Practical Suggestion: If you are just testing a business idea or concept, it may be okay to start as a sole proprietor or partnership for a short time until you know if the project is going to work. However, keep in mind that if you get sued during the time you operate as a sole proprietor, even though you may incorporate or form an LLC later, you will have no liability protection for events which occurred before you formed the entity.

1. Liability protection and
2. Tax considerations

Text books sometimes cite other issues such as perpetuation of the entity, continuity, ability to raise capital, etc. However, in my experience, these are not important considerations for most small businesses.

Liability Protection: With respect to liability protection, corporations (both C and S corporations) and LLC’s provide the same or similar limited liability protection. It is sometimes said that corporations may be more predictable because they have a longer history of legal case precedent to help decide issues of liability. Limited liability protection is also available in limited partnerships and limited liability partnerships but these forms are not frequently used for small businesses.

Special note: I often hear people say they have been told that an LLC is easier to operate than a corporation because there are no corporate formalities to observe. In my experience, this is simply not a major factor since both small business corporations and LLC’s are relatively easy to operate. I do not believe this should be a deciding factor in most cases.

Tax Considerations: With respect to taxes, the best advice is to project your net income for the next year or two and then ask your accountant or tax advisor to calculate which entity will provide you with the best tax savings. The information below provides some basic considerations:

• If saving money on the FICA or the 15.3% self employment taxes is important to you, an S corporation may be the best entity of choice. The tax law requires that you pay reasonable compensation to the shareholders who work in the business. Many accountants define “reasonable” to mean approximately half of the net income of the business (this may vary depending on the nature of the business and what employees in similar businesses earn) The proper FICA taxes must be withheld and paid on the compensation. The rest of the income which is distributed to the shareholders is not subject to the FICA taxes (it is, however, still subject to income taxes). Most accountants suggest that this same savings on FICA taxes is not currently available when using an LLC.Special Note: Some tax advisors are recommending the use of an LLC which elects S corporation tax status. This is a fairly new approach that might provide the benefit of reduced FICA taxes coupled with the informal operating requirements of an LLC.
• If you plan to leave most of the earnings in the business for purposes of expansion, then a C corporation might be most beneficial. This is because the first $50,000 of net income in a C corporation is generally taxed at a lower rate than the individual tax rates of S corporation shareholders or members of an LLC. Thus, you can leave the first $50,000 of net income in the business and pay a lower tax rate. (You can leave net income in the business in both an S corporation and LLC but the shareholders and members will be required to pay income tax on the money at the end of the year, regardless of whether they actually received it or not, at their individual tax rates)
• If you plan on losing money or borrowing substantial money in the start-up phase, you should consider an LLC which may allow you to write off greater losses than you could if operating as an S corporation or C corporation. That’s because you get a little better tax basis when using an LLC.
• There are some limitations on S corporation election. The rules require all shareholders to agree to S election and all shareholders must be citizens or permanent residents of the United States. S corporations are limited to 75 shareholders and to only one class of stock such as common voting stock. Other entities such as corporations or LLC’s cannot be S corporation shareholders with the exception of a few types of special trusts.
• If you are planning on the business expanding rapidly and possibly going public, S corporations and LLC’s do not work as well. Even though you leave the net earnings in the business to expand it, you will have to pay income tax at your personal rate on the net earnings.
• If there is a need to distribute income and allocate losses on a basis different than ownership ratios, then an LLC may work best. An LLC operating agreement can provide for a different allocation of profits and losses (S corporations must allocate profits and losses strictly on the basis of the ratio of share ownership) For example, if some owners of the business need income but others need losses to write off against other income, an LLC allows the members to adjust these allocations based on their needs rather than strictly on ownership ratios.
• Some experts believe that a business involved in the transfer and sale of real estate in and out of the entity might work best in an LLC. (This does not include real estate agents or mortgage loan brokers who earn a fee for their service but are not transferring title to real estate in and out of their entity)

However, with respect to taxes, the C corporation itself is considered a taxable entity. That means that it files a tax return and pays income taxes on its net income. If the corporation then distributes income in the form of dividends to the shareholders, they are taxed again on the income.

This is often referred to as the double tax of corporations. Most small businesses can avoid or reduce this double tax by paying substantial compensation and providing benefits to the shareholders who work in the business.

