Most business owners start out with a business name, when really they should start out thinking about what type of business entity to form. Selecting a name, registering that name, and possibly trademarking the name mean that you have made a commitment to that name.
Check out these great tips from www.mynewcompany.com:
Which Type of Business Entity to Form?
When starting a new business, one of the first decisions to be made is deciding which legal structure your company should take.
You have 4 choices:
A DBA (also known as a “sole proprietorship”, “Doing Business As”, or a “Fictitious Name”) is a business that is not separate from its owner, merely a different name that the business owner operates under. The owner is personally liable for the company and its debt; all income is added on the owner(s) personal tax returns (pass-through taxation). If there is more than 1 owner, then the business is classified as a “General Partnership”.
PROS: Easy to setup, easy to maintain.
CONS: Owners are personally liable for the company and its debt ( the owner(s) could lose a house, cars, personal assets, etc.) in a lawsuit. Usually not recognized at the State level, only in your city/county. No corporate “prestige” of having the “Inc.” or “LLC” attached to your name. LLC’s have primarily replaced DBA’s as the entity of choice for even the smallest businesses.
Regular Corporation (or C-Corporation)
A corporation is a separate legal entity that can shield the owners from personal liability and company debt. As a separate entity, it can buy real estate, enter into contracts, sue and be sued completely separately from its owners. Also, money can be raised easier via the sale of stock; its ownership can be transferred via the transfer of stock; the duration of the corporation is perpetual (the business can continue regardless of ownership); and the tax advantages can be considerable (i.e. you are able to deduct many business expenses, healthcare programs, etc. that other legal entities are not). Income is reported completely separate via a tax return for the corporation.
A corporation is set up in this structure:
- Shareholders own the stock of the corporation.
- Shareholders elect Directors (known as the “Board of Directors”).
- Directors appoint Officers (President, Secretary, Treasurer, etc.).
- Officers run the company (day-to-day operations).
In many cases (especially during the startup phase), you will be the 100% owner of the stock, therefore you elect the directors (usually yourself) and then appoint yourself as an officer (or all the officers: CEO, Treasurer, Secretary).
The rules for operating your corporation are set in what are called Corporate Bylaws. This document sets the rules for the company and can be modified as the business grows and changes. Operating a corporation involves at the minimum holding a yearly Directors and Shareholders meeting (the location is determined by you and the expenses are deductible), keeping written minutes of major company decisions and maintaining general corporate compliance as dictated by the Corporate Bylaws.
PROS: The oldest, most successful and most prestigious type of business entity; provides personal liability protection; conveys permanence, can reduce taxes (lower tax rate on retained profits, items like healthcare, travel and entertainment are deductible).
CONS: More expensive to set up than a DBA; more paperwork and formality required than an LLC (holding Shareholder/Board meetings, keeping minutes and resolutions).
The Lowdown: Though more complicated to run and manage than the LLC, the Corporation is still the oldest and most prestigious form of entity. C Corporations are taxed at a lower rate on profits and are able to deduct items like healthcare, travel, entertainment, etc. that LLC’s and S Corporations cannot. More complicated tax and management issues than an “S Corporation”.
After a corporation has been formed, it may elect “S-Corporation Status” by adopting an appropriate resolution and completing and submitting a form to the Internal Revenue Service (some states require their own version). Once this filing is complete, the corporation is taxed like a partnership or sole proprietorship rather than a corporation. Thus, the income is “passed-through” to the shareholders for purposes of computing tax returns.
Most new small corporations elect S-Corporation Status (90%+) so profits and losses can be added to the shareholders’ personal tax returns without having to pay taxes on profits once, then again when they are given back to the shareholders as income (dividends). This is known as “double taxation” and is the reason why S-Corporations were created. An S-Corporation can also revert back to regular Corporation status fairly easily.
There are some limitations on S-Corporations: they cannot deduct some expenses like health insurance, travel, entertainment, etc. that normal corporations can. Also, they are restricted to 100 shareholders or fewer and those shareholders must be U.S. Citizens. Finally, S-Corporations may not own or be owned by other business entities.
PROS: Prestige of the corporation without the double taxation. Ideal for “1 person corporations”.
CONS: More expensive to setup than a DBA; more paperwork and formality required than an LLC (holding Shareholder/Board meetings, keeping minutes and resolutions).
The Lowdown: Though taxed in a similar manner to LLC’s, still requires the corporate formalities of a regular corporation (holding Board meetings, keeping minutes and resolutions).
Limited Liability Company
A Limited Liability Company can be best described as a hybrid between a corporation and a partnership. It provides easy management and “pass-through” taxation (profits and losses are added to the owner(s) personal tax returns) like a Sole Proprietorship/Partnership, with the liability protection of a Corporation. It’s a relatively new form of business created in 1977 in Wyoming and now recognized in all 50 States and D.C.
Like a corporation, it is a separate legal entity; unlike a corporation, there is no stock and there are fewer formalities. The owners of an LLC are called “Members” instead of “Shareholders”. So in essence, it’s a like a corporation, with less complicated taxation and stock formalities.
The heart of a Limited Liability Company is known as the “Operating Agreement”. This document sets the rules for operating the company and can be modified as the business grows and changes. Operating an LLC is less formal than a corporation, usually only requiring an Annual Members’ Meeting and Members’ agreeing to changes of the Operating Agreement and other major company decisions.
PROS: Provides the liability protection of a corporation without the corporate formalities (Board meetings, Shareholder meetings, minutes, etc.) and extra levels of management (Shareholders, Directors, Officers). Taxed the same as a sole proprietorship (1 Member LLC) or partnership (2 or more Members).
CONS: Usually more expensive to form than a DBA, requires more paperwork and formal behavior.
The Lowdown: The Entity of Choice for 1-5 person startups, has recently surpassed corporations in popularity. Easy management and limited compliance requirements have made the LLC the user-friendly solution for small business.