Now that we understand limited liability, we need to discuss what might influence your decision on particular types of legal entities. Different legal entities can be used for different purposes. They each have their own set of rules that govern them and there are benefits and drawbacks to each of them. Business organizations is a semester long class in law school. Just to get an overview. So this post, of course, will be a very brief overview of the types of entities. We will focus in on the entities that will be more important in your decision making process.
Over the years, different types of entities have been created to fill a need perceived by the business community. At first, the only way to secure any kind of liability protection was to incorporate. The problem with incorporation was that it was so expensive and often cost prohibitive. Many decided to be partners or operate as sole proprietors as it made more sense to forego the expense and headache of forming a corporation than to have the protection against a lawsuit that might never happen. During the 80’s and early 90’s we saw the rise of the S-Election for the Corporation, the Limited Liability Partnership, and the Limited Liability Company.
If you want to know a little bit more about each entity, you can read about them here:
What is the “P” for?
Some entities have a variety that you may see in the Healthcare arena. These “Professional” entities (you can have a Professional Corporation or P.C. Or a Professional Limited Liability Company or PLLC) are designed for entities that offer professional services within a single entity. Because of the nature of being a “Professional Entity” there are limitations on ownership and limitations on the services or products that can be offered. In my practice, I tend to avoid professional entities because our economy does not encourage limitation of revenue sources.
Professional entities are not entities that allow a lot of entrepreneurial venturing.
In Alabama (and most other states), the formation of an entity requires you to list the purpose of the business entity. Technically, this listing limits the business to the business purposes named in the entity. One of the options for a business purpose is to say “any legal purpose”. That means the business can do anything it is legally permitted to do.
Professional Entities are, by definition, limited to the provision of the professional services of the owners. That means, the “any legal purpose” is not available to the Professional Entity. The professional entity is not able to come up with new and different ways of making money because of these limitations. That means, if you come up with something that does not fit into the provision of those professional services, you would likely have to form another legal entity. It would limit, in many ways, the different types of ownership structures you can create for a business with multiple revenue streams.
There is nothing that prevents Professionals from having LLCs or Corporations of the Non Professional Variety. That way, you are only limited by the regulations that control your profession (for instance, I have an LLC, but my wife can’t own any part of it because she is not licenses to practice law which is a limitation of law practices). But, because I have an LLC and not a PLLC, I can develop new and different products and services that may be questionable if I had a PLLC.
This, of course, is my opinion. I work with a lot of entrepreneurs. A lot of what I do is to help businesses think outside of the box in their industry, so I tend to dislike anything that limits creativity and innovation.
So, now we know you need to limit your liability and you want to form an entity. Nowadays, the conversation is around two primary entities: LLC and the Corporation (with the S-Election otherwise known as the S-Corporation).
So, let’s break these two entities down.
Taxation of Small Businesses
DISCLAIMER: I am not a tax professional. I am not an accountant, but I am going to give you a brief crash course in taxes to help you understand what is going on in the Corporation versus S-Corporation realm:
There are two primary types of taxation that we talk about when it comes to businesses. They are “flow through taxation” and “double taxation”.
Flow through taxation means that the entity does not pay taxes. The taxes “flow through” to the owners. The money made by the entity is only paid once by the partners (or individual owner).
Double taxation means that the money made by the corporation is taxed twice. The Corporation pays taxes, then the shareholders (owners) will pay taxes on their portion of what they receive. This makes a lot of sense for Apple. This is part of how the economy works. This can, however, be a problem when the people working in the company are also the people who receive the money. That means you actually feel the double taxation.
Corporations are double taxed. A corporation pays taxes as a “person” and the people who receive the profits of the company also pay taxes. In Corporations, however, the second level of taxation only hits the shareholders if they do, in fact, receive a portion of the profits. Meaning, the only amount of double taxed money is money the owners receive from the profits (not including their paychecks).
If you choose a Corporation as your legal entity, you have the option to select “flow through taxation” under Subchapter S of the IRS code. That means, you can choose how your corporation is taxed. We will more about some of the limitations placed on the S Corporation if that choice is made, but for now, it means that the owners share the taxes of the company.
Please note, the S-Corporation is not an entity type, but a tax election. The entity is a Corporation.
Unlike the C-Corporation, in an S-Corporation the Shareholders will pay their share of the profits of the business, whether or not they receive them. That means if the business made $10,000 in profit, and the two partners (each owning 50% of the business) decided the money should stay in the business as an emergency fund, the partners would each have to include $5,000 in profit on their taxes.
Limited Liability Company
The Limited Liability Company (or LLC) is a hybrid entity. It combines the limited liability of the corporate structure with the benefits of being treated as a partnership. Because of that, the LLC has come to be the most common entity selection among startups, small or large, because of its simplicity and its flexibility.
The LLC has even more flexibility than the C versus S Corporation on how it is taxed. The IRS has something called “Check the Box” provisions that allow the LLC to be taxed in a way chosen by the owners. That means the owners have the flexibility to adjust the tax structure for the current needs of the business.
LLCs are, by default, taxed as a partnership (for more than one owner) or a sole proprietorship (just like your personal taxes). You can, however, elect to be taxed as an S Corporation or a C Corporation.
Why would you do that? Growth, that’s why.
LLC’s are, by default, not only taxed as a partnership, but they are to be treated as a partnership, which is simpler than the S Election and the restrictions on S Corporations are nonexistent. This allows the LLC to be functionally whatever it needs to be. The LLC, like the partnership, is a creature of contract. That means, it can do what it needs to do. You can take investors how you need to, you can structure ownership how you need to. It can look as creatively as you (and your lawyer) want it to be. I have seen some neat things done with the LLC.
But, that is a conversation for another time. Tomorrow, we will talk about funding the business (equity versus debt) and how to deal with investors.