Small Business Terminology Basics
What is a "sole proprietorship"?
A sole proprietorship is essentially me doing business as myself. If I am a sole proprietor, or one of my clients is a sole proprietor, they don't have a separately recognized legal entity that they're doing business under, like a corporation or a limited liability company. Sole proprietorship is if I were a plumber, and I wanted to go out and start up my own plumbing shop, I could say this is Chas Rampenthal Plumbing Shop; I do business under my own name; I am the business. Since there's nothing separate in a sole proprietorship, all the debts are all my own personal debts, all the income is my own personal income and all of the liability is my own personal liability.
What are the pros and cons of forming a sole proprietorship?
There's actually a few pros and cons both. The pros for forming a sole proprietorship is that you don't need to form it, it just happens. The day you start doing business it's formed. Nothing else really need to happen, additionally there's no formalities. There's not legal paperwork to file. It's very inexpensive because there are no actual formalities. The cons are a little bit tricky and would depend on what your appetite is for risk. Again all the liabilities you would incur if someone were to sue your business; they would be suing you personally. There's no business to fall back on. If you were to lose that lawsuit you stand a chance to lose anything you own. Whether it's a home or prized possessions or a car. Anything that wouldn't be excluded under bankruptcy. Again if you business goes bankrupt, you personally go bankrupt. Also there are some tax limits. Whenever you're filing you individual taxes you would file them on a schedule C- which is a separate business income instead of filing a whole separate return for the company.
What is a "corporation"?
A corporation, unlike a sole proprietorship or a partnership, is a separate legal entity. It is, in a sense, a new legal person, whereas I am a natural person. So, a corporation can own property, it can open bank accounts, it can conduct business, it can hire employees, it can do pretty much everything that a natural person like myself can do. The things that a corporation does even more though, is it allows for a lot greater flexibility when it comes to raising capital, to eliminating liability, to assisting you with taxes and tax planning. And also, growing the business, raising capital, keeping capital in the business, it just becomes way easier to do a lot of those things when you have a corporation.
What are the pros and cons of forming a "C corporation"?
A "C" corporation is the "default corporation." Whenever you file or organize a corporation in any state in the United States, it is automatically classified as a "C" corporation for IRS and tax purposes. Some of the benefits for any corporation, whether it's a "C" corporation or not stand true. The liability of a C corporation's owners is limited to the amount that they have invested. So, if you invested a certain amount in and the C corporation is sued, only the amount that's inside the C corporation could be affected or drawn upon in the proportions of the ownership. Additionally, C corporations have abilities just like another person. C corporations can hire employees, they can do almost everything another person can do, with some added benefits of allowing for better tax planning. With "C" corporations, you can even retain earnings at the corporate level to grow your business or to help entice investors or to make strategic partnerships or to purchase other companies, so you can do things with a C corporation that you can't do with other types of corporation, or even with sole proprietorships. Some of the cons of a C corporation, are that it's a little expensive. A lot of times your C Corporation could require, the help of an attorney or a legal document preparations site online, or going and researching online could be time consuming. I think the upkeep of a C corporation can be a hassle for some people. There are formalities and things that have to be taken care of by the directors and the officers of the C corporation. Additionally, you have to file a separate tax return for the C Corporation. A lot of individuals are perfectly comfortable filing their own taxes, but often filing a business tax return can be a little bit daunting for the average person. And the overall time and energy expended running a C corporation can be a little more difficult, so you should always take a look at whether the pros outweigh the cons for each individual case.
What is a "limited liability company"?
A limited liability company or what almost everyone likes to call an "LLC" is very similar to a corporation. As a matter of fact, it has all of the good parts of corporations and all of the good parts of partnerships as well. What I mean when I say it's like a corporation, is that it is a separate legal entity. There is a filing made with the state. You have to let everyone know. You have to organize it and follow certain procedures. But instead of a normal sea corporation that's formed whenever you form a corporation in the state, the profits of an "LLC" will flow straight through to the individual owners - what everyone calls members of a limited liability company. Additionally, limited liability companies have a lot more flexibility typically than corporations when it comes to how they're managed. There is an operating agreement. There is a little bit less corporate formality as well.
What is the minimum number of members required to form an LLC?
In the past few years this has actually changed; I'd say probably within the last 7 to 10 years. When limited liability companies were first coming to the forefront, which has actually only been for about the last 25 years, you had to have two or three members a lot of times, because a lot of people thought that it was kind of silly to have 1 person as its own company. However, all 50 states right now have agreed that 1 member limited liability companies are fine.
What are the pros and cons of forming a limited liability company?
