Perhaps the question I get most is, “If an LLC gives me liability protection and pass-through taxation, why would I want to form a corporation?”
If you’re in California or plan on forming a business in California, please schedule a consultation. We will discuss the best entity choice for your business.
An LLC is a good choice for almost every small business. It provides you with liability protection and passes through taxation. There are exceptions. If you are a professional (i.e., doctor, lawyer, accountant, etc.), your state, such as California, may prohibit forming an LLC. You may have to form a limited liability partnership or a corporation.
However, there are better entity choices than an LLC if you want investors or would like to go public.
Equity in a Corporation
In a corporation, you can offer shares in your company in exchange for money or services. The owner of the shares holds an interest in the company. This is equity. Shares (subject to securities laws) are bought and sold easier than buying and selling a membership interest in an LLC. An investor wants a return on their investment. The benefit is that the investor is generally not liable for the corporation’s debts beyond the amount they have invested. In other words, if an investor gives you $1,000 in exchange for 1,000 shares, the only amount they can lose is the $1,000.
Downsides
One of the downsides to a corporation is that both shareholders and the corporation are taxed. This means that a corporation that only has a few shareholders and is run by the shareholders would pay taxes twice. Once on the corporation’s net income and once on the gains from their shares. The alienability of the shares and the limited liability of the shareholders comes at a price.
Another downside I will not discuss in this post is that to keep the limited liability of the shareholders, the company must keep its corporate formalities. If formalities are not maintained, it is easier for a judge to pierce the corporate veil and access the shareholders’ personal assets.
S-Corporation
The IRS allows a small company to be taxed as a partnership (i.e., pass-through taxation). This is an S-corporation or S-corp for short. A corporation has to meet and maintain some fairly complex requirements to qualify. However, it allows them to have the benefits of a corporation without the burdens of double taxation.
In other words, people looking to begin their business as a corporation can start with the benefits of pass-through taxation. This allows them to grow. However, once the company has grown sufficiently, it will no longer qualify for s-corporation status. The company is taxed on its net income, and the shareholders are taxed on their capital gains.
Final Thoughts on Choosing a Corporation Over an LLC
Choosing the correct entity is crucial. It can cost you significantly if done haphazardly or without a goal. You will spend more money and waste time adjusting the entity. It can be done, but it means focusing on fixing it and not running it. That time is better spent growing your business.
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