Small Details You Should Know Before Forming a Legal Entity

legal entity
Image Credit: Tomas Armanavicius on Flickr

Details matter. This is perhaps never more true than when you’re deciding which type of legal entity you should form for your new company. A Google search for advice brings up thousands of articles about how to set up C corporations, S corporations, and LLC’s.

For every advantage, there are numerous disadvantages. Almost everyone advises budding entrepreneurs against going for a sole proprietorship. But every outfit has unique needs. So how do you know whose experiences would most accurately predict your future?

The answer lies in the details. You can gather hundreds of personal stories about how a specific structure benefited each firm. However, that’s not sufficient.

You need to know precisely how taxes and liability affect each type of legal entity. In this way, you can anticipate potential scenarios for your operation. Understanding the technical details will empower you to prepare for the downside of whichever course you choose.

For example, if you form an S corporation and hope to expand your business in the future, you’ll have to deal with not being permitted to retain money. That’s because an S corporation is a “pass-through” entity. This means profits and losses sift through to its owners.

Similarly, if you don’t form a corporation and remain a sole proprietor, your private property is at risk.

Here’s what you need to know about your options with each legal entity. Use this knowledge to help you make the right decision.

 

RELATED ARTICLE: SOLE PROPRIETORSHIP VS. PARTNERSHIP VS. CORPORATION

 

S Corporations and LLC’s Are Pass-Through Tax Entities

The only difference between an S corporation and a C corporation is the way they’re taxed. For example, a C corporation must pay income tax twice. First, it pays taxes on its net profits as a company. Then the shareholders pay taxes on the dividends.

An S corporation and an LLC, on the other hand, don’t pay taxes as a corporation. All profits and losses are distributed to shareholders and claimed on personal taxes.

 

Forming an Entity Will Protect Your Personal Assets

This being so, you should think long and hard before deciding to remain a sole proprietor. In many industries, not incorporating could be costly.

For example, if you’re a freelance website developer and a client sues you for not meeting your deliverables, you could lose your personal assets in the judgment. Another industry in which sole proprietors are at risk is real estate. Green Residential points out that some real estate investors form an LLC to protect themselves.

“Let’s say one of your tenants trips on a loose floorboard and breaks her nose,” the article suggests. “You likely become an immediate target. The tenant may choose to sue you. However, if you are operating as an LLC, your personal assets are protected. The tenant can still come after your company. However, she can’t come after your personal assets.”

That would be the case if you filed for bankruptcy, as well. You might lose company assets. However, you wouldn’t have to worry about losing your personal property to settle a business debt.

 

 

Both S Corporations and LLC’s Can Elect to Be Taxed as a C Corporation

S corporations and C corporations get taxed differently. However, if you form an S corporation or an LLC, you can file paperwork to be taxed as a C corporation.

 

S Corporation Owners Can Receive Dividend Payments from the Corporation

As explained in this thorough resource, receiving dividend payments on top of a salary lowers your tax bill. That’s because dividends aren’t subject to self-employment tax. It’s worth noting that self-employment taxes aren’t cheap.

Within reason, an S corporation can also “deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders.”

 

Tax Law Determines the Qualifications for Forming S Corporations

An S corporation is generally the most appealing entity. However, there are significant drawbacks that may come as a shock if you’re not aware of them in advance. For example, an S corporation faces strict requirements with regard to the number and type of allowable shareholders and shares.

There’s a maximum of 100 shareholders. And you may issue only one class of stock. In other words, an S corporation can’t have one class of preferred stock and another of common stock.

It’s also a violation to have differences in common shares. For instance, one set of common shares may not receive a different percentage of the profits from what another set gets.

Additionally, all rights to distribution and liquidation proceeds must be identical. Unfortunately, many businesses don’t have the foresight to understand how everyday business transactions may be treated as a second class of stock.

For instance, a buy-sell agreement that establishes a purchase price significantly above or below fair market value might be found to be in violation. This could invalidate your S corporation status.

 

Research Common Problems and Solutions Before Choosing a Legal Entity 

Knowing such details will make it easier to decide which legal entity you’d prefer. Before making a final selection, you should investigate worst-case scenarios. Find out how other businesses resolved classic problems. Take other people’s experiences with a grain of salt, but scan them first for lessons.


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