book? Shouldn’t you be devoting more time to your accounting, your competition, your overhead, or your business plan? After all, as Calvin Coolidge once said, “The chief business of the American people is business”—so why not hire a lawyer to advise you about your choosing a legal entity for your business, put down this book, and get back to work?

Why Your Choice of Entity Matters

Here are three reasons why you need to learn more about the various legal forms your business might take:

• You’re making a business decision. Your ability to raise capital, defend your rights, survive business taxation, or manage your company efficiently is all tied to your choice of business entity. In other words, your decision about what type of business entity to form can be as crucial to your business success as your marketing, hiring, or sales decisions. The only way you can be sure you’re on the right course, even if you hire a lawyer, is to understand the legal and financial basics of each business structure.

• You’ll save money. Hiring a lawyer can be helpful, particularly if there are disputes among multiple owners of a business. But hiring a lawyer can also be expensive or unnecessary. If you take the time to read this book, you can save money and make a reasoned decision about your choice of entity. You can also save money by using products or services that specialize in business formation.

• You’ll keep your options open. Every growing business changes its form of entity. Most start as sole proprietorships or partnerships and then evolve into corporations or LLCs. The business entity you choose today may affect your choice of entity in the future. In other words, you’re not just picking a business entity; you’re plotting a business strategy. The more information you have, the better equipped you will be to plot the right course.

Now that you know why this is an important decision, it’s time to learn some basic information about each type of business entity.

TIP

Pass-through deduction. Under the federal “Tax Cuts and Jobs Act,” owners of sole proprietorships, partnerships, LLCs, and S corporations may be eligible to deduct up to 20% of their business income on their federal tax returns. Limitations apply to personal service businesses. This deduction began in 2018 and is scheduled to end on January 1, 2026 unless extended by Congress. For more information, read Nolo’s article “The 20% Pass-Through Tax Deduction for Business Owners” at www.nolo.com or ask your tax adviser for more information.

Sole Proprietorships

The simplest way to be in business for yourself is as a “sole proprietor.” This is just a fancy way of saying that you are the owner of a one-person business. There’s almost no cost or bureaucratic red tape involved in forming a sole proprietorship, other than the usual license, permit, and other regulatory requirements that your state and/or locality imposes on any business. And you don’t have to do anything to create a sole proprietorship: If you start a one-person business and don’t form a corporation or LLC, you have created a sole proprietorship, and that’s how the state and the IRS will treat your business.

As a practical matter, most one-person businesses start out as sole proprietorships just to keep things simple.

EXAMPLE: Winston is a graphic artist who started a sideline computer graphics business in his garage. Winston works only part time in his own business and has no employees. He has just a couple of clients and no pressing personal liability issues, so he chooses to operate as a sole proprietor (his other choices would be to form an LLC or a corporation). Outside of a business license, fictitious name filing, and tax permit, Winston does not need to file any legal paperwork. Unless Winston takes steps to change the legal structure of his business—by filing the necessary papers with his state to form a one-person LLC or corporation—his business will automatically be classified and treated as a sole proprietorship.

Businesses Owned by Spouses

Generally, if a husband and wife carry on an unincorporated business together and share in its profits and losses, they are considered the co-owners of a partnership, not a sole proprietorship, and they must file a partnership tax return for the business. However, there are a few exceptions to this rule.

One exception provides that if one spouse manages the business and the other helps out as an employee or volunteer worker (but does not contribute to running the business), the managing spouse can claim ownership and treat the business as a sole proprietorship.

Another exception is that the spouses can elect to divide up the profits of the business and report them separately for each spouse on their joint 1040 tax return, provided that:

• The business is unincorporated and is not a state-created business entity, such as an LLC or limited partnership.

• The only members of the business are a husband and wife who file a joint 1040 tax return.

• Both spouses materially participate in the trade or business.

• Both spouses elect not to be treated as a partnership (the spouses do not file a separate partnership return for the business).

They accomplish this reporting by filing a Schedule C for each spouse with their joint 1040 tax return, showing each spouse’s share of profits on each Schedule C. Each spouse also includes a self-employment tax schedule (Schedule SE) to pay self-employment tax on each owner’s share of the profits. If the spouses qualify for this exception, each spouse gets Social Security credit for his or her share of earnings in the business.

