One of the most important steps in creating a successful offering is choosing the right business formation option. A wide range of choices exists, but they are not all created equal. Making an informed decision is crucial, as the business structure will affect everything from taxation to the number of members required, and much more.
In this post, we will explore some of the more commonly used business structures, including LLCs. We’ll also highlight some of the strengths that make LLCs the go-to option for so many people.
Before beginning our comparison of business structures, understand that this blog post does not constitute legal advice. It provides information to educate only and should be used for informational purposes.
Do You Want to Start a Business?
Aspiring business owners have a few options to structure their businesses. We’ll begin with the basics and build up from there. The two most basic business structures are:
- Sole proprietorships
A sole proprietorship is an individual going into business for themselves; it’s a single person. The business could have an assumed business name, which can be anything the owner wants, so long as it doesn’t infringe on another business. Owners can take that name and register it with the county or state government and do business under an assumed name (DBA).
These are simple and easy to set up and allow owners to jump right into serving customers or clients. However, they come with some major drawbacks. For instance, there is no limit to the amount of liability the owner takes on by starting this business. Anything bad that happens in your business comes back to you.
A partnership is very similar to a sole proprietorship, except it involves two or more people going into business together. Again, this could have an assumed name. However, not only do owners have unlimited liability for risks encountered during business operations, but they also have unlimited liability for anything illegal or unethical other partners do. Any mistake made by an owner (of any degree and any type) is the direct responsibility of all owners and the business itself. Another drawback of partnerships is that they’re often created by accident. If you just simply start doing business with somebody else, that can create a partnership. Aspiring business owners must exercise caution to avoid finding themselves in business with someone else without even realizing it.
The real question in business structure is not whether you want to start a business or how to start a business but how to limit liability. Over time, there have been many ways to limit your liability. The oldest is the limited partnership or what came to become a limited partnership. This structure dates to the days of Julius Caesar in the first century BC.
As far as how they’re structured, limited partnerships require two or more people. There must be at least one limited partner and at least one general partner. Limited and general partners diametrically oppose one another and offset risk.
- Limited partners have little or no control over the actual business. However, they also have limited liability because they are limited partners; exposure is limited to the amount they contribute to the partnership and anything that contribution earns.
- General partners, on the other hand, are in the same position that they would in a regular partnership, or what’s often called a general partnership. General partners have control over the business. However, they also have unlimited joint and other liabilities just as they would in a general partnership.
Fast forward a few centuries to about 300 AD and we begin to see what will eventually come to be known as corporations. In ancient Rome, these were called corpuses, a body of people performing a business. It didn’t look exactly like today’s corporations, but the idea was very, similar, and corpuses directly evolved into corporations.
Corporations involve one or more people. Officers appointed by a board of directors elected by shareholders manage corporations. All those hats could be worn by just one person. However, corporations require multiple positions/titles, and they offer limited liability for shareholders.
Like limited partners, shareholders are not responsible for the bad acts of the company. However, despite their benefits, corporations come with numerous drawbacks. As we said, limited partnerships have unlimited liability for their general partners. Corporations have very inflexible structures. They must have a board of directors, for instance. In the case of an S Corp, they have restrictions on the classes of stock or the number of shareholders they can have.
Then there are limited tax elections. The taxation of corporations isn’t flexible. There are two choices: S Corp or C Corp. C Corps faces double taxation. Of course, that’s not necessarily the end of the world, and sometimes C Corps are used to create tax benefits, but options are still very limited when using a corporation. Then corporations require corporate formalities or things that you must do to keep that corporation in good standing and make sure that the protections it offers remain in place.
For a very long time, corporations were the only business structure possible outside of partnerships and sole proprietorships. And then something amazing happened in 1977. Technically, many amazing things happened that year, including the debut of Star Wars, the birth of the Atari 2600, the Voyager mission, Saturday Night Fever, and the debut of Meat Loaf – Bat Out of Hell. It’s also the year that Wyoming gave us the first limited liability company in the United States (Germany beat the US to that business structure by almost a century).
To say that the LLC structure was revolutionary is putting things mildly. Within 20 years, every state in the nation offered this type of structure. It is incredibly useful for many reasons, including the following:
- LLCs give limited liability to all stakeholders. There’s no general partner with unlimited liability. Everybody involved has their liability limited.
- LLCs have a flexible structure. You can design them almost any way you want. Owners can have the business operate however they want, and they get to make up most of the rules.
- LLCs have flexible tax elections. LLCs are the chameleons of the tax world and can take on the form of other business entities for tax purposes.
- LLCs have fewer formalities than corporations, so owners can even write out what formalities are required within their LLCs.
The Flexibility of LLCs
LLCs can be member-managed, which is another way of saying owner-managed (all members are owners). The members themselves can manage the LLC, or the business can be set up so an outside individual or company that may or may not be a member can make management decisions. LLCs do not necessarily have to have a board. If the owners want a board, they can create one, which offers immense flexibility to suit varying needs.
Here’s a basic outlay of how flexible LLCs are:
- In a member-managed LLC, members exercise control over the company.
- In an outside-managed LLC, an external individual or organization manages the company, and may or may not be part of the organization.
- In all events, managers run the company while members do not.
- Profit sharing and voting can be divided as the LLC decides and do not have to be divided according to investment amounts.
Class A & B
Let’s imagine an LLC that has one or more managers over here and two classes of members. We’ll designate these Class A and Class B. Let’s say the managers didn’t put any money into this business, but Class A members and Class B members each put 50% of the money. We could design this where the managers still get 20% of the voting power and 20% of the profits in that LLC.
