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Your business structure or entity is the organization under which you sell your product or service. The first thing you need to know is that business entities are formed at the state level, which means they're governed by state laws and vary from state to state. Common business structures include corporations, partnerships, limited liability companies, and nonprofits. Each business structure brings a unique balance of legal protections, benefits, and limitations.
Do you know how to choose the legal structure for your business and plan for its taxation? In this guide, we will show you the fundamental implications of these structural and tax choices:
If you have never filed papers with a state government to create a legal entity for it and just one person owns your business, you have a sole proprietorship. A sole proprietorship can raise money from investors through loans, but not it cannot sell shares or equity in the business.
If two or more people own a business and have not filed to make it a business entity (see below), then the business is a partnership. A partnership can raise money in the form of loans and it can also bring on additional partners who can purchase equity in the partnership.
Sole proprietorships and partnerships are “disregarded” for tax purposes. This means that the sole proprietorship or partnership itself is not taxed, and all the tax issues belong to the people who own the business. This means that at the end of the company’s fiscal year, you calculate if the business made a profit or loss and whether there are any other tax items to report. These items and the net profit or loss are declared on the personal tax returns of the owners. This pass-through tax treatment is available for other kinds of entities as well, as discussed below.
If you want to raise money from investors, it is generally recommended that you form some kind of business entity. The formation of an entity also allows you to protect your personal assets in case something goes wrong. Corporations and LLCs have limited liability, which means that owners of these entities generally don’t put their personal assets (e.g., their home or car) at risk. If the entity defaults on a loan or loses a lawsuit, the owners can lose their entire investment in the business, but their personal assets (in most cases) will be shielded from liability.
Another reason to form a business entity before raising money from investors is that it gives you more options for bringing in investors. In addition, it makes you appear more serious about your business because you have invested the resources necessary to create a formal structure.
LLCs are a relatively recently invented entity that combines the limited liability protection of a corporation and the flexibility of a partnership. You form an LLC by choosing a state where you want to form, and filing a document called the Articles of Organization or the Certificate of Formation with the state government. The state statute under which you form your LLC lays out various requirements governing the LLC, which are much fewer than for a corporation. Under state LLC law, you can write almost anything you want into the LLC’s internal governing document, known as the operating agreement. You can have multiple classes of equity, each with different rights, and you can also be creative with how the LLC is governed. Unlike corporations, LLCs are not required to have a board of directors, officers, or even meetings. The equity interests in an LLC are called memberships or membership interests. From time to time, you may also hear them referred to as units. Generally, you would not use the term share or stock when referring to an equity interest in an LLC.
The default type of taxation for an LLC is taxation under Subchapter K (partnership taxation). Subchapter K provides for a pass-through treatment for the tax items of the entity. Remember, S Corporations also have pass-through treatment, but the two subchapters do have some differences. For example, with partnership taxation (Subchapter K), everyone who owns an equity interest in the LLC who also works for the LLC has to pay self-employment tax on all income from the LLC, regardless of whether it is called a salary or profit-sharing. However, under Subchapter S, dividends paid to shareholders who work for the company are not subject to employment tax.
This is why some LLCs elect to be taxed under Subchapter S instead of Subchapter K. They can also elect to be taxed under Subchapter C (or Subchapter T if the LLC operates like a cooperative—see the Cooperative section for details).
A corporation is an independent legal entity, separate from the people who own, control, and manage it. You form a corporation by choosing a state where you want to incorporate and filing a document called the Articles of Incorporation or the Certificate of Incorporation with the state government. The state statute under which you form your corporation lays out various requirements, such as the number of people you must have on your board of directors, what officers you must have, how you have to give notice for shareholders’ meetings, and the like. The corporate structure was invented hundreds of years ago and generally includes the same basic building blocks regardless of the state. These building blocks include a board of directors that has ultimate responsibility for all corporate decisions and the owners of the corporation, who are called shareholders or stockholders.
Generally speaking, the number of shares you own, divided by the total number of outstanding shares that have been issued (i.e., sold to shareholders), represents the percentage of the company that you own. For example, if you own 300,000 shares, your cofounder owns 200,000 shares, and no one else owns any shares, then you own 60 percent of the corporation, and your co-founder owns 40 percent. The shareholders with voting rights elect the board of directors.
Corporations can offer different types of stock to investors. These types of stock are called classes (or sometimes series). So, for example, you could have a class of voting stock and a class of nonvoting stock. All corporations have common stock that is issued to the founders when they first form the new company. Common stock is straightforward and usually comes with the right to vote (one share, one vote).
The default rule under federal law is that corporations are taxed under Subchapter C of the Internal Revenue Code, where the company’s profits are taxed at the corporate level at corporate tax rates. As a result, if the company pays out a share of the profits (dividends) to its shareholders, the shareholders have to pay income tax on the dividends. This is known as the “double tax” because the same profits are taxed twice—once at the entity level and again at the individual shareholder level when paid out as dividends. Note, however, that dividends are often taxed at a lower rate than the regular income tax rates.
Many smaller corporations elect to be taxed under Subchapter S of the Internal Revenue Code because it allows them to avoid the double tax. The company’s profits are taxed at the shareholder level and not at the entity level. This means that regardless of whether the company pays dividends, the shareholders have to pay tax on their share of the company profits. However, if the company has a loss, it may be deductible on the shareholders’ tax returns. This type of taxation is called pass-through because the tax items are “passed through” to the shareholders. The company must issue a K-1form to its investors every year to tell the investors what they must report on their taxes. Paying dividends to the investors does not affect the amount of income tax they have to pay because the investors pay tax on their pro-rata share of the company profits, not on the actual cash they receive.
