When completing a business formation through Legalinc or another service provider, the first question you’ll have to answer is what entity type you’d like to form. This question is far from arbitrary and has overarching impact on your liability and taxation, whether you’re a business owner yourself or are forming the entity on behalf of your client.
To help make this decision as easy as possible, we’d like to run through the business types you can form through Legalinc, what they mean, and what considerations should be top of mind when choosing that entity type. These types, which are among the most common, are an LLC, a Corporation, an S-Corp, a Non-Profit, a DBA, and a Partnership.
An LLC, which stands for a Limited Liability Company, is regarded as being between a corporation and a partnership. LLCs create an independent legal structure from their owners but are taxed like a Sole Proprietorship if there is a single owner, or a partnership if there are multiple owners.
The greatest benefit of an LLC, especially for new business owners, is the ability to shift from the tax structure mentioned above to that of an S- or C-Corp, which adds flexibility to accommodate fluctuating business trends. For this, and many other reasons, roughly 80% of small businesses are LLCs.
A Corporation, also known as a C-Corp, stands in contrast to LLCs, as it’s one of the oldest formation types. It is similar to an LLC in that it helps separate personal assets from business debts, doesn’t limit the number of shareholders, and creates independent legal structures from the owners.
However, the differences between a Corporation and an LLC are important. Corporations are taxed on corporate profits & shareholder dividends, and require annual meetings with meeting minutes recorded. The benefits of a Corporation, especially to larger businesses, include versatility in compensation to reduce the overall tax rate and a greater ability to provide fringe benefits to owners and employees.
An S-Corp is essentially a Corporation that files a Form 2553, which provides similar benefits to small business as those mentioned in the LLC section. Just like an LLC, S-Corps receive pass-through taxation, meaning that federal income tax is not assessed and instead, profits are distributed to shareholders and then are subject to their individual tax rates. In certain situations, choosing an S-Corp over an LLC can help minimize payroll taxes, resulting in large savings. Typically, these companies have little overhead outside of payroll.
Still, as a corporation, annual meetings must occur and meeting minutes must be recorded. However, unlike both entity types mentioned above, there is a limit on the number of shareholders and all shareholders must be U.S. citizens or residents.
A Non-Profit, as you might expect, is markedly different than the entity types we’ve discussed up to this point. Speaking technically, a Non-Profit entity’s purpose is public benefit, first and foremost. Because of this, Non-Profits are given a pass on property, sales, and federal taxes. Like LLCs and S-Corps, Non-Profits receive pass-through taxation, meaning owners still pay income taxes at their individual tax rates, but the entity itself is exempt from federal income tax.
A common misconception is that Non-Profits can’t report any profit. Despite its name, a Non-Profit is certainly permitted to generate profits from efforts that are not subject to taxes, but it’s how those profits are used that is heavily regulated. Non-Profits may use profits for salaries, new projects, and other operating expenses. However, they may not use income for the individual profit of a director, officer, or another leadership figure.
Most Non-Profits are designated as 501(c)(3) by the government. To learn more about this designation and its requirements, visit the IRS’s exemption requirements page.
A Partnership is essentially a Sole Proprietorship that involves multiple owners. Unlike a Corporation, there is virtually no legal difference between the business and the owners themselves, which means they are liable for lawsuits filed against the business. The benefit of a Partnership is the lack of filing technicalities and ease of operation.
The owners in a Partnership are required to formalize how profits and losses will be shared, but the terms within that agreement are not regulated by any governance. Moreover, owners simply report those profits and losses on their personal tax returns.
For these reasons, Partnerships have many advantages for extremely small businesses, but once a business reaches any significant size or formality, Partnerships are no longer viable.
Finally, we have a DBA, which stands for Doing Business As. This is substantially different from all the other entity types we’ve talked about because it requires an entity to have existed previously. DBAs are used when an existing business or organization wants to begin using a different name in the market for a multitude of reasons, ranging from marketing to new lines of business.
DBAs are effectively fictitious business names, and the process of creating a DBA is done to inform the government and public at large that you intend on doing business this way. One of the most important reasons to form a DBA relates to banking. Before opening a business bank account under the name of your DBA, the bank will require that the business be designated as such by the government.
We hope this overview helped to clarify the confusing world of entity types and business formations. If you have any additional questions about business formations, our Customer Success Team is standing by, ready to help! If you’d like to get started with your Legalinc business formation, we encourage you to create your free account today!