One of the most common mistakes business owners make is neglecting to formally incorporate the company. Deciding which type of entity is best for your business can be confusing, but make sure you speak with an attorney early on to take the necessary steps.
By default, if you do nothing to establish an entity your business will automatically be considered a general partnership or sole proprietorship. The major drawback to these types of entities is that there is no distinction between business and business owner, which means you could become personally liable for any legal action or issues.
For example, if your company is sued or becomes unable to pay its debts or bills, you could lose your personal assets as a result. The Limited Liability Company (LLC) and C-corporation are both common entity options because they limit the personal liability of a business owner, but they have very different tax benefits.
An LLC is typically structured as a pass-through business entity, which means the business doesn’t pay income taxes on profits. Instead, the tax responsibility is passed onto the business owners and claimed on personal tax returns.
A corporation is considered an independent legal entity, and the company is required to submit a business tax return and pay income taxes on any profits generated. In some cases this can lead to double taxation, so consider how much your tax bill could increase if you structure your company this way.
Members of an LLC are required to pay taxes on their share of the profits, even if they choose to reinvest that money in the company rather than taking it as income. On the other hand, corporation owners are only required to pay taxes on the money they receive as dividends. This means that even if your share of profit is $100,000 in a tax year, if you leave $40,000 in the company as corporate profit you only have to pay taxes on the $60,000 you collected as salary. This is a common practice that allows corporation owners to take advantage of lower income brackets.
Members of an LLC have limited options when it comes to offering employee benefits. Certain types of retirement plans, stock option plans, and employee stock purchase plans are only available to companies structured as corporations. Plus, LLC members are required to pay taxes on certain types of employee benefits — including health benefits, employer contributions to HSAs or FSAs, and life insurance benefits. Corporation shareholders are not required to pay these types of taxes.
These points are a great place to start when you’re deciding how to form your entity, but you should consult with a tax attorney or business accountant if you have any questions about your particular situation.
