Starting a business? One of the first steps you will take towards establishing a solid business plan and foundation will be legally incorporating your business entity. Determining which legal structure is right for you and your startup is crucial, and will play a significant and consistent role throughout the duration of your company’s lifetime, especially when it comes to how your business will be taxed. The three most popular forms for small businesses are C corporations, S corporations, and Limited Liability Companies, more commonly known as LLCs. Every entity type has their advantages as well as disadvantages. It is important that you are knowledgeable on how each type will affect your company structure, as well as your bottom line. Give us a call today if you would like for one of our accountants to walk you through this process!
C Corporations: When a small business incorporates, it automatically becomes a C corporation, also known as a regular corporation. A C corporation is legally viewed as an individual entity, meaning an entity separate and apart from its owners, who are referred to as shareholders. Since a C corporation is legally viewed this way, the IRS views it this way as well, making this corporation type eligible for double taxation; once as a corporation, and then again as a shareholder when dividends are distributed.
When entrepreneurs are faced with the decision of which entity type to incorporate under, many view this as a huge downfall of choosing a C corporation. However, if you do choose a C corporation, double taxation is not an inevitable fate. If owners who are working for the business are taking reasonable salaries for themselves, the corporation can deduct these salaries, allowing for the owners to pay taxes on the money they receive. The passing of the Jobs and Growth Relief Reconciliation Act in 2003 allowed for lower tax rates on dividends and has eased the impact of double taxation. Also, there is limited liability offered under the C corporation option. Shareholders are only personally liable to the extent of their holdings in the corporation. As opposed to business forms such as partnerships or sole-proprietorships, their personal assets are not on the line. Another upside to a C corporation is that there are more incentives to attract investors, due to the fact that they have available stock to sell and there is an opportunity for dividends. Other advantages include the ability to deduct fringe benefits, and the continuance of existence, which means that transfer of stock or death of an owner, will not affect the corporation.
However, if you still feel as though the C corporation is not the right fit for you and/or your small business, if your business qualifies, you can choose S corporation status upon incorporation.
S Corporations: S corporations, whose name is derived from electing Subchapter S of the Internal Revenue Code, is popular among many business owners because it allows a corporation to avoid double taxation. Generally an S corporation does not pay federal corporate taxes; selecting subchapter S allows a business to pass all income, losses, deductions, etc., directly to shareholders, whom will then be liable for claiming tax responsibility on their personal tax returns. This allows the corporation to bypass being taxed as a separate entity.
However, not all corporations are eligible to become an S corporation. The company must have no more than 75 investors, who all must unanimously agree to the decision and sign the necessary paperwork, and all investors must be US residents or citizens. Also, certain types of companies are restricted to filing Subchapter S tax election by the IRS.
The major benefit of forming an S corporation is avoiding the double taxation impact experienced under C corporation status. However, S corporations have their downfalls as well; paying taxes on “absent” income, eligibility to be taxed on fringe benefits, and liability for state, as well as, local taxes. Another thing for S corporations to watch out for is ensuring that the salaries paid out to those stockholders who are working for the corporation are “deemed reasonable” by industry standards. If they are not, the IRS can require stockholders to pay payroll taxes on total income received from the corporation.
Limited Liability Company (LLCs): The Limited Liability Company is looked at as somewhat of a mix between a partnership and a corporation. The main difference between corporations and an LLC is that LLCs are usually taxed the way that partnerships are. Owners of an LLC are referred to as members; members may be individuals, corporations, or other LLCs or entities. Similar to an S corporation, an LLC provides limited liability and allows for all income, losses, deductions and credits to be passed on to the owners, allowing LLCs to avoid double taxation as well. Members may allocate these items any which way they like, providing much more tax flexibility then corporations. The structure of an LLC is not as restrictive as that of an S corporation, making Limited Liability Companies a very popular option for startup companies. Seeing as they are similar to partnerships, they allow much more management flexibility as well.
Before deciding if an LLC is the right choice for you and your small business, be sure to remember that rules and regulations regarding LLCs differentiate in every state. Make sure your state regulations are a right fit for you as well. It is also important to keep up with the laws regarding Limited Liability Companies, being that they are a fairly new practice in the US; legal standards are still being perfected. Also keep in mind, there are some businesses that do not qualify to for LLC status, such as banks, insurance companies, and nonprofits.
Each type of business structure has their advantages and disadvantages. It is important to find which structure will be the right fit for you and your small business. Understanding the tax code and laws applicable to each can be a challenging task. Be sure to thoroughly discuss all of your options with your CPA before moving forward with incorporating your business. If you need a CPA, tax advice, or help incorporating, give The Tax Club a call at 888-773-7176! Or you can contact us through our Facebook, Twitter , and Google+ page! Also, be sure to follow us!