Understanding the Differences
No liability protection. Running a business as a sole proprietor is almost never recommended.
There are two types of partners, general and limited. The general partners are exposed to liability. Limited partners are most often passive investors and may not be subject to liability. However, rather than exposing you or your business partner to liability, this entity is almost never recommended.
Limited Liability Company (LLC): The name explains it well: a company with limited liability. LLCs are a newer type of business entity, the first statute being created in Wyoming in 1977. However, most states didn’t create statutes allowing LLCs until around1988. Because LLCs are so young (in relation to the Corporation), when most people think of starting a business, they talk about becoming a corporation and getting “Inc.” after the business name. What they may not realize is that in the majority of circumstances, the LLC is superior to the corporation (with few exceptions): same liability protection, greater flexibility, fewer taxes, and less formalities.
LLCs allow for single owners, multiple owners, different shares of ownership, other entities can hold interests in LLCs, etc. These interests can also vary in economic scope and voting power. Also, corporate formalities, such as having a board, holding meetings, and recording minutes, is not required for LLCs. Most states allow LLCs to exist for 99 years. Having an operating agreement is crucial to the LLC as it controls the business (business purpose, management, profit and loss allocation and rights to distributions, rules governing entry and exit of members, etc.) and is generally why one seeks an attorney for setting up a business. LLCs can be member-managed or manager-managed, which provides a good amount of flexibility. LLCs also allow for pass-through taxation, i.e. not subject to a double-tax, using subchapter K or sole proprietor taxation methods.
See the heading Maintaining Limited Liability below.
Other types of Limited Liability structures that are similar are the PLLC and LLP.
This is a special kind of corporation that has some unique benefits, but in exchange has some unique restrictions. Unlike its brother the C corporation, the S corp allows for pass-through taxation like the LLC and partnership (no double-tax). However, other limitations that may make this entity less desirable include: a maximum amount of 100 unrelated shareholders; other entities, such as corps, LLCs, and most trusts, cannot be shareholders; cannot have foreign shareholders; each share of stock must have the same economic interest; when property that has appreciated is passed from the S corp to a shareholder, capital gains tax applies; shareholder basis is not affected by 3rd party debts. However, S corp owners may be able to reduce their Social Security tax by reducing their salaries (as employees) and taking more of their income in the form of dividends (however, be weary of this approach).
When most people think of big businesses, they think of this type of corporation. A C corp is necessary before going public; i.e. being listed on a stock exchange. Because of certain taxes and other things that apply, this type of entity is generally not recommended unless the business plans to go public in the near future. However, in some instances, with careful planning, some tax advantages can be utilized that make this structure more beneficial. Because this tax-shifting is quite complicated, it is beyond our discussion here. If you are interested, please contact me.
C corps provide for the same liability protection provided to LLCs. However, C corps are generally required to have more than one shareholder, a board of directors, hold annual meetings, and take minutes at these meetings. In order to help avoid getting the veil pierced (veil piercing = personal liability), these procedures should be followed, as well as the others mentioned below in Maintaining Limited Liability. A quick note about taxes: C corps are subject to federal taxes separately from the shareholders; i.e. dividends paid out are federally taxed at the business level, and income received by the shareholder is taxable, hence the “double-taxation.” I would take this a step further and call it a triple tax in most states, because the state will charge what is known as a “franchise” tax or fee. For example, in Utah, the franchise fee is 5% or $100, whichever is greater. An LLC is not subject to these additional franchise state taxes. Therefore, unless there is a good reason to select the C corp, the taxation alone should generally persuade you to select a different entity. There are ways to reduce these taxes, but playing games with the IRS can be risky. People try to skirt the double-tax by paying out large salaries to the owners, as these are deductible. However, the IRS may seek to deny deductions for an unreasonable salary and to recharacterize salary or interest payments as non-deductible dividends—which results in large amounts of tax due.
Maintaining Limited Liability: In order to maintain limited liability, it is crucial that the business have separate bank accounts from the owners. This is crucial. The owner cannot treat the business bank account like a personal bank account; this is probably the strongest factor for getting the limited liability veil pierced (veil piercing = personal liability). Other factors leading to veil-piercing include personal guarantees on business loans, thin capitalization, and absence of arm-length transactions. Keeping records and treating the business as a business and not an alter ego helps keep the veil in place.