So yesterday we took some time to review the first two business entities, sole proprietorships and general partnerships. It may make sense for some of you out there who are trying to start an online business to elect one of these corporate entities, but you are certainly in the minority.
What are the best business entities for starting an online business?
The vast majority of our clients, especially those that are making money (or anticipate making money, why else would you be in business?), will elect to form either a corporation (C-Corp or S-Corp), or an LLC for online business. There are advantages and disadvantages to each, and we’re going to cover both below.
As always, if you aren’t sure which entity to choose, it is important that you consult with a legal professional to go over your options.
Corporations for Online Business?
Any discussion of corporations must start with the understanding that a corporation is a legal entity separate and apart from the person who owns the corporation (i.e. the “shareholder”). Pretty much any business you patronize, from a restaurant chain like Starbucks (where many online entrepreneurs work…), to a big box store like Target, to the Honda dealership where you bought your car, is a corporation.
Here are some of the benefits of forming a corporation vs. an LLC for your Online Business.
Limited Liability
The biggest advantage of forming a corporation is that you, as a shareholder, will have limited personal liability for the debts and actions of the corporation. This means that if the corporation gets sued, and a judgement is entered against the corporation, you as shareholder would not be held personally liable for the judgment.
NOTE ON LIMITED LIABILITY: You should be aware that if you do form a corporation and you try to get a loan from a bank or other creditor, it is highly likely that you will be asked to sign a personal guarantee – meaning that you could be liable on the debts of the corporation regardless of the fact that you are an individual separate from the corporate entity.
Types of Corporate Entities
There are two types of corporations, C-Corp’s and S-Corps. There are significant differences between the two that you need to be aware of before you organize your online business as a corporation.
C-Corporations vs. S-Corporations
What are the differences? A C-Corporation is a completely separate entity from a legal standpoint than its shareholder owners, and must file its own Federal and State tax returns. In addition, a C-Corporation also pays it’s own taxes on its net profit. An S-Corporation is not a separate legal entity per se, but rather it is a tax election that can be made by either a C-Corporation or an LLC. An LLC or a C-Corp that has elected to be taxed as an S-Corp files what is considered an “information return” and the net income flows through to the shareholders (or members in the case of an LLC) in proportion to their ownership interest.
Tax Treatment. The main advantages to operating as an S vs. a C-Corporation, or vice versa, are the tax benefits or drawbacks of each, depending on your unique situation. Since a C-Corporation pays its own taxes on net profits, (even profits that are distributed as dividends, which you must also pay taxes on at the personal level; this is known as “double taxation”), you must consider the corporate tax rate vs your personal income tax rate in making this decision. In addition, an S-Corporation passes both income and losses through to the shareholder owner. That means that in the early stages of a business, you can use those losses to offset income from other sources on your personal tax return. A C-Corporation will not pass on losses to shareholders.
Opportunity to Lure Investors. As an S-Corporation, you are limited to 100 shareholders. A C-Corporation, on the other hand, can attract unlimited investors. Based on your growth projections and how you plan to finance your business, a C-Corporation may make more sense if you are looking to investors for financial backing or if you are considering “going public”. If, on the other hand, you intend to remain small and “bootstrap” you business in the form of retained income, personal loans, or possibly friends and family, then an S-Corporation may make more sense.
Should You Use an LLC for Online Business?
The last form of business entity that we need to discuss is the LLC. An LLC is a sort of hybrid business entity that has a lot of flexibility in how it is taxed and managed, while still maintaining the limited liability of a corporation.
Main Benefits. The main benefits to doing business as an LLC are that 1) it enjoys limited liability, just as a corporation does, 2) you can elect to be taxed as a partnership, a C-Corporation, or an S-Corporation, depending on your personal situation, 3) it allows for a flexible management structure, meaning that the LLC can be run by a single member, joint members, or even an outside management company, and, 4) the members of an LLC can distribute profits and losses anyway they wish, regardless of the percentage ownership of each member.
Main Disadvantages. An LLC has reduced opportunities to receive tax benefits from the payment of certain fringe benefits that are paid to owner-employees of a corporation. In addition, you cannot offer stock to LLC employees as incentive compensation, because LLC’s don’t offer stock, they have “membership interests”. For this same reason, LLC’s cannot introduce a stock offering to the public at large.
Which Corporate Entity to Choose for your online business?
As you can plainly see, the decision to incorporate vs. form an LLC vs. stay put as a sole proprietor or partnership is not an easy one. The decision is complex and there are lots of “moving parts.” You must consider the potential costs of incorporating, versus the likelihood that you would like to offer stock to employees or the general public, versus the risks that your business will be sued.
This isn’t a one-sized-fits-all decision. If you are considering forming a business, we highly recommend that you seek out the professional advice of an attorney to help you navigate these waters.
DISCLAIMER: It is entirely possible that you will need professional advice concerning what legal entity is best suited for your online business. This blog is a resource guide for educational and informational purposes only and should not take the place of seeking out the advice of a lawyer in your jurisdiction. None of the information provided in this post constitutes legal advice or creates and attorney-client relationship.
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