The best part about launching a business today is you can submit most paperwork online. This includes the most important paperwork of all: filing to create your business entity, whether it’s an LLC, an S Corp, or a standard C Corp.
The process is easy, but before you submit your documents, make sure you contact an attorney for the following reasons:
1. You Might Form The Wrong Type Of Entity
While the option exists to form any type of business entity you want, some entities are a better option than others. For example, if you’re a freelancer or solopreneur, it doesn’t usually make sense to form a corporation. The initial filing fees might be cheaper than an LLC, but maintaining a corporation will unnecessarily complicate your life.
Both S Corps and C Corps require formalities like meetings, reports, and officers. This is to protect shareholder assets. If your C corporation goes bankrupt, and you didn’t maintain formalities, your personal assets might become fair game to creditors. If you form an S Corp, the IRS could end up putting you under a microscope to see if you’re misclassifying dividends as wages in order to pay lower taxes.
An LLC, on the other hand, is perfect for most freelancers, solopreneurs, and some small businesses with multiple owners. As Incfile explains, an LLC is simpler and more flexible than a corporation. There are no required formalities. The LLC business structure has the pass-through taxation of a partnership, and the limited liability of a corporation. Owners are referred to as members. An LLC is the most popular option among the 42 million independent contractors in the U.S.
It usually costs less than $300 to form an LLC and get a taxpayer ID number. If you’re the only owner, income is reported to the IRS like a sole proprietorship (except for the District of Columbia). When an LLC has multiple members, The IRS treats that LLC as a partnership for tax purposes.
The lack of required formalities is mostly a benefit, but can also be a problem. For example, the law doesn’t require multiple members to create an operating agreement. Without an agreement, member rights and responsibilities are unclear, which can lead to problems. When disagreements arise – and they will – you could find yourself arguing over daily decisions and positions of power. To avoid this issue it’s recommended to create an LLC operating agreement even if the state doesn’t require it. This document will ensure all of the business details are covered and enforceable.
A lawyer will tell you this right away and if you choose to form an LLC, they’ll help you draft up an agreement between all members.
2. Some Industries Are Barred From Forming Llcs
There are some businesses and industries that can’t form an LLC. This is generally limited to financial companies like banks, trust companies, and insurance agencies. California bans architects, accountants, and licensed healthcare providers from forming an LLC.
If you aren’t allowed to form an LLC, and you try, you might get denied right away. If you somehow slip through the cracks, you could end up in a mess when it’s discovered.
3. There Are Important Differences Between S Corps And C Corps
An S corporation is designed for smaller businesses. S corporations are treated as pass-through entities, but face more scrutiny from the IRS looking for misclassified dividends. S corporations are limited to 100 shareholders, while C corporations can have unlimited shareholders. S corporations are also limited to offering one type of stock.
If you’re a freelancer, unless you’re looking for funding from a venture capitalist or your tax advisor suggests it, don’t form a C corp. You’ll end up paying a significant portion of your income for double taxation. The S corp portion of the tax code was specifically created to eliminate the double taxation.
4. You Might End Up Sharing Profits Unfairly
Imagine you’ve formed an S corporation with a partner, and you decide to split the profits, so you receive 75% and they receive 25%. This split makes sense because of the amount of effort each person will be putting into the business.
It’s in your agreement, so it’s a legally binding contract. When tax time rolls around, however, the IRS will require you to report income in direct proportion to your ownership in the company, which may be a different percentage.
Either way, it’s going to be unfair to at least one partner. To make it fair, you’ll either need to adjust your agreement or figure out a different approach.
Legal Counsel Makes Sense Of Confusing Options
These are just a few mistakes businesses make when forming an entity.
The business entity that’s correct for you depends on what your vision is for the future of your business, especially if you’re a first-time business owner.
Consult with a lawyer to untangle the confusion and make sense of your options.