Business Entities

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How do you select which type of business structure is the most appropriate? LLCs, LLPs and corporations (S-corps and C-corps) are different in terms of formation, ownership, taxes, and governance requirements.

The most common business structures, LLCs and corporations offer their owners (members or shareholders) limited liability protection. This is the major reason that individuals incorporate or form an LLC for their business rather than owning it as a sole proprietorship. If a business is run as a sole proprietorship, the business creditors can reach any of the owner’s assets, even if those assets have nothing to do with the business. Because corporations and LLCs have their own separate legal existence, the business alone is responsible for the business debts, liabilities and obligations. The liability of the corporation’s shareholders and the LLC’s members is limited to their investment.

Summarized below are the operational requirements, the tax benefits or limitations of these different business structures:

LLC (limited liability company):

  • simple to organize and no annual reporting requirements to the State after organization;
  • great flexibility in management;
  • can have any number of members (owners);
  • members do not have to be US citizens or residents;
  • LLC owners do not have to file a corporate tax return; an owner simply reports their share of profit and loss on their individual tax return;
  • by default, the IRS classifies an LLC as a disregarded entity (for a single member or married couple) or a partnership (2 or more members who are not married to each other), giving the business pass-through taxation; this avoids double taxation; however, by making an IRS election, the LLC can choose to have the LLC taxed as a C-corporation or an S-corporation; a decision best discussed with an accountant;
  • owners pay self-employment taxes, which can result in a higher overall tax liability than employee taxes paid through a corporation;
  • raising venture capital can be more difficult than it is for a corporation.

S Corporation:

  • business is formed as a corporation and then an election is made with the IRS to be treated as an S-corp;
  • initial set up involves more than the LLC and there are annual filing requirements with the State; 
  • shareholders must be US citizens or residents;
  • there can be no more than 100 shareholders in order to elect an S corporation status;
  • informational tax returns are filed but no corporate tax is paid at the corporate level; profits/losses of the business are passed-through the owners (shareholders) and reported on their individual tax returns; any tax due is then paid at the individual level, avoiding ‘double taxation’;
  • the owners (shareholders) can be considered employees and paid “a reasonable salary”; withholdings and employment taxes are taken out and paid on the amount of the salary generally making “self-employment taxes” somewhat less than the self-employment tax assessed on the profits passed through an LLC to a member; 
  • it is possible that corporate earnings after salary may be treated as unearned income that will not be subject to self-employment taxes or, alternatively, draws by owners after salary are calculated as part of the income/loss which is passed to owners on a Schedule K which is reported on the owner’s individual tax return. 
  • the S-corp (like a C-corp) must: 
    • create, adopt, and follow corporate bylaws (amending them when necessary)
    • elect a board of directors and hold regular board of directors meetings (at least one annually)
    • hold regular shareholder meetings (at least one annually)
    • document meetings with formal written minutes
    • issue stock certificates
    • record stock transfers
    • provide periodic reports to shareholders (which can be done at annual meetings)

C-corporations:

The disadvantages of a C-corp are often pointed out over its benefits. Some of the benefits are:

  • it is easier to raise money from investors and make an initial public offering;
  • there is no restriction on owners; there can be US or foreign shareholders;
  • there can be an unlimited number of stock and issue of different types of stock;
  • the corporation can offer stock options as incentives to keep employees and attract talent.

Many start-ups choose not to set up as a C-corp because of double taxation:

  • the business income first gets taxed at the corporate level;
  • the shareholders are then taxed again on their individual tax returns, if they receive dividends from the business;
  • to avoid the double taxation the business would need to reinvest all profits back into the business; the salaries paid would remain deductions for the business and taxable income to the recipient.

In Arizona (and in most states) the corporation must comply with the following requirements to remain in good standing:

  • create, adopt, and follow corporate bylaws (amending them when necessary)
  • elect a board of directors and hold regular board of directors meetings (at least one annually)
  • hold regular shareholder meetings (at least one annually)
  • document meetings with formal written minutes
  • issue stock certificates
  • record stock transfers
  • provide periodic reports to shareholders (which can be done at annual meetings)

Tax Deductible Business Expenses:

A business can deduct certain expenses incurred in the operation of its business.

  • These business expenses include such items as:
    • accounting, legal and professional fees
    • advertising and promotion
    • bank charges
    • continuing professional education expenses
    • contract labor costs
    • credit and collection fees
    • delivery charges
    • dues and subscriptions
    • employee salaries, wages, and other compensation
    • equipment rentals
    • insurance
    • interest paid
    • internet subscriptions, domain names, and hosting
    • licenses
    • maintenance and repairs
    • office expenses and supplies
    • postage, printing and copying expenses
    • professional development and training fees
    • rent
    • software
    • telephone
    • utilities
  • certain expenses are not fully deductible such as meals, travel, entertainment and gifts; these types of expenses are subject to limitations defined by IRS guidelines; automobile expenses also have certain restrictions based on business and personal use; refer to IRS guidelines to assess how best to use these deductions;
  • other deductions apply depending on the type of business; an accountant can help to determine all the deductions available to the business.

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