Maybe Class A gets 35% of the profits and the voting control, and Class B gets 45%. For whatever reason, maybe each class B member contributed more, or they came in earlier, so they get a bigger benefit than the other members. Again, owners can design this however they want.
Most provisions of state LLC acts can and should be superseded by a company agreement. In some states, they call it an operating agreement. It’s an agreement between the members and the manager (if there’s a manager) about how the LLC will operate, and it can supersede a state’s LLC Act. For instance, the LLC Act might define voting in a certain way, but a company agreement could change that. It’s essential to have a company agreement in place for that reason. Let’s look at an example.
A Real-World Example
A client calls their attorney. That client was a member of a particular LLC located in Texas, in which one member was also the manager, and that member also contributed 60% of the capital within the business. There were two other members, and they each contributed 20%. The two non-managing members decided they did not like the managing member because they felt he was doing a poor job of running the company. They wanted to change things.
To determine if that was possible, the attorney asked to see the company agreement. Unfortunately, there was no company agreement, so the attorney had to defer to the state’s LLC Act. Thankfully, Texas’ LLC Act allows managers to be removed with or without cause at a meeting of the company’s members. The attorney informed the two members of this, and they arranged the meeting.
If this situation had occurred in a business with another structure, things would have turned out very differently. The managing member also owned 60% of the company. Under other business structures, that would have meant control remained with him. However, because this was an LLC, every member’s vote carries the same weight regardless of capital contributions.
The two non-managing members forced a vote and carried the day with a two-thirds majority. They were able to take control away from the managing member. However, that individual remained a member of the LLC, as well as the profits and economic benefits. He simply lost his position as the manager.
The moral of the story is simple:
- Create a company agreement.
- Design the company to operate the way you (and your partners, if applicable) want it to.
- Don’t leave important outcomes to the state’s LLC Act.
Taxation of LLCs
One interesting thing with LLCs is there is no tax form. As far as the IRS is concerned, LLCs don’t exist. So, LLCs must choose how they’re going to be taxed. They’re taxed as one or the other entity types we discussed earlier. The options available include the following:
- Disregarded. This is basically how a sole proprietorship is taxed where the business is ignored. All the tax burden flows through to the owner. This can be done on any single-member LLC, or an LLC owned by two spouses in a community property state. There are nine community property states in the country, and married couples can also have their LLCs disregarded in Texas, Arizona, and California.
- Partnership taxation. This option is for multi-member or multi-owner LLCs. Partnership taxation is based on a partnership return that dictates how much profit or losses the company took and how those losses or profits are split among the different partners or members. The LLC issues a K1 to those partners and the partners pay the tax burden or receive the tax benefit on their income tax statements.
- C corporations. C corporations have a 21% tax rate, and when they distribute money to add to their owners and shareholders in the form of dividends, those dividends are taxed, which creates double taxation.
- S Corp taxation. S corporation taxation passes through to its owners.
1. Disregarded Entities
A disregarded entity could be an LLC held by a single individual. That LLC does not file any taxes. The individual files all the taxes for that business themselves. Again, that LLC could be disregarded if a married couple in a community property state owns it. If an LLC is owned by another LLC or another business owner, if there’s one owner, that LLC can be disregarded.
Another way to do it is if someone owns multiple LLCs. They can set up a holding company structure where one LLC owns several others. If this LLC is the sole member of all these other LLCs, then none of these LLCs must file any tax returns. They can be disregarded, and all the taxes flow to that one LLC. If that is all seized on by a single member, the taxes could flow down to that member.
A Note on Partnerships
Partnership taxation is interesting because businesses have flexibility in how they allocate taxes. Each member receives their portion of the profits in the loss of the business. A K1 is sent to that taxpayer, and the taxpayer uses that to determine how much they owe on their tax return, which is flexible.
Let’s say we have an LLC with three partners. We’re going to have a partnership taxation election on this LLC, three partners, and let’s say they all own it. They could elect to divide the tax burden equally, with each owner shouldering one-third of it. However, they could also do something different. So long as the taxes are paid, LLCs can structure the burden as they see fit.
2. C Corps
C Corps face double taxation. That means the corporation itself pays a 21% income tax rate. When it makes distributions or pays dividends to its owners, those owners pay taxes on what they receive. The income is taxed twice, once at the corporate level and once at the shareholder level.
You can avoid some of this by paying a salary to the shareholders, assuming those shareholders are doing some kind of service for the LLC. You avoid double taxation because the expense of paying the shareholders a salary is written off by the corporation. However, that also adds payroll tax to what they’re getting paid. With a C Corp, the IRS wants you to pay if it’s making salary payments to shareholders and wants them to pay as little as possible. This works well in some cases. For instance, a startup that’s not distributing much cash could very well benefit from this structure. It’s worth discussing with a CPA or tax planner whether C Corp taxation makes sense in a particular situation.
3. S Corp Taxation
S Corps have a few more restrictions than C Corps and are taxed differently. One restriction is that there’s only one class of stock allowed. The economic interests must match relative ownership. So, if you own 40% of an S Corp, that’s your economic interest. You get 40% of the profits and 40% of the losses. The owners providing services to that business must receive a reasonable salary for their services. If they are providing services to the LLC, they must be compensated for their time as an employee of that LLC. S Corp formation also provides an additional 20% Qualified Business Income Deduction (QBI).
At the end of the day, the right business structure will offer the flexibility and protection you and any partners need. While all business formations offer some mixture of benefits and drawbacks, LLCs are perhaps the most useful and deliver substantially more protection against liability.