Finally, there is another special exception to partnership tax treatment available in several states. Specifically, IRS rules say that an unincorporated business (including an LLC) that is owned solely by a husband and wife as community property (and in community property states including Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), can treat itself as a sole proprietorship by filing an IRS Form 1040 Schedule C for the business, listing one of the spouses as the owner. Only the listed spouse pays income and self-employment taxes on the reported Schedule C net profits. This means only the listed Schedule C owner-spouse will receive Social Security account earning credits for the Form SE taxes paid with the 1040 return. For this reason, some eligible spouses will decide not to make this Schedule C filing and will continue to file partnership tax returns for their jointly-owned spousal LLC.

Also note that the IRS treats the filing of a Schedule C for a jointly owned spousal LLC as the conversion of a partnership to a sole proprietorship, which can also have tax consequences.

For more information on spousal businesses, see the sections entitled “Community Property,” “Husband and Wife Partnership,” and “Qualified Joint Venture,” in the “Forming a Partnership” portion of IRS Publication 541 (Partnerships), and other information on the IRS website (www.irs.gov). In all cases, be sure to check with your tax adviser before deciding on the best way to own, file, and pay taxes for a spousal business.

Number of Owners

By definition, a sole proprietorship has only one owner. If your one-person business grows and you wish to include other owners, you will need to choose another business structure, such as a partnership, LLC, or corporation.

Liability for Business Debts

Unfortunately, although forming and running a sole proprietorship is simple, it can also be risky. That’s because sole proprietors are 100% personally liable for all business debts and legal claims. For example, if someone slips and falls in a sole proprietor’s business and then sues, the owner is responsible for paying any resulting court award (unless commercial liability insurance covers it). Similarly, if the business fails to pay suppliers, banks, or bills from other businesses, the owner is personally liable for the unpaid debts. This means that the owner’s personal assets, such as his or her bank accounts, equity in a house or car, and other personal assets can be taken by court order and sold to repay business debts and judgments.

Of course, some businesses are much more vulnerable to debts and lawsuits than others. If you run a part-time business that does not operate on credit and is unlikely to engender lawsuits, you probably don’t need to worry about these issues. (Chapter 2 provides more information about personal liability.)

Income Tax Treatment

Sole proprietors report their business profits or losses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship), which they file with their 1040 individual federal tax returns. The owner’s profits are taxed at his or her individual income tax rate. This is called “pass-through” taxation because the income passes through the business to the owner’s individual tax return. In other words, like a partnership, a sole proprietorship is not taxed separately under the federal tax scheme.

Most start-up business owners prefer pass-through taxation of their business income, at least in the beginning. Why? Reporting and paying individual income taxes by preparing a Schedule C (and a Schedule SE for self-employment tax) are a lot easier than preparing a corporate tax return or dealing with partnership income taxes.

Because sole proprietors are self-employed, they have no employer to chip in part of their Social Security and Medicare taxes (called “self-employment taxes” for those working for themselves and “FICA taxes” for regular employees). Regular employees generally pay half of these taxes through payroll deductions, and the employer pays the other half. Sole proprietors must pay the entire amount themselves (by preparing Schedule SE, the Self-Employment Tax return, which must be filed along with a Schedule C and 1040 income tax return each year).

Although this might seem like a disadvantage of forming a sole proprietorship, it actually isn’t. If that same sole proprietor had instead formed a one-person corporation, he or she would personally pay half of the tax and the corporation would pay the other half. The money would come from two different sources, and the tax reporting requirements are different, but the whole amount still ultimately comes out of the owner’s pocket.

TIP

Unincorporated business owners can deduct the cost of health insurance. Federal tax law allows sole proprietors, partners, and LLC owners who work as employees in their business to deduct the full cost of health insurance premiums paid out by their business for themselves and the other employees in the business. This tax break is available to unincorporated business owners who work in their business.

General Partnerships

A partnership is a business in which two or more owners agree to share profits (and losses). If you go into business with at least one other person, you have automatically formed a general partnership—even if you never signed a formal partnership agreement. A general partnership really can be started with a handshake (although it makes far more sense to prepare and sign a written partnership agreement—see “Create a Written Partnership Agreement,” below).

EXAMPLE: Two web designers set up a side business to design websites for nonprofit organizations. They are too busy working to bother thinking about the best business structure for their new sideline business. Without taking any formal action or creating a partnership agreement, they have formed a partnership. If the partners were to have a dispute—over the division of profits, perhaps—in the absence of an agreement, state partnership law would control the outcome. Once they realize that their informality might subject them to rules that are not of their choosing, they decide to prepare a written p...

Table of contents

• Cover
• Title
• Copyright
• Acknowledgments
• About the Author
• Table of Contents
• Your Legal Companion
• Part 1
• Part 2
• Part 3
• Appendix
• Index