Which Business Entity is Best?
So, you’ve already read Should I Incorporate My Business? and What Are The Benefits of Incorporation? -- and you’ve decided to incorporate.
Now you move on to your selection of business entity. You want to know which business entity type is best for you.
For our purposes I’m only going to discuss three kinds of business entity: The C-Corporation; S-Corporation; and LLC.
[Note that since an LLC is not a corporation, you technically don’t
“incorporate an LLC.” Instead you “form” and LLC. But, you’ll see that
an LLC is treated very similarly to a corporation.]
Let's compare these 3 forms of business entities:
-- This is the big one. That’s a corporation with all the bells and
whistles. If you have a C-Corporation, you can take advantage of all
the corporate tax benefits available. Frankly, I have never formed a
C-corporation so I don’t have first-hand experience with them. But,
suffice it to say if you have significant income from your business you
will almost certainly be best off forming a C-Corp. By “significant
income” I mean enough that you might be able to afford to pay for health
benefits or a retirement plan for you or your employees. If you are
"there," you really should just stop reading this and go see a good tax
lawyer or CPA. The fee you pay them will be returned to you many times
over in tax savings. The disadvantage of a C-Corporation is that it is
more formal and requires more complicated tax filings. You have more
requirements to hold shareholder meetings; keep corporate minutes, etc.
Another potential disadvantage is double taxation. C-Corp. profits are
taxed once at the corporate level and again if distributed as dividends
to shareholders (including you). Of course, there are ways to lessen
or even eliminate this problem, and often corporate tax rates are lower
than personal rates -- but all of that gets into complicated tax issues
that are beyond the scope of this article. Again, if you are making
significant money, you likely should go with a C-Corp; but go see a tax
professional ASAP (and before deciding).
-- It is simpler to run an S-Corporation than a C-Corp. The
requirements discussed above are not as formal. The tax filings are
much simpler because it is a “pass-through” entity for tax purposes.
This means that any income or loss the S-Corp. makes passes through
directly to its shareholder. This avoids the “double-tax” issue that
C-Corporations face. Also, because income passes directly to the
owner(s), you can avoid paying employment taxes (Social Security,
Medicare) on that income. With a C-Corporation you can’t do that. You
have to either pay income to the shareholder as a dividend (hence double
taxation) or as salary (hence payment of employment taxes – by both the
corporation and the employee (so, currently 12.7% combined total in the
US). And, losses can’t be passed on to the shareholders at all –
without dissolution of the corporation. Having said all that, even with
an S-Corp, if you are making money, you do have to pay yourself a
“reasonable salary” which will require paying those same employment
taxes. But, at least once a reasonable salary is paid, above that the
income can flow directly to you, free of employment taxes.
-- I formed my first business as an S-Corp. (simply by filing an
“S-Corporation election” with the IRS). I knew I would have losses my
first couple years and wanted to be able to claim them on my personal
tax form. An S-Corp or LLC was the only way to do that as both are
“pass-through” entities. I went with an S-Corp because it seemed
simpler. All I needed to do was file an “Articles of Incorporation”
with the state. After that, the rules were pretty much set. I was
going to own the company with my wife as equal shareholders; didn’t
anticipate adding any other shareholders; so, the S-Corp seemed the way
to go. However, after about 18 months, I wanted to add a new partner.
The problem was I only wanted him to share in part of the business; not
all of it. With an S-Corp you can’t do that. You are limited to 35
shareholders (no problem there) but also each shareholder has to share
equally in the corporation. That was the problem. And, this is the
benefit of an LLC. It is a bit more work to set up initially because of
the operating agreement. However, in the long run it allows for more
flexible arrangements. So, my second company was an LLC. Tax-wise, you
can elect to have your LLC treated as a partnership and thus have profit
and/or loss pass through the same as an S-corp. So, you can avoid the
double-tax issue that a C-Corp has. The biggest disadvantage with an LLC
is that it can’t go public. So, if you ever want to sell it you have to
sell to a private buyer or re-organize as a corporation. If you are
planning an IPO down the road – you don’t want an LLC.
A common question is: "Can I incorporate it alone?" The answer is: "Sure." You can have a single member LLC or be the sole shareholder of a corporation. No problem. But, you will need to check your state rules regarding whether someone else (or some other entity) has to serve as the registered agent.
So, what kind of business entity is best for you? Like most things, it depends. Hopefully, I’ve given you some things to think about. If you still have questions, you might want to check out the resources at "Legal Zoom" or consult with a lawyer. If so, check out the links in the ads to the right.
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The purpose of this feature is to stimulate discussion and share experiences regarding topics of interest. However, please note these submissions are not reviewed for legal accuracy. They may not apply to your situation and should not be considered legal advice. For specific legal advice you must consult with your attorney.
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