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The type of business entity you select for your company is an important choice. It will depend upon a number of factors including liability, taxation, control, and the raising of capital. Each business entity has its advantages and disadvantages. The help of a legal professional can help evaluate the factors upon which the choice of business organization should be based.
Among the many forms of business structures available, most businesses are operated as an LLC (Limited Liability Company) or a corporation. If a corporation is chosen there is a further choice of whether to be taxed as an S corporation or C corporation. When compared to each other, each one enjoys both similarities and differences.
As a rule of thumb, the LLC is the most flexible of all of the business forms when it comes to deciding how it will be managed and how the owner’s financial interests will be split up. It’s also more flexible in how it can be taxed for income tax purposes, as it can elect to be taxed as an S corporation or a C corporation, rather than as a partnership or sole proprietorship. Often an LLC will enable more tax-advantaged transfers of ownership interests to family members.
On the other hand, it can be easier for corporations to obtain outside funding as some investors and banks prefer to invest in corporations than LLCs. Also, if you plan on attracting venture capital or doing an initial public offering (IPO) in the future, a corporate business structure could be a better choice. If that is the case you should also let the corporation be taxed as a C corporation. IRS rules, among other things, limit the number and type of shareholders an S corporation can have—which can make it unavailable for venture capital or IPOs.
In addition to choosing your type of business entity, you'll also need to select the state where you'd like to file to form your business entity—also known as your domestic state, formation state, or home state.
Many business owners choose to file with the state where they live and are doing business.
But, you don't have to. You can choose any state in the nation as your formation state, regardless of whether you reside or do business in that state. For example, many businesses choose Delaware or another state well known for its favorable business environment. If you form in Delaware and are doing business elsewhere, you'll need to also register or foreign qualify in the state where you're doing business (typically the state where you live).
LLCs and corporations offer their owners limited liability for business debts. (It doesn’t matter if it is a C corporation or S corporation as that only affects the corporation’s taxation). Limited liability helps protect an owner's personal assets from being used to pay business debts (but not if you co-sign a business debt in your individual capacity). Business assets are subject to business debts. Personal assets are subject to personal debts. LLCs are commonly thought to offer somewhat stronger protection, although it depends on the situation.
Company assets (e.g., computer, business bank account and receipts) and the owner's personal assets (e.g., family home) are separated—there's effectively a "wall" or "veil" or "shield" (or similar term) between the two types of assets. In limited cases, this corporate veil might be pierced (e.g., if the owner failed to treat the business as a separate entity or used it to carry out a wrong or injustice).
Although forming an entity is a necessary first step to obtain limited liability, how you run your business matters as well. It's important to keep business and personal assets separate, follow corporation meetings or other formalities, and keep a company in good standing.
An individual operating a business as a sole proprietor doesn't need to file any forms to create the sole proprietorship. An individual in business as a sole proprietor owns all business assets as an individual and is personally liable for all the business debts.
As a business, a sole proprietorship still has to comply with other business filings. For example, you may have to complete a DBA (doing-business-as) or obtain a home-based permit or other business licenses or permits.
A significant “downside” to operating as a sole proprietor is that the business owner has unlimited personal liability for business debts. And, if the business has employees, the owner is also liable for acts of employees.
CT Tip: By operating a business as an LLC instead of a sole proprietorship, a single-owner of a business could obtain limited liability while still being taxed like a sole proprietorship.
A general partnership involves two or more co-owners (instead of just one owner) who carry on a business for profit. Like sole proprietorships, general partners have unlimited personal liability.
Other types of partnerships, like the limited partnership (LP), limited liability partnership (LLP), and limited liability limited partnership (LLLP) offer limited liability. (Although in an LP, only the limited partners have limited liability; the general partners do not.)
However, LLCs and corporations are more popular today than these other forms of business. Often, LLCs have fewer restrictions and provide greater liability protection.
If protecting your personal assets from business liabilities is the only goal you hope to accomplish by creating a separate business structure, then any of the “big three”—LLC (limited liability company), S corporation, or C corporation will do the job.
However, most business owners also want their company structure to provide them with tax advantages. For this reason, the “pass-through” tax advantages of the LLC or the S corporation are viewed as particularly appealing.
What is pass-through taxation?
Pass-through taxation means what the name implies. Profits are not taxed at the company level. Instead, profits, losses, and other tax items are “passed through” to the owners, reported on the individuals’ tax returns, and taxed at the individuals’ tax rates. Pass-through taxation eliminates the specter of dividend income being taxed on both the corporate tax return and on the shareholder’s individual tax return.
Although pass-through taxation can be an advantage, that is not always the case. Many factors, including the individual and corporate tax rates, determine whether it is better for the LLC or corporation to be taxed as a separate entity or a pass-through entity.
When selecting your business structure, if you ask yourself the question, “Will this matter to me in 5-10 years?”—the answer will almost always be “yes.”
The type of entity you choose for your business affects taxes, day-to-day management, ultimate control, financing, exit strategies and many other aspects of your business. Usually (but not always), the differences help “narrow down” your choices in determining which form is best for your unique needs and business.
The value of professional advice early on often pays for itself, many times over, by saving both money and headaches as your business grows. Talk with an experienced, knowledgeable advisor (attorney or accountant) at the outset about which type of business structure best serves your unique objectives and goals.
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