A lot of the things that are good about forming a limited liability company is that in my opinion, it takes a lot of the great aspects of corporations and a lot of the great aspects of a general partnerships and combines it into one entity.For instance, like a corporation, it has limited liability for its members or owners. Additionally, like a partnership, the income that is received or the revenues that are received from a limited liability company flow directly through to each of its members. Therefore, at the end of the year, even though the limited liability company will have to file a tax return, it's a zero tax return and there's no separate tax that's imposed on a limited liability company. Now, some of the cons similar to a corporation are that it can be a little costly to form. You have to go through a process and form it at the state level. And, there are some formalities that you have to adhere to even though, in my opinion, compared to a corporation, the formalities are a lot less.
What is the difference between an LLC and a corporation?
There are a lot of differences, as a matter of fact, and I think that can be explained by looking at the advantages of each of them. In my opinion, the advantage of an LLC, and there are several of them. Number one, it's automatically treated like a pass-through entity without making an S-corp election, which is what you'd have to do for a corporation. That means that taxes and earnings, as they're earned by the company, are flowed directly through to its members or owners and that there's no separate or double taxation of profits at the corporate level. Additionally, with an LLC, there are fewer corporate formalities. The requirement of taking meeting minutes and having certain board of director meetings that you have for corporations isn't present when it comes to a limited liability company. Also, when you look at a limited liability company and an S-corp, which look a lot like the same from a tax perspective, however limited liability companies offer more flexibility in that individuals who are shareholders or not shareholders but the members of a limited liability company are not restricted in number like they are for S-corps. They can be entities or other non-natural people and they can also be non-U.S. citizens, which isn't the case for that. Now, there are some definite benefits to having a corporation. Typically, those benefits are that if you wanted to retain earnings at the corporate level, that is automatic when you have a C-corporation. Also, at times, depending on the type of corporation you have and the types of benefits and fringe benefits that you have in a corporation, you can have better tax treatment of a C-corp and also, like I said, the ability to retain earnings. And even though you might be taxed on them at the corporate level, a lot of companies require that and actually need that type of cash retention.
What is an "S corporation"?
An "S corporation" is essentially a tax status. Every corporation when it's filed is classified as a "C corporation" and in order to make your corporation an "S corporation" you have to file a form with the IRS, I believe it's Form 2553, and then your corporation is essentially taxed like a partnership. So, whereas a "C corporation" incurs tax at the corporate level on profits that it makes, and then a second tax to the individual shareholders when profits are distributed to them, an "S corporation" is taxed only once, and that's as the profits flow straight through to each individual shareholder, and they're taxed individually at their personal income tax level. Now, in order to qualify for an "S corporation", the "C corporation" that you form has to meet certain minimum requirements. Typically there's a few qualifications that you have to meet: number one, you have to have fewer than one hundred shareholders, each of the shareholders has to be a US citizen, and generally it would have to be a natural person, with some very few limited exceptions. There has to be a fiscal year end date, in other words a tax reporting date, of December 31st, and you aren't allowed to have any preferred stock. And that means that if you would like to have someone come in and make passive investments, you wouldn't be allowed to give them different rights than everyone else had, which can be very limiting when you're raising money.Last, but not least, if you want to have "S corp" status or treatment in a current fiscal year, the year that you start the corporation you typically have to file your IRS Form 2553, which is the "S corp" election, within 9 days of starting the company, or else you have to wait until the next fiscal year in order to get that treatment.
What are the pros and cons of forming an S corporation?
Some of the benefits of forming an S Corporation are that it's treated, your corporation, the C Corporation that you actually had when you first filed it is treated more like a partnership, and that is that the profits that it's receives are going to flow straight through to every one of the individual shareholders in proportion of their ownership. That allows for no what's called "double taxation" - in most C Corporations when the company makes a profit it will get a corporate tax on that profit. Then, if it wants to take those profits and distribute them to it's shareholders as a dividend, that "shared dividend" would also be taxed on the individual level, essentially, the one chunk of money that you make gets taxed twice. So that's a great thing to have whenever you're an S Corporation. Now, some of the disadvantages are, a lot of people when they have a C Corporation, they want the ability to retain earnings at the corporate level, to hold money in a sense, and not distribute it to all the shareholders. They might want to take the money and grow, they may want it to do a strategic acquisition, and they would be able to do that without asking for individual investments from each of their shareholders again.
What is the difference between an S corporation and a C corporation?
An S corporation is taxed differently to a C corporation. Essentially, they're both corporations. However, one of them receives a different tax treatment. C corporations receive what I would call a normal tax treatment. A normal corporate tax treatment in that profits that a C corporation makes are taxed at that corporate level. You have to file a corporate tax return at the end of every fiscal year, and then, if profits are distributed to shareholders, they are personally taxed on that as some sort of an income or capital gain depending on how their treatment of it is done. With respect to an S corporation, it is treated as a partnership for tax purposes. So, you're not allowed at corporate level to retain any income or any profits. They all must be passed through to the individual shareholders. Therefore, it's reflected completely on their individual tax returns.