Compensation and benefits are generally tax deductible to the corporation as a business expense. If a benefits plan is structured properly, the value of the benefits may not be considered taxable income to the employee.

Compensation must be reasonable or there is the possibility that the IRS could reclassify it as a dividend making it subject to the double tax problem. The other method of avoiding or reducing the double tax is to elect an S corporation status. Unlike a C corporation, an S corporation itself is not a taxable entity.

The S corporation files an informational tax return on form 1120S, but the corporation itself does not pay taxes on the net income of the business. An S corporation is a pass -through entity which means the profits or losses are reported by the owners (shareholders) on their individual tax returns.

An S corporation can also pay compensation to shareholders who work in the business. If the S corporation distributes income to the shareholders, there is no double tax because the S corporation as an entity does not pay any tax. Only the shareholders of the S corporation report and pay income taxes on their prorata share of the business net income.

In most small private corporations, the shareholders are actively involved in the business and also serve as officers and directors of the company.

There are some larger corporations with a substantial number of shareholders who choose to remain private for several reasons including more privacy and the high cost of going public and maintaining a public company.

A public corporation is one that is authorized to sell its stock to the public. Usually, only companies with substantial revenue and a large number of shareholders can afford the cost to go public and comply with the many regulations imposed on public companies by the securities laws and other governmental regulations.

Usually, the statutes provide that only a person holding the license required to practice the professional service can be a shareholder or at least a majority shareholder. In addition, only those holding the professional license can normally be a director or officer of the corporation except for the corporate secretary.

The reason for these restrictions is that the professionals are strictly regulated by license requirements of their profession and the law does not want unlicensed people making decisions that might compromise the professional’s judgment on matters within their expertise.

On the other hand, some states have adopted special statutes for a “close corporation” which describes a corporation with a small number of shareholders that is authorized to function without directors. This bypasses some of the normal corporate formalities involved with a board of directors and supposedly simplifies the process.

My experience is that in some cases this may make operation of a small corporation easier but on the other hand, it sometimes complicates it because the business world is accustomed to dealing with directors.

For this reason, owners or shareholders of a “close corporation” may find themselves trying to explain to a banker or other business person why they don’t have directors and why they don’t need director approval for various corporate actions. As a practical matter, the “close corporation“ structure may not provide that much benefit after all.

If the corporation is a small business corporation and does business primarily within a single state, incorporating in the home state is typically preferable. The cost of incorporation in your home state will usually be less than incorporating in a different state and then trying to qualify to do business as a foreign (meaning from another state) corporation.

A foreign corporation that qualifies to do business in another state is subject to taxes and annual report fees from both the state of incorporation and the qualifying state. Another disadvantage of incorporating outside of your home state is the possibility of having to defend a lawsuit in another state. You will also have to maintain a registered office and agent in the other state, which is an additional cost each year.

If you operate a business, within no particular location or home base, such as an internet business, then you might want to consider Nevada or Delaware. However, you may find the cost of operating and maintaining your corporation higher in Delaware than in your home state due to the franchise fees charged by Delaware and the need for a registered agent in Delaware.

Many large corporations are domiciled in Delaware but my opinion is that Delaware does not provide many benefits to smaller companies that could not be found in their home state. Nevada promotes the incorporation business by claiming no state income taxes and not sharing tax information with the IRS.

However, if you do business in another state, you will likely still pay state taxes in the state in which you conduct business. Each state has its own formula for deciding if a business owes state taxes. It’s best to consult an accountant about this question.

As far as sharing tax information with the IRS, the IRS can obtain your records in Nevada by way of subpoena if they want. Also, I believe in being aggressive with tax savings, but not cheating. So what do you have to hide?

Nevada promotes the incorporation business and a lot of incorporation services have sprung up there. Some of these offer valuable services while others advocate advantages, which are more puff than reality.

Due to this and the large number of corporations formed in Nevada, some experts say that Nevada incorporating has developed a questionable reputation with the IRS and may subject a business to a greater likelihood of an audit if it is formed in Nevada.

If you are a US citizen and earn income from an offshore corporation, you are obligated to pay income tax in the US on that income. Trying to hide it in an offshore corporation will likely be viewed as tax evasion.

If you are looking to incorporate offshore for liability protection, there are several important considerations. First, in order to protect assets, you will need to transfer the assets into the offshore corporation, which will likely involve moving them to the offshore country or location.