Many investors do not like pass-through taxation because it makes the preparation of their personal taxes more complicated and because there’s a risk that they will have to pay tax on profits they have not received. At the same time, investors who have passive gains on other investments may like the idea of investing in an early-stage S Corp that is making losses because the investor may be able to use the losses to offset the gains from other investments.
Taxation under Subchapter S can be very favorable in some circumstances, depending on the shareholders’ personal tax situations. However, there are some limitations on whether a corporation is allowed to elect taxation under Subchapter S:
If a social cause is at the core of your business objectives, then you’re likely a mission-driven business. Charitable, educational, scientific, or religious organizations, whether nonprofit or for-profit, public or private, governmental or non-governmental, philanthropic, or spiritual in nature, all qualify as supporting the greater good. Adopting fair trade or environmental sustainability business practices might also qualify. From resonating with your customers to getting some special tax treatments, some business structures are designed to lift you up for doing good.
Over the last several years, there has been a movement to create new corporate statutes that allow corporate leaders to consider the interests of all stakeholders (workers, suppliers, customers, the environment, the community, and so on) when making decisions without fear of getting sued by shareholders. This movement was spurred by situations where mission-driven public companies were pressured by shareholders to sell the company to the highest bidder even though the founders feared that the company’s mission would be compromised. Approximately 30 states have adopted these statutes, known as benefit corporation, social purpose corporation, or public benefit corporation statutes.
Companies formed under these statutes have the same options regarding the types of securities they can offer, and they are taxed in the same way as regular corporations. The primary difference between these new corporate forms and conventional corporations is that the board of directors has more protection if it decides the name of public or environmental benefit that shareholders do not consider to be in their best financial interest. These companies are generally required to be evaluated according to a third-party standard to demonstrate that they have a public benefit or social purpose. Whether you structure your business as a regular corporation, a benefit corporation, or a social purpose corporation, there is no effect on the tax treatment of the business or its shareholders.
Are you running your company for profit, but with a social conscience? Then a B Corporation is a perfect option for you. A B Corporation is, in the eyes of the IRS, a typical corporation, but it has the added benefit of being certified as socially responsible. B Corporations must meet certification requirements that measure the business’s social and environmental performance. This resource outlines what a business needs to qualify: https://bcorporation.net/about-b-corps
Nonprofit organizations are usually a special kind of corporation that are like regular corporations except that no one can own them and they cannot issue stock. When a nonprofit organization closes, any assets must be given to another nonprofit. Because a nonprofit does not have any ownership interests, it cannot offer an equity investment. It can only raise money from investors in the form of donations or loans. Depending on the location where it was formed, there may be additional limitations on what a nonprofit can do. In most cases, the board of a charitable nonprofit organization may not receive any compensation or financial benefit from it.
The default rule is that nonprofits are taxed just like any corporation, but most nonprofits apply for federal tax-exempt status. There are many different categories of federal tax-exempt status. The most well-known is tax exemption under Section 501(c)(3), which is available for charitable and educational organizations. Tax-exempt status prohibits the nonprofit from compensating anyone, including employees, contractors, and anyone else, at a level that would be considered above the standard market rate.
Co-ops are very diverse because each state’s co-op statute is different. Many states have more than one co-op statute governing different types of co-ops. Generally, the equity owners of a co-op are called members. The members of the co-op include “patrons” of the co-op. The term patron applies to anyone who does business with the co-op, including customers, producers, or workers, or a combination of multiple kinds of patrons. However, co-ops can generally have nonpatrons as equity investors (i.e., members) as well.
One of the considerations for co-ops when raising money from investors is ensuring that the patron members remain in control. This usually means that they have the right to elect a majority of the board of directors and to have the final say over major decisions such as the sale of the company, merger, or the choice to convert to another type of entity. Most cooperative statutes do not allow outside investors to choose a majority of the board or have other rights to control the cooperative. Many state co-op statutes also limit the financial returns that can be paid to outside investors.
A section of the tax code called Subchapter T is designed to be used by co-ops. Subchapter T provides a beneficial treatment of dividends that are paid to patrons – unlike dividends paid to investors, patronage dividends are not subject to the double tax. Some co-ops elect to be taxed under Subchapter T; others may choose a different tax treatment. Recently, a new type of cooperative structure has been adopted in several states called the limited cooperative association (LCA). Many co-ops formed as LCAs elect to be taxed under Subchapter K (partnership tax).
New Directions for Nurses (NDN) provides personalized coaching, education, and tools that help holistic nurses make the world better through their businesses. NDN is not a law firm nor a substitute for an attorney or law firm. The information in this article is for informational purposes only, and it does not provide legal advice. Though NDN aims to keep its information and templates up-to-date and accurate, the law changes rapidly, and there are variations in regulations in different jurisdictions, so we make no guarantees as to the accuracy or completeness of this information. It is the reader’s responsibility to ensure that the information they choose to use is appropriately tailored to and accurate for their particular business. Readers should contact an attorney in their state to obtain advice concerning any legal questions, issues, or problems, or state-specific requirements or customizations necessary for operating their business.
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