Starting a Business in USA
U.S Types of Legal Entities
If you are interested in starting a business in the United States, it is crucial to have a strong understanding of the different types of legal entities available. The business opportunities in the world’s largest economy are endless, and the country is one of the most attractive markets for entrepreneurship. The election of a right corporate structure is essential for the company’s future well-being and legal status. The following structures are available for companies incorporating a company in the USA:
- Limited Liability Company (LLC)
- Corporations (S, C and Joint Ventures types)
- Sole proprietorship
- Partnerships (Limited and Unlimited)
A corporation is a common legal entity for larger companies registering a business in the USA requiring a more robust vehicle. In the United States, there are both domestic and foreign corporations. Domestic corporations have been incorporated under the laws of the USA, while foreign corporations are incorporated under the laws of another country or state, and if they register with a certain state in the USA, they are authorized to conduct business operations in that state. Taken from a functional point of view, there are two types of corporations – a business corporation and a not-for-profit corporation.
Types of corporations
Within the corporation type of entities, investors have different options to register a company in the USA. Depending on the entity’s intended activity they can be classified in business corporations and non-profit corporations.
- Business corporations: Formed for conducting business in a broad sense of the word, transactions are used to turn a profit. Under a business corporation, there are the C and S types of corporations
- Non-profit entities: self explanatory
This classification refers to any corporation in the United States that is taxed separately from the owners. C Corps does not have any limits on the number of shareholders, both foreign and domestic. Anytime the profits or earnings of a C Corp are distributed to the shareholders, they are considered by U.S. income tax purposes as a dividend.
There are exceptions that exist for certain distributions that are made in exchange for stock instead simply as cash dividends. These exceptions include distributions for a shareholder’s complete termination of interest and distributions for the liquidation of the corporation at the end of its legal life.
In order to be classified as an S Corp, three requirements must be met.
- It must be an eligible entity (LLC which has elected to be taxed like a corporation or a domestic corporation);
- Cannot have more than 100 shareholders;
- There must be only one class of stock;
Simply put, this model passes corporate deductions, credit, losses, and income through shareholders for federal tax purposes. Generally, an S Corp is a corporation that operates under the laws of the state where the entity is organized. Income is taxed at the shareholder level, meaning that the money distributed to the shareholders was not previously taxed. Certain corporate penalty taxes (e.g., personal holding company tax, accumulated earnings tax) do not apply to an S corporation.
This model is oriented towards companies incorporating a non-profit making organization attaining benevolent, education, or charitable objectives. Non-profit Corps can generate surplus revenue, but the organization must retain them for expansion, self-preservation, or for the future. Unlike the other corporation models, they cannot be distributed to shareholders.
A corporation can be owned by an individual person, and have just one officer and director, depending on state law. The owner(s) are known as shareholders. Shareholders have the power to elect directors to represent them, setting the corporation’s policies. In turn, the directors are empowered to appoint offers to provide leadership, managing the company’s day-to-day operations. The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are examples of such officers. Legally, corporations are required to follow more formalities than other organizations. They must have an annual meeting of the directors and shareholders, and if the shareholders desire to take a significant action, they must have a board approval.
The shareholders and the corporation are legally separate. For example, this means that a shareholder could not take company funds for him/herself without entering a board resolution into the records of the company and thoroughly documenting the reason.
Features of a Corporation
- It is considered a legal entity separate from its directors, employees, and shareholders. In the eyes of the law, a corporation is considered a person, having the same rights and responsibilities as a citizen of the USA.
- A corporation can assume liabilities, make contracts, and sue and be sued.
- The relationship between the corporation and its directors and shareholders is clearly defined, with each having specific obligations and duties to each other.
Corporate taxation is much more complex compared with sole proprietorship, partnerships, or LLCs. Taxation rules are dependent on the number, residency, and type of shareholders. A corporation could be taxed as if it were a partnership (an S corporation), and therefore not pay taxes itself, or it could be considered a taxable entity (a C corporation).
S corporations let shareholders treat profits as distributions and pay taxes on profits through their own personal tax returns.
C corporations are taxed twice, first at the corporate entity level, then at the personal level. The Tax Cuts and Jobs Act reduced the U.S. federal corporate income tax rate from 35 percent to 21 percent, but corporations must still face another level of corporate income tax levied by the state the corporation is registered in. Therefore, the average income tax rate of a corporation in the United States is 25.7 percent.
Limited Liability Company (LLC)
This type of organization is a combination between a corporation (which possesses the ability to limit personal liability), and a partnership (which assigns profits and losses to individuals). It can be used as the structure for a wide range of business scopes and is especially common among professional practices such as law firms or investment consulting companies doing business in the U.S.
