Once you’ve developed a great new business idea, there are several structural issues you have to take into consideration. One of the most important decisions you’ll need to make next is to decide what kind of legal entity you’ll set up. Depending on whether you have a partner, multiple partners or you’re going it alone, there are various legal entity choices.
According to the IRS, most businesses get set up as a limited liability company, limited partnership, or a subchapter S corporation. So which is the right type for you?
There are four major considerations that enter the picture: how you want to handle liability, income taxes, investments, and business cost maintenance. Read on to see how they differ and to determine the best model for your business’s needs.
Limited Liability Corporation
The Limited Liability Corporation, or LLC, is popular because it is a hybrid version of a corporation that allows multiple owners or partners to operate as one for tax purposes. LLCs protect their owners because the owner is not personally responsible for any financial failure endured by the LLC. LLC earnings “pass-through” to the individual owners’ tax returns and allow for deductions. Likewise, the LLC is not subjected to the strict IRS codes imposed on S Corps and the number of shareholders that need to be maintained.
Subchapter S Corporation
The Subchapter S Corporation or S Corp also does not hold their shareholders liable for corporate financials. According to IRS data, the S Corp has gained extreme popularity in recent years and now accounts for two-thirds of all U.S. corporations. The S Corp is a separate entity liable for its own debts. Shareholders report their losses or gains via the S Corp on their taxes and losses can be deducted as long as they don’t supersede the investment made. If the losses do supersede the investment, the remaining amount will be carried over to the next year’s taxes. If original shareholders sell their stock to ineligible entities such as another business, the corporation will lose its S Corp status. The S Corp would then become a C Corp and lose the ability to for shareholders to deduct business losses.
This structure is ideal for businesses that have raised capital from investors who want to be protected by limited liability. Those who invest become a limited partner who receives a regular limited partnership exchanges. The LP doesn’t have to worry about managing the business or being held liable for any risk the business takes but they still benefit when the business does well.
Depending on whether or not you have multiple partners or investors and how you want to incorporate those investors into your business, you’ll choose a different model. Each of these models features limited liability for partners except in the case of general partners in the limited partner model. The S-Corp does not allow special allocation of income and losses to owners. It only allows allocation based on ownership percentage. But the S-Corp does provide protection to its shareholders who will not be liable for any business deficit. Whether you want a simple model or a model that allows protection for multiple investors, your business model will be one of the most important foundations you lay for your future protection and success.