Clients are calling me more frequently these days about setting up small businesses. Maybe it’s a sign of the times with people losing their salaried positions with larger companies and having to reinvent themselves, or maybe it’s just that good old fashioned American entrepreneurship taking hold in a down economy. Whatever it is, small business start-ups need to get the real facts on whether an LLC or a corporation is the way to go for them.
In a nutshell a corporation requires more formality and is taxed at the corporate tax rate; whereas, an LLC is known as a “pass-through” entity because its profits or losses pass through to the individual member(s) and are reported on her personal return and taxed at her individual tax rate. True, an individual may still incorporate and elect S-corporation status, which permits the same pass-through management of profits and losses but unless all of the income or loss is passed through to the individual shareholder(s), there is still a corporate tax which must be paid. Also, corporate filings must be observed. However, depending on the actual income of the entity, the corporate solution may be the better choice and only a thorough discussion with your accountant will help you make that determination.
By way of example, with an LLC, an individual who makes $150,000 would have to pay self-employment tax on ALL of the income (including income tax and social security). However, with an s-corp, the individual may choose to pay herself a reasonable salary to minimize this self-employment tax. Therefore, perhaps $50,000 could be attributed to that reasonable salary while $100,000 would be corporate profits, which are taxed differently and which may be offset by certain other corporate expenses and losses.
As to formalities, establishing an LLC in New York may be initially more expensive because of the state’s mandated “publication” rule which requires new LLCs to publish an announcement of the new company in two newspapers, once each week, for six consecutive weeks. Further, you cannot select any newspaper but must adhere to the newspapers listed by the county clerk for the county in which the company is established. That means if you set up in any one of the five New York boroughs, or an equally established metropolis, the publishing costs could be several thousand dollars versus the start-up cost of a few hundred to incorporate. The state takes this publication rule seriously and limited liability entities that do not comply with the requirement within 120 days after their formation or qualification will have their authority to carry on, conduct or transact any business suspended. However, there are few other formalities required of an LLC and practically anyone can establish such an entity.
For a corporation, on the other hand, you must be a US citizen or have US residency status in order to incorporate and if you elect s-corp status, shareholders will be limited. You will have shareholders rather than members, who can only be individuals, and you must follow certain corporate formalities, such as naming a Board of Directors, holding regular and annual board meetings, issuing stock and maintaining financial records.
Too many small business owners fail at the record-keeping end of a corporation and this is where they open themselves to liability and financial exposure. Let me dispel those rumors that setting up a corporation or an LLC limits your personal risk should you be sued for an error or omission or some other liability, such as debt, for your corporation. Invariably whenever I ask a client why they think setting up a corporation will limit their personal liability, they always tell me: “because my accountant said it would.” I truly wish non-lawyers would stop giving legal advice for much the same reason I would not presume to give tax advice, for not wanting to misinform my clientele.
When you are a small business owner, even worse when you are providing a service rather than a tangible product, you are exposed because your business is you. There is a legal theory called “piercing the corporate veil” which allows creditors and anyone else who does business with your corporate entity to go after you, PERSONALLY. I will address that theory in a subsequent post later this month. For now, you should know that unless you are truly going to act like a corporation, you are not totally granted a “safe harbor” from the risks of doing business in today’s litigious society.
The bottom line is that you should always discuss your personal situation with your own attorney and accountant and know that while an LLC is more expensive to start up, it may be easier to run for the small business owner.