This is part 3 of a 7 part series highlighting common legal missteps of small businesses.
Mistake #3: Failing to incorporate.
Why incorporate? By incorporating your business, you separate and protect your individual assets in the event a lawsuit or liability is levied against the entity. In other words, your company’s creditors are prevented from looking to your individual assets to satisfy your company’s debts. In addition, incorporation provides your entity perpetual existence, protects the name of your entity, and allows you to deduct expenses before you allocate income to the owners.
You can incorporate as either a “corporation” or a “limited liability company”. Within each, there is another level of complexity that is tax driven. A corporation can elect to be taxed as a “S” corporation or a “C” corporation. There is a similar election for limited liability companies, but as almost all limited liability companies’ elect to be taxed as a “partnership”, this will not be discussed further. The advantages and disadvantages of each entity type are discussed below.
The traditional business vehicle is the “C” corporation. The “C” corporation can have an unlimited number of stockholders and more than one class of stock. The major disadvantage is that the “C” corporation is taxed at a corporate level and on the stockholder level; its stockholders are taxed on any distributions (read profits) they receive from the entity.
The “S” corporation, on the other hand, is only taxed at the stockholder level and not at the corporate level. However, it is limited as to the number of stockholders (100), type of stockholder (another corporation or limited liability company cannot be a stockholder), and can only issue one class of stock. Within that class of stock, you can, however, have voting and non-voting shares.
b. Limited Liability Company
The limited liability company is a somewhat new creation. The limited liability company provides greater flexibility than a “S” corporation and, in most circumstances, also provides its owners the beneficial taxation of a “S” corporation. For these reasons, the limited liability company is one of the most popular forms of incorporation for small businesses. Disadvantages of a limited liability company include:
- A single member limited liability company is considered a disregarded entity, resulting in a combined individual and corporate tax return;
- The owner of a limited liability company must pay self-employment tax on the entire net income of the business; and
- A limited liability company cannot issue incentive stock options
Moisan Legal P.C. is a boutique law firm focusing on representing entrepreneurs and businesses in a variety of legal issues. Matthew J. Moisan can be reached at 646.741.5222.