A guide to help business owners decide which business structure is right for them, and how to start a corporation or LLC.
Business owners can structure their companies in several different ways, depending on the size of the business, its growth potential, how the business is managed, how the owners want to be taxed, and many other variables. Anyone starting a business should consult a qualified tax professional, such as an accountant or tax attorney, for advice on which corporate structure best fits their goals—but it helps to understand some of the factors that typically influence such decisions.
Many entrepreneurs wonder what types of business ownerships are possible and how to determine which one is right for their business. The following is a guide to the most common questions prospective business owners have about how to structure a business enterprise in the United States.
What are the main types of business ownership?
New companies can be set up in five different structures: Partnership, Limited Liability Company (LLC), Sole Proprietorship, S Corporation or C Corporation.
Two of the most common types of business configurations are C corporations (C corps) and S corporations (S corps). There are advantages and disadvantages to each structure, and C and S corps are taxed differently, but there are also similarities.
Both C and S corps:
- Provide limited liability protection for their owners and shareholders, so the business owners’ personal assets are protected against lawsuits and debt collection is leveled at the corporation.
- Must adhere to compliance standards that require them to adopt bylaws, issue stock, hold regular meetings, file government reports, and pay annual fees and taxes.
- Are required to submit tax return filings for business income and profits.
While each C and S corporations each have their pros and cons, the nature and goals of your business will determine which one best suits your needs.
Which is better, a C corp or S corp or LLC?
There is nothing inherently “better” about a C corp, S corp, or LLC—these designations simply describe how a company is taxed and which rules it must obey in order to stay compliant with the Internal Revenue Service (IRS). How one should incorporate really depends on the nature, size, and goals of the business in question.
In general, C corps tend to be larger companies and S corps tend to be smaller businesses or sole proprietorships, but that’s not always the case. Indeed, there is plenty of gray territory when it comes to deciding the most strategic tax status for growing small- and mid-size companies, including LLCs (which we’ll discuss later).
What is a C Corporation?
Generally speaking, a C Corp – named for its inclusion in subchapter “C” of the IRS code – is an independent legal entity, owned by its shareholders, that has unlimited growth potential. Most large businesses and public companies are formed as C corps because a C corp is a business structure that allows for limitless growth through stock sales (which makes them appealing to investors) and is ideal for large, retail-based businesses.
Another distinguishing feature of C corps is that they are subject to double taxation. This means that the corporation itself is first taxed at the federal corporate tax rate of 21%, and any dividends or profits the company passes on to its shareholders are taxed a second time as personal income. In fact, one of the most compelling reasons to file as an S corp is to avoid double-taxation (more on that later).
What are the pros and cons of forming a C corp?
There are many benefits to establishing a C corp, most of which involve tax advantages and provide mechanisms for growth. On the other hand, creating a C corp can be expensive, because the complex nature of a C corp usually requires consultation with tax and legal professionals to help with state and federal filing requirements as well as documents such as Certificate of Incorporation and by-laws. Management and labor costs also add to the bill, and as a company grows, so does its complexity and expense.
On the pro side, a C Corp can:
- Issue more than one class of stock, i.e., common and preferred stock
- Grow through virtually unlimited stock sales – essential for companies that want to go public
- Attract investors seeking passive income which helps fuel growth
- Have shareholders who are not U.S. citizens which is great for international businesses
- Own other companies, LLCs, partnerships, and trusts – allowing growth through diversification
- Elect to go public – a major growth step for expanding companies
- Raise business capital without having to give investors voting rights
The cons of forming a C corp include:
- More regulations and reporting responsibilities, e.g., C corps must file annual reports, financial disclosures, and business income taxes, hold regular board meetings, and keep by-laws and voting records on the premises)
- Stricter management requirements, e.g., board of directors and management must be separate entities)
- Higher overall operating costs such as legal fees, payroll, insurance, regulatory compliance—it all adds up
Nevertheless, for entrepreneurs who envision a company with growth potential and expansive investment opportunities, starting a C corp may be the best choice.
How do you start a C corp?
Starting a C corp is not something one does lightly, for it involves some time-consuming and difficult work up front, as well as a binding commitment to the company’s purpose and success.
To form a C corp, a business owner must take the following steps:
Step 1: Register the organization with a distinctive name no one else is using.
Step 2: Appoint corporate officers to include a chief executive officer (CEO) and a board of directors.
Step 3: File Articles of Incorporation with the secretary of state in the state where the company is registered.