LLCs can be as simple or as complex as the members require for their business setup in USA. They can have no limited liability for any members, meaning every owner is fully legally liable. They could also direct liability dis-equally at different members, meaning some members have limited liability and some are without. This is like the limited partnership model previously described. Finally, an LLC could have the same limited liability like a corporation, meaning none of the members are legally responsible for profits and losses, and the obligations of the LLC.
One difference from corporations is that some States require LLCs to designate a future date at which the LLC will automatically dissolve. In addition, some States require that if a member were to go bankrupt, die, or meets some other calamity, the members that remain must convene to vote to continue, or dissolve the partnership.
- Limited Liability Companies are taxed in a way that is most similar to a Partnership. This means that the income is passed through, and the individuals themselves pay personal income tax on the percentage of the company that they receive profits from.
- It must be ensured that no more than two out of the four qualities that determine a corporation (continuity of life, the ability to transfer ownership interests, limited liability concerning assets, and centralization of management) are met.
- If more than two are, the LLC is then considered to be a corporation and would be taxed accordingly. At higher levels of net income, LLCs may be paying taxes at a lower rate than a corporation. For example, an income of $75,000 would corporately be taxed at 34%, while the personal income tax rate is 25% for the same amount.
A sole proprietorship is the simplest type of business entity in the United States. It is commonly used by those who are interested in opening a small business. Common examples of Sole Proprietorships include Nail Salons, auto-care shops, and restaurants.
- A Sole Proprietorship is inexpensive to incorporate.
- A potential business owner need only register his or her own name, secure the necessary business licenses, and then they are in business. It can exist under the owners’ name or can conduct business under a fictitious name.
- The owner and the sole proprietorship are legally tied together, meaning that they are fully liable for all profit and loss. This also means that any debt the sole proprietorship holds is legally considered the owners’ debt.
- There are no formalities that must be observed except basic bookkeeping.
- Can hire employees
- A Sole Proprietorships is dissolved on the death of the owner.
Because the owner and the sole proprietorship are legally tied together, the profits and losses of the business are considered the owner’s personal income.
The proprietorship firm can be disregarded for tax purposes. Essentially, the sole proprietor pays their own personal income taxes, and that also takes care of the firm’s taxes.
The IRS calls this “pass-through” taxation. Under the Tax Cuts and Jobs Act, up to 20% of business income earned by the owner can usually be deducted as an additional deduction. However, if the sole proprietor has an income of over $157,500 (if single) or $315,000 (if married filing jointly), they must have depreciable business property or have employees to receive this special deduction.
A partnership is a model for setting up a business in the USA in which two or more persons are involved. The individuals are responsible for the partnership, including for all profit or loss. The persons registering a partnership company make an agreement on how to share the profits and losses.
Because the liability of partners is joint and separate, any of the partners could be made to pay the partnership’s entire debt, regardless of the capital contributions made into the partnership or the allocation of profits and losses.
Compared to a sole proprietorship, the members of a partnership are required to file a return to the government detailing the information regarding what the profits and losses of the partnership were, and how they were chosen to be allocated to the partners.
Types of Partnerships
There are three main types of partnerships: Unlimited, limited, and joint venture.
This is the simplest type. All liability and management are shared equally between the partners, unless otherwise specified. Basically, this structure assumes equal partnership, and therefore equal ownership.
This model is slightly more complicated. There are one or more general partners who manage the business, and they are also liable for the partnership’s debts. There is also another type of partner. This type contributes capital and shares in the profits but does not run the business and is not liable for the debt and tax obligations of the partnership beyond their personal contribution. They are basically a silent partner: contributing money and sharing in profits but removed from daily operations.
This version of a partnership is time-based. Sometimes, two or more individuals are interested in working together on a project for a period. This company formation structure is temporary and is dissolved upon completion. If the individuals would like to continue to work together afterward, they would then register under the general partnership model.
Features of partnerships
- Partnerships are inexpensive to form. Because there are several people involved, each partner has several and joint liabilities to the partnership.
- The risk and reward for everyone are lower than a sole proprietorship because there are multiple people who would be responsible for the partnership’s liabilities.
- The administration and structure of a partnership could be as complex or simple as the owners wish it to be.
- >When certain requirements are met, such as the bankruptcy or death of one of the partners, or if the owners decide to end the partnership, the partnership would cease to exist.
Partnerships operate under “pass-through” taxation. This means that it is the owners who are taxed, and not the partnership entity itself. Therefore, the tax rates on partnerships are the same as the individual’s tax rates, likely in the range of 25-28 percent. Partners must account for their own tax obligation. They must estimate the amount of tax owed quarterly and annually.
There are various deductions available that partnerships can take advantage of, including operating expenses, product and advertising, costs for startup, travel costs, entertainment, and meals.