There are a lot of horror stories about people losing their assets in offshore companies. You need to be very careful about whom you trust and whom you do business with. Secondly, you will be dealing with laws from another (offshore) jurisdiction that may be considerably different than the local corporation laws or US laws that you are used to.

In most cases, the risk and effort in setting up an offshore corporation will outweigh any potential benefits you might receive.

The corporation provides a shield or protection for your personal assets. This protection is not absolute and often depends on the facts of each case. However, it is a valuable protection and should be considered any time you are involved in business. (For a more detailed discussion of limited liability protection see Part 7 in the Book).

The main disadvantage of incorporating is the cost and extra time involved in getting organized and operating the business as a corporation. Once the corporation is set up, it may not involve much more time than just operating a sole proprietorship. Any business requires that you keep records for tax purposes.

1. Liability Protection. With respect to liability protection, corporations (both C and S corporations) and LLC’s provide the same or similar limited liability protection. It is sometimes said that corporations may be more predictable because they have a longer history of legal case precedent to help decide issues of liability. Limited liability protection is also available in limited partnerships and limited liability partnerships but these forms are not frequently used for small businesses.
2. Tax Considerations. With respect to taxes, the best advice is to project your net income for the next year or two and then ask your accountant or tax advisor to calculate which entity will provide you with the best tax savings. The information provides some basic considerations:

Special note: I often hear people say they have been told that an LLC is easier to operate than a corporation because there are no corporate formalities to observe. In my experience, this is simply not a major factor since both small business corporations and LLC’s are relatively easy to operate. I do not believe this should be a deciding factor in most cases.

If saving money on the FICA or the 15.3% self employment taxes is important to you, an S corporation may be the best entity of choice. The tax law requires that you pay reasonable compensation to the shareholders who work in the business. Many accountants define “reasonable” to mean approximately half of the net income of the business (this may vary depending on the nature of the business and what employees in similar businesses earn).

The proper FICA taxes must be withheld and paid on the compensation. The rest of the income which is distributed to the shareholders is not subject to the FICA taxes (it is, however, still subject to income taxes). Most accountants suggest that this same savings on FICA taxes is not currently available when using an LLC.

Special Note: Some tax advisors are recommending the use of an LLC which elects S corporation tax status. This is a fairly new approach that might provide the benefit of reduced FICA taxes coupled with the informal operating requirements of an LLC.

If you plan to leave most of the earnings in the business for purposes of expansion, then a C corporation might be most beneficial. This is because the first $50,000 of net income in a C corporation is generally taxed at a lower rate than the individual tax rates of S corporation shareholders or members of an LLC.

Thus, you can leave the first $50,000 of net income in the business and pay a lower tax rate. (You can leave net income in the business in both an S corporation and LLC but the shareholders and members will be required to pay income tax on the money at the end of the year, regardless of whether they actually received it or not, at their individual tax rates.)

If you plan on losing money or borrowing substantial money in the start-up phase, you should consider an LLC which may allow you to write off greater losses than you could if operating as an S corporation or C corporation. That’s because you get a little better tax basis when using an LLC.

There are some limitations on S corporation election. The rules require all shareholders to agree to S election and all shareholders must be citizens or permanent residents of the United States. S corporations are limited to 75 shareholders and to only one class of stock such as common voting stock. Other entities such as corporations or LLC’s cannot be S corporation shareholders with the exception of a few types of special trusts.

If you are planning on the business expanding rapidly and possibly going public, S corporations and LLC’s do not work as well. Even though you leave the net earnings in the business to expand it, you will have to pay income tax at your personal rate on the net earnings.

If there is a need to distribute income and allocate losses on a basis different than ownership ratios, then an LLC may work best. An LLC operating agreement can provide for a different allocation of profits and losses.(S corporations must allocate profits and losses strictly on the basis of the ratio of share ownership.)

For example, if some owners of the business need income but others need losses to write off against other income, an LLC allows the members to adjust these allocations based on their needs rather than strictly on ownership ratios.

Some experts believe that a business involved in the transfer and sale of real estate in and out of the entity might work best in an LLC. (This does not include real estate agents or mortgage loan brokers who earn a fee for their service but are not transferring title to real estate in and out of their entity.)