The decision to form a new business can be complex. It involves both state-law considerations (whether the business will be a corporation or LLC under state law, for example) and tax considerations (what tax classification is best for the business). These considerations determine both the type of entity to form and how it should be structured.
This guide cuts through the confusion. It is designed to provide practical, actionable guidance on choosing the right business structure to accomplish your business and legal goals at the lowest tax cost.
The Choice-of-Entity Decision
You have a business idea. You think it is a good business idea. After some deliberation, you decide this one is worth your time. You are going to go for it.
Unfortunately, this decision—which attorneys call the choice-of-entity decision—has been unnecessarily complicated by the staggering amount of bad advice dispensed by attorneys, CPAs, LLC formation scam artists, and misinformed laypeople.
One attorney may tell you that all businesses should be formed as LLCs. Another may say that you should organize as a corporation to attract investors. Another may say that an S corporation can help save employment taxes.
Even though this advice may be well-intended, it often reflects the bias of the person dispensing the advice. The truth is that there are no one-size-fits-all business entities. The business structure that is right for you may be an awful choice for someone else. As with most legal issues, a lot depends on your specific situation. Each business has characteristics that make it more suited to one business entity type and tax classification than another.
The Four Business Profiles
To prevent missteps that need to be corrected later, it is important to select the business that accomplishes your legal and business goals at the lowest tax cost. Many new businesses fit into one of four business profiles, each of which has its own legal and tax needs:
- Real Estate Owners or Investors. Real estate owners and investors often benefit from LLCs that are either disregarded for tax purposes or taxed as partnerships. This structure can provide charging order protection, avoid double taxation, and give the owners better opportunities to use entity-level debt to save taxes. Depending on the number of investments, a series LLC or holding company structure may provide added protection.
- Service Businesses and Other Self-Employed Individuals. Service providers and self-employed individuals—including consultants, developers, designers, writers, instructors, or professionals in the fields of law, medicine, engineering, or accounting—can use LLCs taxed as S corporations to both avoid double taxation and save self-employment taxes.
- Bootstrappers. Bootstrappers sell physical or digital products and plan to use their own sales to propel future growth. Although they may want to keep the option open to attract investors, their business plan doesn’t depend on seeking outside funding. Bootstrappers can use a wait-and-see approach to entity formation, starting out as an LLC with the possibility of converting to a C corporation later (if needed to attract investors).
- High-Growth Technology Startups. A high-growth startup with immediate plans to seek funds from venture capitalists or other institutional investors is often served best by a state-law corporation taxed as a C corporation. Although C corporations are taxed twice on their income, this may not be as much of a concern for founders that plan to reinvest profits and sell their stock as qualified small business stock in a tax-free sale.
These four profiles provide an analytical framework for evaluating the choice-of-entity decision. Although there are businesses that do not fit cleanly within any of these profiles, most businesses fit roughly into at least one category. Understanding which profile fits your business can help you choose the businesses entity and structure that is right for you.
Why You Need a Corporation or LLC
You know that you should form an LLC or corporation for any business that owns assets or produces income. But you may not understand why, exactly, you must form one of these business entities or which type to form.
The best way to understand why you need an LLC or corporation is to understand what can happen if you don’t have one. If you conduct business without an LLC or a corporation:
- You Can Lose Your Personal Assets for Business Obligations. Without a corporation or LLC, you are personally responsible for the debts and obligations of the company. If you are found to have breached a contract or end up in a lawsuit, the plaintiff’s attorney will file claims against your personal assets to satisfy the judgment. Your personal real estate, bank account, and automobiles may all be at risk for debts and obligations of the business. LLCs and corporations limit your personal liability for business obligations.
- You May Miss Out on Tax Savings. Strategic business planning can often reduce your overall income tax liability. Your tax savings opportunities depend on the entity you choose, the income the business earns, the potential deductions available to you, and your income from other sources. Without the right business structure, you may lose out on these opportunities.
- You Have No Framework for Operating Your Business. When you form a new business with the state, it becomes subject to a set of default rules that govern how the business is conducted. These default rules are further customized by your governing documents (like an LLC operating agreement or corporate bylaws). Taken together, state law and your governing documents provide a framework for organizing and operating your business. Without that framework, your business operations are left to whim and can be easily challenged.
- Your Business Dies When You Do. Unless they are formed for a specific term, businesses never die. This perpetual existence allows you to form a business that can continue to operate and be passed to others at your death. Depending on your personal tax liability, your business can use advanced tax planning to reduce your estate and gift tax liability. Without an LLC or corporation, your business dies with you.
- You Lose Professionalism and Credibility. An LLC or corporation provides professionalism and credibility when dealing with third parties. Lenders, investors, contractors, and customers expect to deal with corporations or LLCs. They may question your professionalism if you conduct all of your business through your personal name.
- You Will Have Trouble Raising Money or Selling Your Business. Without a business entity, there is no way to convey a portion of your business to an investor or buyer. Any angel investor, venture capitalist, or other investor will expect a properly formed business entity as a condition of their investment. Similarly, any lender or prospective buyer of a business will expect the business to be legally formed and operated.
- You Forfeit Your Privacy. When you conduct business under your name, that name is used on every single contract, advertisement, legal filing, or other matter involving the business. LLCs and corporations protect your privacy by providing a professional business name through which to conduct the business.
Forming an LLC or corporation provides relatively low-cost risk protection and can avoid each of these problems.