WHAT CORPORATE ENTITY IS BEST FOR YOUR BUSINESS?
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What type of business entity is best for your business?
S-Corporation
What is an S-Corporation?
An S corporation, also known as an S subchapter, refers to a type of corporation that meets specific Internal Revenue Code requirements. If it does, it may pass income (along with other credits, deductions, and losses) directly to shareholders, without having to pay federal corporate taxes. Usually associated with small businesses (100 or fewer shareholders), S Corp status effectively gives a business the regular benefits of incorporation while enjoying the tax-exempt privileges of a partnership.
Pros of an S-Corporation
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Corporate protections such as limited liability and transfer of interests
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Prestige and credibility
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Tax benefits: there are no self-employment taxes and unlike C-Corporations owners do not double tax their shareholders
Cons of an S-Corporation
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S-Corp could have some restrictions that can limit growth due to qualifications to maintain its status as an S-Corporation
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Compliance rules are complex
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Costs of incorporation
Why form an S-Corporation
S corporations can be the best of both worlds for a small business, combining the benefits of corporations with the tax advantages of partnerships.
Specifically, S corporations offer the limited liability protection of the corporate structure—meaning an owner's personal assets can't be accessed by business creditors or legal claims against the company. But, like partnerships, they don't pay corporate taxes on any earnings and income they generate. They can also help owners avoid self-employment tax, if their compensation is structured as a salary or a stock dividend.
How an S-Corporation works
In many ways, an S corp works as any corporation does. Operating under its home state's corporation statutes, it establishes a board of directors and corporate officers, by-laws, and a management structure. It issues shares of company stock. Its owners cannot be held personally or financially liable for claims by creditors or against the company.
S corps are distinguished by the fact that they are not federally taxed on most of the earnings they generate and distribute, leaving more money to pass to shareholders (who do pay taxes on the funds, at their ordinary-income rates). The funds must be allocated strictly based on the shareholders' equity stake or their number of shares.
S corps must restrict their number of shareholders to 100 or less, and these must all be individuals, non-profits, or trusts. These stockholders, along with the corporation itself, must be U.S.-based.
Come tax time, S corps must distribute the form Schedule K-1 to shareholders, indicating their annual profits or losses from the company, and file Form 1120-S with the IRS.
C-Corporation
What is an C-Corporation?
A C corporation (or C-Corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.
C-corps can be compared with S-Corporation and limited liability companies (LLCs), among others, which also separate a company's assets from its owners, but with different legal structures and tax treatment.
Pros of an C-Corporation
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Large numbers of shareholders allowed
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Limits of personal liability
Cons of an C-Corporation
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Double taxation rules (personal and corporate)
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Compliance rules are complex
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Required to register with the Securities and Exchange Commissions (SEC) upon reaching specific thresholds
How an C-Corporation works
Corporations pay corporate taxes on earnings before distributing remaining amounts to the shareholders in the form of dividends. Individual shareholders are then subject to personal income taxes on the dividends they receive. Although double taxation is an unfavorable outcome, the ability to reinvest profits in the company at a lower corporate tax rate is an advantage.
A C corporation is required to hold at least one meeting each year for shareholders and directors. Minutes must be maintained to display transparency in business operations. A C corporation must keep voting records of the company's directors and a list of the owner's names and ownership percentages. Further, the business must have company bylaws on the premises of the primary business location. C corporations will file annual reports, financial disclosure reports, and financial statements.
Limited Liability Company (LLC)
What is an LLC?
An LLC is a type of business entity that can have one or more owners, referred to as "members." LLC members typically participate equally in the management of the business unless they elect an alternative management structure called "manager management."
An important feature of LLCs is "limited liability," which means that all LLC owners are protected from personal liability for business debts and claims. This means that if the business itself can't pay a creditor—such as a supplier, a lender, or a landlord—the creditor cannot legally come after an LLC member's house, car, or other personal possessions. Because only LLC assets are used to pay off business debts, LLC owners stand to lose only the money that they've invested in the LLC.
In addition, an LLC is not considered separate from its owners for tax purposes. Instead, it is what the IRS calls a "pass-through entity," like a partnership or sole proprietorship. This means that business income passes through the business to the LLC members, who report their share of profits—or losses—on their individual income tax returns.
Pros of an LLC
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Pass-through taxation
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Simplicity
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Flexibility in Ownership
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Options for management
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Flexibility in taxation
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Personal asset protection
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Credibility
Cons of an LLC
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Cost
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Investment disadvantages
Who should form an LLC?
Corporations pay corporate taxes on earnings before distributing remaining amounts to the shareholders in the form of dividends. Individual shareholders are then subject to personal income taxes on the dividends they receive. Although double taxation is an unfavorable outcome, the ability to reinvest profits in the company at a lower corporate tax rate is an advantage.
A C corporation is required to hold at least one meeting each year for shareholders and directors. Minutes must be maintained to display transparency in business operations. A C corporation must keep voting records of the company's directors and a list of the owner's names and ownership percentages. Further, the business must have company bylaws on the premises of the primary business location. C corporations will file annual reports, financial disclosure reports, and financial statements.
Partnership
What is an Partnership?
A partnership is a formal arrangement by two or more parties to manage and operate a business and share its profits.
There are several types of partnership arrangements. In particular, in a partnership business, all partners share liabilities and profits equally, while in others, partners may have limited liability. There also is the so-called "silent partner," in which one party is not involved in the day-to-day operations of the business.
Pros of an Partnership
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No federal statute defining partnerships
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Partnerships do not pay income tax
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Not double taxed like corporations (although they operate as a pass through)
Cons of an Partnership
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Cost and be high
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You have to work with a partner
How does a partnership work?
In a broad sense, a partnership can be any endeavor undertaken jointly by multiple parties. The parties may be governments, non-profits enterprises, businesses, or private individuals. The goals of a partnership also vary widely.
Within the narrow sense of a for-profit venture undertaken by two or more individuals, there are three main categories of partnership: general partnership, limited partnership, and limited liability partnership.
In a general partnership, all parties share legal and financial liability equally. The individuals are personally responsible for the debts the partnership takes on. Profits are also shared equally. The specifics of profit sharing will almost certainly be laid out in writing in a partnership agreement.
Limited Liability Partnership (LLP)
What is a Limited Liability Partnership?
Whether you notice them or not, limited liability partnerships are quite common. A lawyer or accountant often will have the acronym LLP after a list of names, as in “Howser, Hunter & Smith, LLP.”
LLPs are a flexible legal and tax entity that allows partners to benefit from economies of scale by working together while also reducing their liability for the actions of other partners. As with any legal entity, it is important that you check the laws in your nation (and your state) before getting too excited. In short, check with a lawyer first. The chances are good that they have firsthand experience with an LLP.
Pros of an Limited Liability Partnership
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Ownership is shared by a group of professionals
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Reduced cost because costs are spread out
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LLP may have junior partners who work to become full partners
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Personal assets are protected against legal action
Cons of an Limited Liability Partnership
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Limited control of partnership
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You have to work with a group of partners
How does a Limited Liability Partnership work?
In some professions, however, you need something a little more customized than an LLC with a set structure. Enter the limited liability partnership (LLP). The LLP is a formal structure that requires a written partnership agreement and usually comes with annual reporting requirements, depending on your legal jurisdiction.
As in a general partnership, all partners in an LLP can participate in the management of the partnership. This is an important point because there is another type of partnership—a limited partnership—in which one partner has all the power and most of the liability and the other partners are silent but have a financial stake.1 With the shared management of an LLP, the liability is also shared—although, as the name suggests, it is greatly limited.