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Choosing the Best Entity and State When Incorporating Your Business

||Guest Blog: Sam Mollaei ||

Eager to jump into the world of business ownership and wondering whether you should form an LLC, C-Corporation, S-Corporation, Partnership or some other business entity? Let’s look at what you should consider when deciding what entity type to form for your business and where to form it.

Sole Proprietorship

A sole proprietorship is the simplest business form, as it is set up quickly by the owner.  You do not have to legally file as a sole proprietorship. You can establish yourself as soon as you begin working. No state filing is required unless you set yourself as a “doing business as” d/b/a company.

A sole proprietorship is not legally separate from its owner and offers no personal liability protection. The law does not distinguish between the owner’s assets and the business’s obligations. As a sole proprietor, your assets can be and often are used to satisfy the debts and liabilities of the business. In other words, if your business gets sued, your assets (such as your house, car, or any other property you own) may also be at risk. 

Sole Proprietor Advantages

  • Instant, easy & inexpensive.
  • No state paperwork is required for the creation.
  • No separate tax filing is required – profits or losses are reported on the owner’s tax return. 
  • The owner may freely mix business and personal assets.
  • A sole proprietor need not pay unemployment tax on himself or herself (but must pay employee unemployment tax).

Sole Proprietor Disadvantages

  • The owner is subject to unlimited personal liability for business debts, losses, and liabilities. 
  • Obtaining capital, such as a bank loan, can be more difficult – lenders often require a more formal entity structure. 
  • Sole proprietorships rarely survive an owner’s death or incapacity. 
  • A sole proprietorship, by definition, can only have one owner.  

Partnership

A partnership is created automatically when two or more persons engage in a business enterprise for profit. In this type of business organization, all partners share in both the day-to-day management and business profits. A written partnership agreement formalizing the  partnership is highly recommended. . 

A partnership is generally treated as a distinct legal entity separate from its partners. A key attraction of a partnership is that the partnership itself pays no income tax as income or losses flow through to each partner and are reported on the partners’ separate personal tax returns.

Partnership Advantages 

  • Owners can start partnerships relatively easily and inexpensively.
  • No state paperwork is required for the creation.
  • The partnership pays no income tax as income or losses flow through to each partner and are reported on the partner’s individual tax return.
  • Each partner shares in the profits and losses of the business. As a result, there’s no liability protection for any of the partners as each partner is jointly and severally liable for liabilities. 

Partnership Disadvantages

  • All owners are subject to unlimited personal liability for business debts, losses, and liabilities.
  • Individual partners bear responsibility for the actions of other partners.
  • Obtaining capital, such as a bank loan, can be more difficult — lenders often require a more formal entity structure.
  • Poorly-organized partnerships and oral partnerships can lead to disputes among owners.

Limited Liability Company (LLC)

Slowly becoming a standard for businesses, a Limited Liability Company (or LLC) is a hybrid type of business organization. It combines the liability protection of a corporation with the easy administration and tax treatment of a partnership. I wrote a blog on how to set up your LLC you may want to consult.

Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their individual federal tax returns.

While the federal government does not tax income on an LLC, some states do. Check with the state where you form your LLC to learn more about charges of state income tax.

LLC Advantages 

  • Owners have limited liability and are not personally responsible for business debts and liabilities. However, keep in mind that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts, including those of their employees.
  • Pass-through taxation means that LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns.
  • No restrictions are placed on LLC membership.
  • Members enjoy flexibility when structuring the company management
  • An LLC does not require as much annual paperwork or has to observe certain formalities, like a corporation.

LLC Disadvantages

  • More expensive to form than sole proprietorships and general partnerships.
  • Ownership is typically harder to transfer than it is with a corporation.
  • In many states an LLC has a limited life. When a member leaves an LLC the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business.

C-Corporation

A corporation is the most common business structure. A corporation is an independent legal entity owned by its shareholders. Corporations are more complex than other forms of business organizations because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally recommended for established, larger companies with multiple employees.If the corporation distributes profits to the shareholders in the form of dividends, shareholders pay income tax on those distributions. This creates double taxation of corporate profits.

C-Corporation Advantages 

  • Because C-Corporations offer limited liability, owners are typically not personally responsible for business debts and liabilities. When it comes to taking responsibility for business debts and actions of a corporation, the shareholders’ personal assets are protected. Shareholders can only be held accountable for their investment in the stock of the company.
  • Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends while any additional profits are awarded at a corporate tax rate. The corporate rate is usually lower than a personal income tax rate.
  • Unlimited number of shareholders.
  • Ownership is easily transferable through the sale of stock.
  • Unlimited life, which extends beyond an owner’s illness or death.
  • Some business expenses may be tax-deductible.
  • Additional capital can be raised by selling shares of corporate stock.
  • Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.
  • Corporations have an advantage when it comes to raising capital for their business – the ability to raise funds through the sale of stock.

