Starting a new business can be very challenging as well as exhilarating. A key decision for start-ups involves the business structure to be adopted. There are various business structures, each with differing framework, culture and maintenance responsibilities. Tax requirements and financial resources are the most important factors that determine the choice of a business structure. There are common business structures; limited liability companies, corporations and S corporations.
A Limited Liability Company (LLC) is a hybrid formation accepted by state statute and different states can adopt varied laws on a limited liability company. Owners of an LLC are known as members and can be individuals, corporations or other LLCs (“Business Structures”, 2012). Limited Liability Companies have the distinct characteristic of having the limited liability framework of corporations, in addition to the tax treatment and operative flexibility of partnerships. The finite responsibilities for business debts are based on the level of shareholders’ investment, and this provides security to investors. This may be thought of as being analogous to the liability safeguard offered to shareholders in a business. As a result of this characteristic, an LLC is considered as a separate legal entity from the owners.
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Unlike shareholders in a corporation, an LLC is not considered a separate tax entity by the federal government and the LLC itself is not taxed. Federal income tax responsibilities pass directly to the LLC’s members who pay this through self-employment tax contributions toward Social Security and Medicare, just like the owners of a partnership (“Choose Your Business Structure”, n.d.).
The Internal Revenue Service (IRS) categorized two types of corporations with the object of federal income tax imposition; general corporations and S corporations. A general corporation is a separate and independent economic entity from shareholders. The corporation is legally responsible for all management decisions as well as any debts when the business shuts down. Therefore, shareholders’ personal assets are protected from all debts of the company and shareholders have an obligation only for their investment in stock of the company.
A corporation has a capability to raise capitals through the transaction of stocks for the business and pay taxes on corporate profits. The tax rate for a corporation is usually lower than the tax rate for personal income. However, starting a corporation is cost-intensive and time consuming. Compared to other business structures, the start-up and operating costs for a corporation are typically much higher. Another disadvantage in corporations is double taxing; the payment of corporation income tax for corporation profits, as well as income tax for the dividends of shareholders.
S Corporations have a structural framework that is similar to a general corporation. The shareholders of S corporations have the protection of limited liability; the shareholders’ liability cannot be higher than the amount invested in the business by the stakeholders. Taxes on profits and losses are not paid at the corporate level, but rather they are distributed to the shareholders. Shareholders report profit and losses on their individual income taxes.
S Corporations have the flexibility to effect change in company ownership of the company based on sales of stocks. They can also add new shareholders with relative ease. An S-Corporation has a limit of 100 shareholders, and is a separate legal entity from the shareholders. As a corporation, its existence continues even on the death of its shareholders. Shareholders are also actively involved in the management and day-to-day activities of the business. S corporations have an advantage of singular taxation based on certain built-in gains, as well as passive income level. They offer a viable alternative to general corporations (“Business Structures”, 2012).
In conclusion, a sound understanding of the basic frameworks for each of the three business structures is important for start-up decisions, so that the most suitable or viable choice of business structure can be made. This initial choice is however, not set in stone. As businesses grow or risks increase, business structures may be altered or converted in response.
- University of Manitoba (n.d.). An Overview of Available Business Structures. Retrieved June 26, 2013 from http://www.umanitoba.ca/
- Internal Revenue Service. (2013). Business Structures. Retrieved June 26, 2013 from http://www.irs.gov
- The U.S. Small Business Administration Web (n.d.). Choose Your Business Structure. Retrieved June 26, 2013 from http://www.sba.gov/
