LLC, S Corp, or C Corp? Learn about business structures and their tax impacts so you can pick the one that gives you the best chance for success.
There are many exciting things that come with starting a business. Choosing the right business structure might not sound like one of them, but it is huge.
While it can seem overwhelming at first, you can find a lot of joy in bringing your hard work and dreams to life. As I wrote about previously, one of the first steps in getting a business off the ground is to obtain an Employer Identification Number from the Internal Revenue Service (IRS). Related to that, one of the first important business decisions you’ll make is deciding which form of business to establish.
Since each type involves different business structures and tax requirements, it’s important to know a little bit about each one before you form your business.The most common types of large and small business are sole proprietorship, partnership, limited liability company, C corporation, S Corporation, and nonprofit corporation. In this article, we will review each business structure so you can see which might suit your dreams the best.
A sole proprietorship is an unincorporated business with one business owner who is responsible for all the day-to-day operations. The sole proprietorship business structure is the simplest and easiest type of business to form. An individual is automatically considered a sole proprietor if they engage in business activities, but do not register as any type of business with their state. With sole proprietorships, the business and owner are inseparable. Business assets and liabilities are not separate from the owner’s personal assets and liabilities.
The sole proprietorship business structure is the simplest and easiest type of business to form. An individual is automatically considered a sole proprietor if they engage in business activities, but do not register as any type of business with their state.
For example, if Jenny just recently got out of beauty school, she might decide to rent a chair at a local beauty salon and advertise her services online and via her professional social media accounts. With this type of setup, she’d be considered a sole proprietor. She does not have any partners, and she isn’t required to register with her state. She’s also paying all her own expenses, including the chair rent and her hairdressing supplies.
Financing sole proprietorships can be difficult. Due to the risk of unlimited liability and the ease with which sole proprietorships can be started, banks are often hesitant to lend to sole proprietorships. Also, sole proprietorships cannot raise money by issuing stock. In the United States, stock can be issued only by corporations and limited liability companies.
For this reason, many individuals start their sole proprietorships as side businesses while they work a different job. The good news is that there are tax benefits to starting a sole proprietorship, because a portion of the business expenses can be written off.
The applicable tax forms for a sole proprietorship can be found here.
It’s important to note that sole proprietorships still report all their income on a 1040. However, they also must fill out a schedule C for their business income, expenses and losses. Sole proprietors need to pay attention to estimated taxes and the self-employment tax as they are 100 percent responsible for paying all business taxes related to their business income.
A partnership is an arrangement in which two or more individuals share the profits and liabilities of a business. Partnerships have the simplest business legal structure for two or more people. There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
Limited Partnerships (LP)
Limited partnerships have one general partner with unlimited liability, and all the other partners have limited liability. Generally the partners with limited liability tend to have less control over the company. The exact terms should be documented in the partnership agreement.
Partnership profits are passed through each of the partners’ personal tax returns. It’s important to note that the general partner, with unlimited liability, must also pay self-employment taxes.
Limited Liability Partnerships (LLP)
Limited liability partnerships (LLP) are similar to limited partnerships, except every owner has limited liability. This offers better personal liability protection because an LLP protects each partner from debts against the business. This is usually considered a safer option than the LP when it comes to potentially experiencing heavy business losses and debts, because each partner is now partially protected. The applicable tax forms for a partnership can be found on the IRS website.
Limited Liability Company (LLC)
Like a corporation, a limited liability company, or LLC, is a separate and distinct legal entity. It can have the benefits of both corporate and partnership business structures. An LLC’s owners (called members) have limited liability, which means that under most circumstances, they are not personally liable for the debts and liabilities of the LLC.
For example, if an LLC were forced into bankruptcy and the company assets were not enough to pay the company debts, in most instances, the creditors could not go after the personal assets of the LLC members to repay the remaining LLC debts.
An LLC is established at the state level, and different state laws will apply. An LLC faces fewer recordkeeping requirements than a corporation. Unlike most corporations, an LLC is often taxed as a pass-through business.
The IRS taxation of an LLC is discussed in detail on the IRS website.
Corporation business structures
Corporations have the most complicated structure of all the different types of businesses. They typically fall into 3 categories, including C corporations, S corporations and nonprofit corporations, which all have their own corporate structure and legal requirements.
Due to legal requirements, it can be more costly to form a corporation, but a corporation provides the strongest protection to its owners against personal liability.
A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities of an individual, including the right to:
- Enter into contracts
- Loan and borrow money
- Sue and be sued
- Hire employees
- Own assets
- Pay taxes
Due to legal requirements, it can be more costly to form a corporation, but a corporation provides the strongest protection to its owners against personal liability. This is because a corporation is a business entity apart from its owners.
For example, if a court judgment is entered against XYZ Corporation, saying it owes a creditor $200,000, only the corporate assets are at risk. The shareholders cannot be forced to use their personal assets to pay the debt.
Corporations pay income tax on their profits, unlike sole proprietorships and partnerships. Because of the corporate taxes, it is possible for corporate profits to be taxed twice: first, when the company makes a profit; then again after the distribution of dividends when a shareholder recognizes the income on their personal tax returns.
Corporations also require extensive record-keeping, operational processes, and reporting. However, corporations have an independent life separate from their shareholders. If a shareholder leaves the company or sells his or her shares, the C corporation can continue doing business relatively undisturbed.
Corporations also have an advantage when it comes to financing because they can raise funds through the sale of stock. The ability to issue stock can help attract employees if it’s issued as part of the benefits package.
An S corporation, sometimes called an S corp, is a special type of corporation that’s designed to avoid the double taxation drawback of regular C corporations. S Corps allow profits, and some losses, to be passed through directly to owners’ personal income returns without ever being subject to corporate tax rates.
S corps can be treated differently at the state level, but most states follow the federal government. However there are exceptions, with some states taxing S corps on profits above a specified limit, and other states treating the business simply as a C corp. S corps must file with the IRS to get the S corp status. This is separate from the additional process of registering with the state.
S corps cannot have more than 100 shareholders, and all shareholders must be U.S. citizens. S Corps still have to follow the strict filing and operational processes of a C corp. Like a C Corp, if a shareholder leaves the company or sells his or her shares, the S corp can continue doing business relatively undisturbed. For those businesses that meet the criteria, an S corp can be a good alternative to a C corp.
A nonprofit corporation designation is heavily dependent on the work the organization performs. Nonprofit corporations, also known as 501(c)(3) corporations, are organized for charitable, educational, literary, religious, or scientific work. Because they benefit the public, nonprofits can receive tax-exempt status. They pay no state or federal taxes on income. To receive federal tax-exempt status, nonprofits need to apply with the IRS.
Similar to C corps, nonprofit corporations need to follow special rules, including what they do with any profits they earn. Also similar to C corps, nonprofit corporations should register with their state.
Other business designations
Two other business designations may apply to your business in addition to the above listed.
Unincorporated: Not chartered as a corporation, lacking the powers and communities of a corporate enterprise.
Pass-through business: Type of business where individual owners pay taxes on income derived from that business on their personal income tax returns. Pass-through taxation applies to sole proprietorships, partnerships, and S-Corporations
Deciding on a business structure is one of the most important early business decisions of an organization. It is a good idea to consult with an attorney when making this decision.
Getting the business structure right is important because changing business structures can be complicated and expensive. Be sure to proceed through this exciting process with a clear understanding of the wants and potential outcomes to you and your partners.