One of the first big problems faced by every new entrepreneur is figuring out how to incorporate their business. One of the questions we get asked frequently by our customers is, how to incorporate their new eCommerce business. You have heard about corporations and LLCs but aren't really sure how they are different or how it will affect your business. How you incorporate is always your first major concern, and a lot will depend on your future goals for the company.
What is a Corporation?
A corporation is a legal entity owned by people or other corporations which own stock or shares in the corporation. The shares represent a percentage of ownership in the corporation. The people who own these shares are known as the corporate shareholders, and they may or may not be involved in the day to day management and operations of the company.
Key Aspects of a Corporation
A corporation provides the shareholders with limited liability protection for the actions, obligations and expenses of the corporation. That means that the shareholders generally cannot be held legally liable to pay the debts and obligations incurred by the corporation.
Corporations are required to adhere to strict regulations regarding their operation, such as passing by-laws, and holding annual shareholders and board of directors meetings, in which minutes must be taken and the records kept for inspection. The corporation may be required to file an annual report with its state of incorporation or primary place of business.
A corporation is the only entity which is entitled to raise capital or debt equity on a public market, such as a stock exchange, or other public offerings. If you plan on growing your company, or seeking public financing, such as from venture capital firms, a corporation is probably best. For example, what we have typically seen in the market is that eCommerce start-ups including brands and micro-brands, are usually incorporated as a corporation, as they intend to raise funds, whereas a closely held business is typically an LLC. A corporation can also issue options to buy stock in the company, which can help you down the line to attract key talent and hire better employees.
A corporation is typically subject to what is known as "double taxation". Double taxation means that the profits of the company are essentially taxed twice. First, the corporation pays taxes on its profits, just as a private individual would. The second level of taxation comes when the company pays out its profits to shareholders in the form of dividends. The shareholders must report and pay taxes on these dividends, which essentially causes the same profits to be taxed twice.
A Corporation can however elect to be taxed as an S Corporation, which allows the corporation to avoid double taxation by becoming a "pass-through" entity. This means that the profits or losses of the company are declared on the personal tax returns of the company shareholders. The shareholders will declare any profits and pay taxes, or declare any losses and take the appropriate deduction on their personal income tax returns.
What is an LLC?
Much like a corporation, a Limited Liability Company, or LLC provides the owners (known as members) with limited liability protection for the actions, obligations and expenses of the company, so that the members cannot be held legally liable to pay the debts and obligations incurred by the company.
LLC's can be owned by either one person, known as single member LLC's, or by multiple owners, known as multi-member LLC's.
For multi-member LLC's, the governance of the company is usually outlined in an Operating Agreement, which spells out how the company will be run, and how costs and profits will be shared among the members.
Key Aspects of an LLC
The company founders and members have limited liability for the debts and obligations of the company. LLCs also have fewer regulatory requirements, as they are not required to hold annual member meetings, keep minutes or have a board of directors.
Further, an LLC cannot raise public funds or debt equity the way a corporation can, and accordingly are not very good for companies that intend to grow and seek external financing. LLC's are good for small and family businesses, or companies which plan to be closely held by its founders and don't intend to raise external capital from venture capital or private equity firms We see many of our small eCommerce businesses, selling products on Amazon or through a private website, operating as LLCs.
Since LLC's do not have stock as you would find in a corporation, they do not offer employees stock options, or rights to purchase an ownership interest in the company as part of the compensation package.
LLC's by default are pass-through entities for taxation purposes, thereby avoiding double taxation. However, there are times when an LLC may wish to elect to be taxed as a C or S Corporation. An LLC is more flexible from a tax perspective because it can elect to be taxed as a corporation, whereas a corporation cannot elect to be taxed as a pass-through entity except as an S Corp, which has certain limitations.
Where Should You Incorporate?
You may not have even considered this question to be relevant, probably just assuming you would incorporate in whichever state you live in. However, where you incorporate can be just as important, and has many legal and tax consequences. Many of our customers choose to incorporate in Delaware for a variety of reasons, which may or may not apply to you.
What's Best For You
As explained above, what's best for you really depends on your future goals for the business. If you intend for it to stay a small family business, run out of your living room, an LLC is probably best. However, if you intend to grow your business, hire dozens or hundreds of employees and to raise capital by selling stock or debt in the company, then a corporation would certainly be more advisable. Finaloop is happy to assist with any questions you may have.
The information provided on this website does not, and is not intended to, constitute legal advice. All information, content, and materials available on this site are for general informational purposes only. Readers are advised to consult with their attorney or accountant with any questions or concerns.