C-Corporation Disadvantages

  • C-corporations are more expensive to form as compared to sole proprietorships and partnerships. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating and tax costs that most other structures do not require.
  • In some cases, corporations are taxed twice – first, when the company makes a profit, and again when dividends are paid to shareholders.
  • Corporations face ongoing state-imposed filing requirements and fees. Because corporations are highly regulated by federal, state, and in some cases, local agencies, there are increased paperwork and recordkeeping burdens associated with this entity.
  • Corporations require the formal documentation of the annual meeting of directors and shareholders.

S-Corporation

An S corporation is one of the forms of business organization that holds the position of a special type of corporation – a business that is created through an IRS tax election. An eligible domestic corporation can avoid double taxation by electing to be treated as an S corporation. To be considered an S corporation, you must first form a business as a C-corporation in the state where it is headquartered. S corporations are “considered by law to be a unique entity, separate and apart from those who own it.”

S-Corporation Advantages 

  • Only the wages of the shareholder who is an employee are subject to employment tax. One of the best features of the S Corp are the tax savings. While members of an LLC are subject to employment tax on the business’s total net income, only the wages of the S Corp shareholder, who is an employee, are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate if at all.
  • Business Expense Tax Credits – Some expenses that shareholders/employees incur can be written off as a business expense. For example, if an employee owns 2% or more shares in the company, benefits, such as health and life insurance, are deemed taxable income.
  • An S Corp is a type of business organization that permits a business to have an independent life, separate from its shareholders. If a shareholder leaves the company or sells his or her shares, the S Corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that better protects shareholders.
  • Shareholders are typically not personally responsible for business debts and liabilities.
  • Unlimited life, extending beyond the owner’s illness or death.
  • Additional capital can be raised by selling shares of the corporation’s stock.
  • Pass-through taxation. 

S-Corporation Disadvantages

  • The IRS imposes restrictions or a criteria that must be followed by S-Corp owners: the company must be a domestic corporation, or based in the US; the business can only have up to 100 shareholders; the S-Corp does not cover the interests of individuals, certain trusts, and estates; members cannot be non-resident aliens; and the corporation can only have only one class of stock.
  • More expensive to form than sole proprietorships and general partnerships, S-corps face ongoing state-imposed filing requirements and fees.
  • S corporations must follow corporate formalities, such as holding and properly documenting annual director and shareholder meetings. 

What State Is Best For Your Business Entity?

Sole proprietors or partnerships do not need to select a state in which to base their business. If you are forming a LLC or Corporation, you need to choose a state.

Generally speaking, you should form your LLC in your home state – the state where you are conducting business. Typically the law considers LLC business owners based in a certain state when the business has a physical presence in the state, the business consults with people at its location, a significant portion of your company’s revenue comes from the state, and most of the business’s employees work in the state. 

The best state to form an LLC for an online business is usually the state where you live, unless you live outside the US.

If you form an LLC in any state outside of the state in which you are based, you should also register your LLC in your home state. In general, it’s better to form your LLC in your home state and avoid the fees associated with filing in another state. If you form an LLC in a non-home state you will be required to file as a Foreign LLC in your home state.

Non-US residents will need to obtain a Employer Identification Number (EIN) for a foreign entity before formation. If your company does not plan to have a physical presence in the U.S., meaning that it will operate solely from outside of the U.S., you should form your LLC in Wyoming, the most business-friendly state for non-U.S. residents.

In some cases, you may want to consider incorporating in another state so you can benefit from the tax or organizational advantages. Delaware, Nevada, and Wyoming are the three most popular states for out-of-state business owners to establish LLCs or to incorporate.

Some of the worst states to incorporate a business include Maryland, Iowa, Wisconsin, North Carolina, and Minnesota. The best states are Delaware, Wyoming, or Nevada. 

Nevada is the best state to form a single-member LLC. Some states don’t allow the formation of single-member LLCs. If you’re looking for the best state to form LLC for privacy, you should choose Nevada or Wyoming. Both of these states allow for the total anonymity of a business’s members, you don’t have to publicly reveal that you have set up an LLC.

___________________________________________________________________________________
Sam Mollaei, Esq. is a business lawyer specializing in helping entrepreneurs start their business by taking care of all of the paperwork and offering expert advice. Mollaei Law has helped over 3,000 businesses start their U.S. business without dealing with complicated legal forms.

Photo by Gustavo Fring from Pexels

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