Step 4: Write company bylaws.
Step 5: Issue stock certificates to shareholders.
Step 6: Obtain relevant business licenses.
Step 7: Submit IRS Form SS-4 for an employer identification number (EIN).
Each of these steps requires a great deal of thought and/or follow-through. For these reasons and many others, establishing a C corp is a complicated procedure that typically involves consultation with a tax attorney and, once the enterprise is up and running, investment in a software program to ensure that all tax filings are accurate. Instead, many entrepreneurs may prefer the easier option of creating an S Corporation.
What is an S Corporation?
In principle, an S Corp – named after Subchapter S of the Internal Revenue Code (IRC) – is a business entity that elects to pass taxable income, losses, deductions, and credits through to company shareholders. They are popular largely because organizing as an S corp appeals to small businesses and sole proprietors, offers enticing tax advantages, and provides liability protection for personal property.
S corps are considered “pass-through entities“, which means their taxable revenues are not taxed at the federal level. Rather, they “pass through” directly to the organization’s owners and shareholders’ personal tax returns, thus avoiding double-taxation, because S corps themselves do not pay federal taxes. Instead, they pay up to 13.3% state and local income taxes, plus S corp owners may pay between 10-39.6% for federal personal income taxes on earnings or profits.
Owners of an S corp report business losses, profits, deductions, and credits on their personal tax returns, which can provide significant tax savings. Indeed, thanks to the 2017 Tax Cuts and Jobs Act, S Corp shareholders can deduct up to 20% of Qualified Business Income (QBI), which may reduce an individual’s tax burden by 20-25%. In addition to tax savings, the S corp structure protects the owners’ personal property from any lawsuits or debt collections directed at the S corp.
What are the pros and cons of forming an S Corp?
There are several advantages to running an S corp, as well as some disadvantages.
The advantages of structuring as an S Corp are:
- Owner/shareholders do not have to pay federal taxes on the corporation; rather, they
enjoy pass-through taxation on income, thus avoiding double taxation
- Self-employment taxes are lower, largely because Social Security and Medicare taxes are lower
- Liability protections—all personal property is protected
- Owners have more flexible accounting options, including use of the QBI
- Management requirements are less rigorous—owners and management do not have to be legally separated, and owners can be classified as employees, which can also yield significant tax savings
- Ownership interests are easier to transfer
The disadvantages of an S corp are:
- Can only have 100 shareholders
- Shareholders must be U.S. citizens or legal residents
- All shareholders have voting rights
- Can only issue one class of common stock
- Must operate domestically
Granted, the limitations of an S corp may discourage potential investors and can make it more difficult to raise capital—but they can also attract investors who want more direct involvement with the business.
Not all types of businesses can choose to be S corps, however. Financial institutions are prohibited from being S corps, for instance, as are insurance companies and multi-national corporations. Compliance requirements are also stricter with an S corp than they are with other business entities, such as an LLC or limited liability partnership (LLP). Furthermore, S corp owners can run into trouble with the IRS if they don’t keep meticulous records or pay their employees a salary that the IRS deems “reasonable.”
How do you start an S Corp?
Starting an S corp is easier than starting a C corp, but the process still involves several similar steps.
The basic steps of creating an S corp are:
Step 1: Choose a name for the business, and make sure no other business entities exist that are using the same name.
Step 2: File articles of incorporation with the state, including the corporation’s name, address, purpose, primary activities, and the owner’s name.
Step 3: Elect a board of directors, including chairperson, vice chair, secretary, and treasurer.
Step 4: Write by-laws for governance outlining the rights and responsibilities of the shareholders. (The help of an attorney is advisable for this step, as there are legal consequences involved.)
Step 5: Obtain an employer identification number (EIN), which is your tax ID to pay federal taxes, hire employees, and apply for licenses and permits.
Step 6: File IRS Form 2553, signed by all shareholders, to choose official S corp status.
Step 7: Obtain relevant state and local business licenses and pay state and local filing fees.
Once the S corp is formed, the real work begins in terms of building the business and meeting quarterly and annual reporting obligations. Regular board and shareholder meetings must also be held, minutes recorded, decisions noted, and business records kept accurately and up to date. Sole proprietors must also adhere to these rules, even if they are the S corp’s only board member and employee.
When is it better to create an LLC instead of a C corp or an S corp?
As business structures go, C or S corps may seem overly complex, especially for small business owners or sole proprietors. If you have a small business, you may wish to remain as a sole proprietor who makes all their own business decisions and keeps all net profits. If you are a freelancer or contractor, however, neglecting to organize under some type of business structure could put your personal assets at risk—if, say, a client decides to sue you.
