Choosing the correct entity for your new company will be one of the most critical business decisions you will make.
Should your business be run as a corporation, an LLC, a partnership or something else?
What are the differences, and which one will work best for you?
While owners and businesses are unique, the reasons for choosing a business structure are usually the same.
You want to reduce your liabilities and increase your tax advantages. But the proper business structure will also help you raise capital, deal with banks and financial institutions, and work with institutional investors.
And your structure can help ensure that your business can continue for the benefit of your family even after you are gone.
Most new businesses choose LLCs or S-corps, but there are also C-corps and partnerships to consider.
State Entities and the IRS - The Confusion
Surprise - There is no S-corp business entity.
Business owners are often confused and believe that their states, like Oregon or Washington, and the IRS view business entities the same. They don't.
Business entities are state creations. Suppose you want to form a corporation, a limited liability company (LLC), or a partnership in Oregon or Washington. In that case, you must follow state laws for those entities. Your obligations and protections are also determined by the laws of your state. For example, LLCs and partnerships have different state law protections with regard to liabilities.
But there is no way to form an S-corp in Oregon, Washington, or anywhere else.
An S-corp is not a business structure. It is an IRS tax classification. The S-corp status is used to reduce a business's tax burden in certain circumstances.
So the two-step process in structuring your business is first to choose the entity with your state, like a corporation, partnership, or LLC. Then select the tax regime you want the IRS to apply to your company, assuming you meet certain IRS requirements.
For example, if you incorporate in Oregon or Washington but want to be taxed as an S-Corp, you must file IRS Form 2553, "Election By a Small Business Corporation," and meet specific requirements. Your Oregon or Washington corporation will then be taxed as an S-corp.
And the IRS does not recognize an LLC for tax purposes.
If you form an Oregon LLC or a Washington LLC, you must let the IRS know how you want to be taxed by filing IRS Form 8832, "Entity Classification Election." You may elect to have your LLC taxed as a partnership, an S-corp, or have your LLC income disregarded for tax purposes and added to your personal income. If you don't make this election, the IRS will make it using their default rules.
A partnership is an association between people, or companies, carrying on a business venture as co-owners for profit. There are three types of partnerships: general (GP), limited (LP), and limited liability (LLP).
Liability is the most significant disadvantage to partnerships and one of the reasons most new businesses choose LLCs. But partnerships also enjoy one excellent tax advantage, the flexibility to allocate taxable income among the partners. But the tax allocations rules are complex.
General Partnership (GP)
A general partnership is easy to form under most state laws. In fact, a formal written partnership agreement is not required to create a general partnership.
And people can create a partnership unknowingly. If they engage in business together and don't choose any other entity, they may be deemed a partnership if they have an agreement to share in the profits and losses. Since each partner is personally liable for the obligations of the partnership, this approach is highly risky.
But a partnership pays no taxes as the income, gains, and losses are passed through to the partners. And the IRS allows the allocation of taxable income disproportionately among the partners.
Limited Partnership (LP)
A limited partnership has one or more "general partners" and one or more "limited partners." Customarily, the general partners manage and operate the business. The limited partners own a portion of the business, but they are prohibited from managing the partnership. However, they are usually not personally liable for partnership debts.
But, like a GP, they also enjoy the ability to allocate taxable income or losses disproportionally among the partners.
Limited Liability Partnership (LLP)
Certain licensed professionals, like attorneys, accountants, architects, and doctors, choose an LLP.
Usually, the LLP partners are not responsible for the debts, obligations, or liabilities of the partnership from negligence, malpractice, or other misconduct by another partner or employee.
Corporations are more formal business entities than partnerships or LLCs. There are state requirements, like in Oregon and Washington for registrations, articles of incorporation, meetings, minutes, resolutions, by-laws, shares, reports, and more.
And the running of a corporation is also more formal, with an elected board of directors, officers, shareholders, and employees.
Typically, the shareholders vote and elect a Board of Directors. The Board hires the officers of the company who operate the company and hire employees. Most large corporations with lots of shareholders are C-corps, like Walmart, Amazon, Apple, and more.
The problem with C-corps for small businesses is double taxation.
For example, when Walmart makes a profit, they pay taxes and then send out a portion of the profit to shareholders in dividends. When a shareholder receives the dividend, it is income to them, and they must pay taxes on it.
But in a small corporation, the owner or his family might own all of the shares. If his company is operated as a C-corp, there will be double taxation before the owner can keep the profit.
First, the company pays taxes on any profit. Then if the owner issues himself a dividend, he must pay taxes on that money as well. The owner and their small companies pay taxes twice on the same income.
But if the company qualifies, they can elect to be taxed under S-corp rules, and income and losses pass directly through the corporation to the shareholder/owners, so there is no corporate tax. This is a huge tax saving while maintaining the advantages of a corporate structure.
The IRS rules for qualifying for S-corp taxation are
Must be a domestic corporation
May be individuals, certain trusts, and estates; but
May not be partnerships, corporations or non-resident alien shareholders
No more than 100 shareholders
Only one class of stock
LLCs are by far the most popular business entity for new companies. For example, the State of Oregon shows more than 4,000 LLCs are formed each month, compared to about 800 new corporations. The total number of Oregon LLCs compared to Oregon corporations is about 218,000 to 117,000.
LLCs give you the advantage of limited liability protection, pass-through taxation, and less required paperwork or meetings. You must still register with your state, but there are fewer formalities than with a corporation. You do not have to appoint a Board of Directors, and the Operating Agreement can be as informal as you like.
Ownership in an LLC is in the form of "interests" and not "shares," and the equity owners are called "members" and not "shareholders."
Your Next Best Steps for Your Startup
If you are getting ready to form an LLC, partnership, or corporation, let us help.
We will show you the advantages and disadvantages of all these structures and help you determine which is best for you.
Res Nova is a boutique intellectual property and business law firm based in Camas, Washington and Portland, Oregon, with experience serving innovative companies and entrepreneurs in the Pacific Northwest and beyond.
We represent small and mid-sized businesses, including creative agencies, startups, and more mature companies.
Call Res Nova and let us help you with the next best steps for your company formation.