You have a great idea for a new business, but you don't know where to begin with the legal stuff. How do you register your company with the Secretary of State; what type of entity should you choose (LLC or corporation); or what legal documents you need? Our clients frequently ask us these questions. We are here to help you. In this article, we discuss the first step of the process: Determining what type of legal entity you should choose (sole proprietors are not included in this article).
Limited Liability Company (LLC): A LLC is not a corporation. There is no such entity as a limited liability corporation. Limited liability is a type of protection for your personal assets. It ensures that your personal liability for the business' debts and obligations is no more than the amount of money you invested in the business. This protects your personal assets from being used to pay off any debts accrued by your business. A LLC is formed by filing Articles of Organization with the Ohio Secretary of State. The owners of a LLC are called members, as opposed to stock holders. LLC profits and losses are passed through to individual members, while corporate profits and losses are held by the corporation. The business income of a LLC is considered the owner's or member's income, and the owner/member pays the tax on his or her personal tax return. Therefore, LLCs are taxed based on the Adjusted Gross Income of the owners. Owners of an LLC also pay self-employment tax on their income from the business, while corporate owners who work in the business are considered employees and pay tax on their employment income, along with FICA taxes (Social Security and Medicare). The tax filings for a LLC are much simpler than for a corporation.
Corporation: A corporation is formed by filing Articles of Incorporation with the Ohio Secretary of State. The owners of a corporation own shares of stock in the corporation. The profits and losses of the corporation are held by the corporation and are not passed through to the owners directly. Some earnings of the corporation may be paid to the owners in dividends, but those payments are not direct, or pass through payments. Corporations are taxed at the corporate tax rates, as opposed to the adjusted gross income of the owners. Owners of a corporation do not receive regular paychecks, but they receive dividends, and they are taxed on their dividend income. Since dividends are not tax deductible (like salaries and bonuses), dividends are taxed twice. This is referred to as double taxation. This is not an issue for smaller corporations where only the owners work for the corporation. Instead, owners receive tax deductible salaries and bonuses.While double taxation is seen as a disadvantage for businesses choosing to file as a corporation, this additional tax responsibility can often be offset by federal deductions that are only available to corporations, such as advertising, operating expenses, medical and retirement expenses.
S Corporation: The term "S corporation" means a "small business corporation" which has made an election under § 1362(a) of the Internal Revenue Code to be taxed as an S corporation. If a business elects and qualifies as an S Corporation, the tax difference between a LLC and S Corp is a bit more nuanced. Both a LLC and a S Corp has flow-through taxation (no double taxation). However, a LLC's distribution of profits are subject to an employment tax, whereas an S Corp's dividends are not. With careful planning, a small business can avoid significant employment taxes by electing to become a S Corp. However, there can be drawbacks of a S Corp that may deter a small business from taking this advantage.
You Should Hire a Qualified Accountant: We strongly recommend that every new business owner, whether you have one employee or 50, find a good accountant. Your attorney should work with your accountant to determine the best organizational structure for your new company. This decision will depend upon the expected number of employees, the type of tax structure that works best for you, and the the type of business you want to build.
Our next post will discuss registering your company with the Secretary of State, the Ohio Business Gateway, and the IRS.
Tara R. Jones is an attorney with more than ten years of experience in small business and estate planning legal matters.