On the other hand, if you wish to protect your personal assets but don’t want to form a C or S corp, another option is to form a Limited Liability Company (LLC)—which is the most common organizing structure for small businesses.
What is an LLC?
An LLC is a business structure that protects a business owner’s personal assets from business obligations or liabilities. LLCs can range in size from solo proprietors to businesses with hundreds of employees. For example, many law firms are LLCs, and solo contractors or freelancers may elect to form an LLC to shield personal assets from lawsuits or debt collection directed at the business.
What are the pros and cons of forming an LLC?
Beyond protecting a business owner’s personal assets, there are other reasons to create an LLC – mainly because they are easier to establish.
The advantages of forming an LLC are:
- LLCs are not required to have a board of directors
- LLCs are allowed to have as many owners (referred to as “members”) as they desire
- Members are not required to be US citizens or residents
- LLC owners can make their own business decisions, whereas corporations have boards of directors and shareholders who participate in business decisions
- LLC owners can also hire managers or choose to appoint officers who make business decisions for the LLC
- LLCs do not require detailed record-keeping, but it’s still important to keep accurate books and accounts
The disadvantages of forming an LLC are:
- LLC owners pay taxes on all net profits from their business, just as sole proprietors do, and self-employment taxes are higher than employee taxes
- LLCs are regulated by state laws, and each state has different rules and fee structures related to setting up and maintaining an LLC
- LLCs cannot issue stock and cannot have shareholders, which may limit options for attracting members to the LLC
How do you start an LLC?
LLCs are regulated at the individual state level, so you will want to familiarize yourself with your state’s LLC rules first. However, these are the general steps that are common to most states:
Step 1: Choose a name for your business, one that includes “Limited Liability Company” or the abbreviation “LLC”.
Step 2: Apply for an IRS Tax ID or Employer Identification Number.
Step 3: Visit your state’s Office of the Secretary of State website to learn about filing articles of organization, along with any permits or licenses your state requires.
Step 4: Write an operating agreement to clarify the business’s structure and rules, and to ensure legal protection for the LLC.
Step 5: Understand your state’s LLC tax filing regulations; some states charge additional special taxes for businesses like hotels or cannabis and tobacco businesses.
Step 6: Pay state filing fees.
Step 7: Decide how to file – whether your LLC will file as a sole proprietor or as a C corp or S corp.
Whichever option you choose, running a small business is not easy, so make sure you have the right legal resources available to set up and operate an LLC. Also, as an LLC owner, you are liable for higher self-employment taxes, which is something many entrepreneurs try to avoid. Fortunately, there are ways within the S corp structure to minimize the burden of self-employment taxes.
How can you reduce the self-employment tax liability of an LLC?
LLC owners can lessen their individual self-employment taxes by changing their tax classification to a C corp or an S corp, while keeping the LLC structure. Self-employment taxes are 15.3%, and include 12.4% for Social Security and 2.9% for Medicare. All of this is in addition to the LLC owner’s personal income tax rate, which ranges from 10-37%, depending on the individual’s tax bracket.
For example, imagine that an LLC owner makes $125,000 in gross revenue and has $10,000 in business expenses. The LLC owner realizes $115,000 in profits, which sounds good. However, now the LLC owner must pay the 15.3% in self-employment taxes and personal income tax on the $115,000, less any deductions.
While most LLC owners will not elect to file as a C corp, due to the high corporate income tax rate of 21%, LLC owners can choose to file taxes as an S corp and take advantage of lower individual tax rates. This does mean that the LLC owner must abide by certain IRS regulations specific to S corp status, but due to recent changes in tax law, an LLC owner filing as an S corp may be able to take advantage of the Qualified Business Income (QBI) deduction, which allows filers to deduct as much as 20% from business income from their taxes.
Final thoughts about choosing the right business structure for entrepreneurs
Whatever the nature of your business, the questions above are the kind all business leaders need to ask themselves to determine which ownership structure is right for their business. Choosing the appropriate business structure is important and should not be taken lightly. Think hard about the kind of business you intend to start and operate, then review your options and choose the one that best fits your business’s purpose and goals.
Regardless of which corporate structure is under consideration, however, a tax professional and/or lawyer can help make the filing process as smooth as possible and ensure that all the necessary requirements are met. After that, it’s up to business owners to put their plan into action.