Legally speaking, it’s easy to start a company.
By default—meaning, if you do absolutely nothing—your startup is a sole proprietorship or partnership, unless you and your co-founders (if any) opt for another structure. Such a business is not distinct from its owners, and its income is reported on your personal income tax returns.
And therein lies the key drawback of a sole proprietorship or partnership: You have unlimited liability for your business’s debts. You are personally liable for deals your partners make, even if you have an agreement that limits individual authority. And a mistake can cost you not just the company but everything you own.
So, if you are starting a business, or if you already run one but haven’t thought strategically about its legal structure, you need to take this matter seriously. For limited liability protection—limited, that is, to what you have invested in your company—the choices come down to a limited liability company or a corporation. The decision is more complicated than it may seem: What the government leaves in one pocket, it takes from another. So, sit down with a lawyer and accountant to weigh the options in light of your individual tax situation.
Keep in mind that liability protections are not absolute. Creditors may be able to pierce the corporate veil that separates a company from its owners’ personal assets in cases of fraud, when the entities are inextricably linked, or when the company fails to adhere to the basic legal and reporting requirements.
When comparing options (LLC versus corporations), the principal decision is whether you want your company to pay taxes on profits before they are distributed to owners or you want the profits to flow straight through to the owners’ individual tax returns.
Remember, you have a certain amount of flexibility when it comes to changing the legal structure of your business and you can easily convert from an S corp to a C corp.
Here’s what you need to know:
This structure essentially melds a partnership with the limited liability protection offered by a corporation. The LLC is a fairly recent innovation—most states didn’t recognize it until the mid-1990s—but because of its flexibility, lawyers have come to recommend it for most small companies. Depending on the state, the owners of an LLC (called members) can consist of a single individual, two or more individuals, corporations, partnerships, trusts, or other LLCs.
How it works: Like a partnership, an LLC is a pass-through entity, meaning that profits, losses, credits, and deductions flow through to your personal tax returns. An owner can use losses to offset other income, but only up to the amount he or she invested, which is called the basis. In an LLC, unlike a corporation, income and losses can be distributed unequally among members—the LLC could, for example, allow one member to take all of the losses but allocate profits based on ownership interest.
Watch out for: LLC members can’t distinguish between income earned as salary and passive investment income, so profits are subject to Social Security and Medicare taxes on top of income taxes.
How to file an LLC: After choosing a unique name (which must end in a variation of Limited Liability Company), you file articles of organization with your state. Many states allow you to do so online; others provide a template to use. Though not required by law, an operating agreement that defines the basic rights and responsibilities of the LLC’s members is also crucial. New York requires notice of the LLC’s formation to be published, which adds to startup costs.
This is the basic type of American corporation—a legal entity that’s completely separate from its owners. Because its shares can be traded among an unlimited number and types of owners, the C corp is the vehicle commonly used for taking a company public. Generally speaking, entrepreneurs choose the C corp structure if they hope to attract professional investors or reward employees with stock. Many small businesses prefer other structures, to avoid the C corp’s “double taxation” (more on that below) and requirements to hold board and shareholder meetings.
How it works: The corporation files its own tax return and pays taxes on its income at the corporate rate. When profits are distributed to shareholders in the form of dividends, they are taxed again—a double tax, some argue—at shareholders’ individual income tax rates. However, because the corporate tax rate tends to be lower than the individual tax rate, some experts recommend a C corp for small companies that reinvest profits. Unlike an LLC, a C corp can distinguish between active and passive income and pay employment taxes only on the salaries of the active shareholders.
The S corp has long reigned as the way to avoid the C corp’s double taxation. Ownership in an S corp is restricted to no more than 100 U.S. shareholders (a family can count as a single shareholder), with one class of stock. Normally, an S corp cannot be owned by another company or own one. Still, it remains a good choice for companies that can’t legally organize as LLCs (such as banks or insurers) or would face higher taxes as LLCs, which is the case in some states.
How it works: In S corps, income flows through to the individual shareholders, and federal tax is paid at the owner level. (Most states follow suit, but a few tax S corps at the company level in certain cases. Also, New York City doesn’t recognize S corps and taxes them as C corps.) Owners of S corps can enjoy tax savings by paying themselves “reasonable” salaries tied to industry norms, subject to self-employment taxes, and then take a distribution of profits, which is free of employment taxes.
How to incorporate: Incorporation begins by selecting a name and filing articles of incorporation, which in most states simply entails completing a registration form. (Filing fees vary by state, from $100 to $1,000.) Then, the founders must appoint directors and draft the company’s bylaws, which stipulate how the business will operate. Finally, the new corporation must deliver stock certificates to its shareholders.
If you need help, more information and legal forms are available online at Nolo.com and LegalZoom.com.
Attention social entrepreneurs: You can structure your business so that “doing good” is part of your for-profit business model.
By becoming a certified B corp and/or benefit corporation (which are similar but different), you can factor in non-financial goals—say, saving the environment—along with the bottom line when you’re making decisions for your company.
The B corp designation was popularized by B Lab, a Berwyn, Pennsylvania, nonprofit founded in 2006. B Lab will certify a company in any of the fifty states as a “B corp” after it’s met rigorous standards of social and environmental performance, accountability, and transparency. The label is akin to other certifications, such as Leadership in Energy and Environmental Design (LEED) or Fair Trade. Well-known B corps include Patagonia, Ben & Jerry’s, and Warby Parker.
As part of the certification process, B Lab requires companies in most states to eventually become a benefit corporation (a legal designation similar to C corp). As of July 2017, thirty-three states and the District of Columbia have allowed this new type of corporation. The status essentially provides a company with greater freedom to pursue social goals without fear of being sued by shareholders for failing to maximize profits.
If you want more information, the Yale Center for Business and the Environment and Patagonia have published An Entrepreneur’s Guide to Certified B Corporations and Benefit Corporations, available for download at cbey.yale.edu.
We’ve outlined some of the early choices you’ll need to make as you turn your idea into a company. In the next chapter, we’ll answer your most pressing questions about money, the lifeblood of any young business.