At any point in the life of your business venture, you may choose to create for it a separate legal entity. Creating a separate entity is essential for those businesses where the potential for liabilities associated with normal operations is an issue. There are also potential tax advantages that derive from the establishment of a separate business entity.
There are two categories of business legal entities: corporations, Chapter S and C, and Limited Liability Company (LLC). Corporations are tax structures and are regulated by the federal government through the IRS. LLCs are created and governed by the states.
Founded in the state of Wyoming in 1977 and now available in all 50 states plus Washington, D.C., the LLC is a comparatively more lenient structure than either the S or C Corporation and for this reason, it is the preferred entity for the majority of small businesses and Solopreneurs. Unlike the S Corp, LLC members, as they are called, are unrestricted in number and are not required to be U.S. citizens nor must they reside here, with the exception of the Registered Agent, who receives official correspondence such as tax and legal documents on behalf of the entity and must reside in the state where the LLC was formed and operates.
Multi-owned LLCs are advised to develop an operating agreement (not required in all states) that along with the percentages of member ownership also specifies member titles and responsibilities, such as Managing Partner and Registered Agent.
In the LLC, whether single or multi-owned, all business income and expenses “pass through,” meaning they are reported on the members’ tax forms. There is no double taxation of business and personal income for single-owner LLCs, but multi-owner LLCs must file U.S. Form 1065 Return of Partnership Income to report profits and losses. All LLC owners must pay the self-employment tax, due quarterly (multi-owners pay on their share of entity ownership).
Real estate investors will find that the LLC is the only available legal entity option that allows passive income (rents) to exceed 25% of gross annual revenues. A big added bonus of real estate LLCs is the ability to create a separate LLC for each property owned, thereby shielding the owner(s) and other properties held from cross-liabilities.
A drawback for owners who plan to attract investment partners (as opposed to those partners who operate the business) is the lack of stock, preferred or otherwise, and this represents a deal-breaker for venture capitalists, who do not invest in businesses structured as LLCs. Even smaller investors prefer stock certificates to LLC member shares. A positive for this structure is that it’s much less expensive to set up than are corporations, costing just a few hundred dollars for the filing (plus the initial set-up fee charged by your accountant or attorney).
If you are considering establishing a legal structure for your business, consider your plans for business growth and also your exit strategy as you do. Growth may cause you to seek money partners, which could point you in the direction of the S Corp. If you see venture capital or an IPO in your future, then only a C Corp will do. If you might want to sell your company to employees as your exit strategy, or if attracting key C Suite level talent to your team would also point you toward the corporate structure, so that stock can be offered as an incentive. If some of your business partners live outside of the U.S., or if acquiring real estate holdings is your business model, then only the LLC will be allowed.
It is strongly recommended that you consult with a business attorney or accountant before you file legal entity paperwork at the Secretary of State’s office.
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