There's so much to think about when running (or considering to run) a business. Location, staffing, regulations, competition...as business owners know, the list goes on and on. But what about your business type, also known more officially as "entity?" It may be something you haven't considered, but it effects your bottom line and much more. Before starting or buying an existing business, you should be familiar with the following terms. It may save you in the long run.
There are many sub-types of business entities, including the sole proprietorship and partnership models. For the purpose of this blog, we'll focus on what some consider the big three: C corporation, S corporation and the limited liability company.
A C corporation, or C corp, is also known as a standard corporation. It's defined by the US Small Business Administration (SBA) as
an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs...Corporations are generally suggested for established, larger companies with multiple employees. For businesses in that position, corporations offer the ability to sell ownership shares in the business through stock offerings.
There are several advantages to the C corp model.
- If you want to keep your company's earnings in the business for reinvestment purposes, a C corp is your best bet.
- C corps also grant flexibility to set salaries, which helps to minimize Social Security and Medicare taxes.
- C corps are audited by the IRS less frequently than other business entities.
- A C corp can have an unlimited number of shareholders who are not required to be US citizens or residents.
- C corps can offer many types of stock.
Are C corps perfect? No. A big downside is what some call "double taxation." Corporate profits are taxed, and when the corporation distributes a share of the profits in the form of dividends, the recipients (aka shareholders) are taxed as well.
S corporations or S corps are defined by the SBA as
a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation. To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are "considered by law to be a unique entity, separate and apart from those who own it." This limits the financial liability for which you (the owner, or "shareholder") are responsible. Nevertheless, liability protection is limited - S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.
There are limitations. An S corp must have 100 or fewer shareholders and these shareholders must be US citizens or residents. S corps can offer one type of stock.
- S corps allows "pass through taxation," meaning that corporate taxes don't apply. Profits and losses are reported on an owner's (or shareholder's) individual tax returns, and these individuals are taxed accordingly.
- Similar to C corps, S corps grant flexibility to set salaries to help minimize Social Security and Medicare taxes. Of course, this must be done reasonably.
- Accounting for S corps may be easier, as the structure allows some companies to use the cash basis method rather than the accrual method.
Limited Liability Company (LLC)
A limited liability company is defined by the SBA as
a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Some see the LLC as the best of both worlds.
- Pass through taxation is permissible, just like an S corp - they're not subject to employment tax.
- Contrary to a sole proprietorship or partnership, owners are protected from liabilities.
- The management structure is flexible.
Other reasons to opt for an LLC include anticipated business losses at start up, the ownership of real estate, and minimizing time-consuming activities such as annual meetings and very detailed record keeping. And who doesn't want to minimize those aspects of business ownership?
So there's a lot to consider. We'll close with a list of resources. Have another favorite? List it in the comments section.
Which Business Type is Right for Me, BizFilings
LLC vs. S Corp vs. C Corp (The Three Minute Version), Oblivious Investor
Create Your Business Plan, US Small Business Administration