State and federal laws recognize the creation of certain legal entities that business owners use to conduct their operations. Two major types of legal entities created for this purpose are a limited liability company -- referred to as an LLC -- and corporation. Each state has enacted laws that govern the creation, maintenance and dissolution of an LLC or corporation. Under federal tax law, a corporation is taxed under either subchapter C or subchapter S of the Internal Revenue Code and is accordingly designated an "S corporation" or "C corporation."
Limited Liability Company
An LLC is commonly referred to as a hybrid legal entity because it combines aspects of both corporations and partnerships. Like a corporation, the LLC gives its owners -- called members -- personal liability protection from the debts of the business. Also, the creation of an LLC requires filing documents with the state, similar to a corporation. However, for federal tax purposes, an LLC is considered a "disregarded entity" and will generally be taxed like a partnership, with the profits and losses of the business flowing through to the members.
Business owners incorporate their business by filing articles of incorporation with the appropriate state agency. The personal assets of the owners -- called shareholders -- are protected from the debts of the corporation; however, the ongoing requirements to maintain a corporation are the most complex of all legal business entities. These requirements generally include adopting written bylaws, conducting regular meetings with minutes taken, and annual filings with the state. Failure to follow the requirements can result in the shareholders becoming liable for the debts of the corporation.
A disadvantage to forming a corporation is the "double taxation" problem. The default federal tax treatment for a corporation formed under state law is subchapter C of the Internal Revenue Code. This means that the corporation pays taxes on its profits and, after distribution of the profits to the shareholders as dividends, the profits are essentially taxed again as part of the shareholders' income. To avoid this problem, the IRS allows a corporation to elect tax treatment under subchapter S by filing Form 2553 (see Resources). An S corporation is taxed like a partnership with the profits and losses flowing through to the shareholders -- there is no tax on the profits at the corporate level.
Choosing a Legal Entity
To protect personal assets from the liabilities of a business, it is always prudent to create a separate legal entity for the business. Deciding which type of entity to create depends on the nature of the business. Professional advice from a business lawyer and accountant should be obtained because of the complexities involved, particularly with tax issues. For example, just like a C corporation, an LLC can choose S corporation tax treatment. An LLC can even choose C corporation tax treatment. Choosing the right type of entity from the onset can result in tax savings.