Any business owner setting up a new company faces the inevitable question: What type of organization is best for my business? It’s never an easy answer. There are lots of choices, and each one has its own set of rules.
There are partnerships and there are corporations. In this article, I won’t discuss partnerships but will focus on the three primary corporate entities: S corporations (S-corps), C corporations (C-corps) and limited liability companies (LLCs). (There are others forms of corporate ownership, like professional corporations, but we’ll just focus on the three most popular.)
Each type of organization provides a layer of liability protection for your assets. But taxation differs between the three options.
An S-corp and a C-corp are different tax entities even though they both are corporations. They file similar tax forms, but an S-corp files 1120-S and a C-corp files 1120-C.
The IRS treats an LLC either as a corporation, partnership or as part of your individual tax return. The income from an S-corp and an LLC “passes through” to your personal tax return and is taxed at your individual rate. The income from a C-corp is taxed at corporate rates.
As you research, it’s easy to get buried in articles that list the pros and cons of each entity. So let’s cut to the chase. As a certified public accountant, this is what I recommend to my clients.
You may want to form an S-corp if you:
- Only have a few shareholders. S-corps must have fewer than 100 shareholders.
- Want your company’s income taxed at individual rates. All income from an S-corp flows to your individual tax return. Assuming your compensation is reasonable, you would also avoid being taxed on any distributions you take from the business. S-corps can also take advantage of the Qualified Business Income Deduction, which allows many (but not all) business owners to deduct as much as 20% of their company’s income before taxes.
- May want to become a C-corp someday. Converting from an S-corp to a C-corp is not difficult. However, converting from an LLC to a C-corp may require additional filings and formation documents.
- Want to use the cash basis of accounting. S-corps can elect to use the cash method of accounting, which may be preferable depending on your company’s size and complexity. However, you have to use the accrual method—which reflects accounts receivable and liabilities—if you have inventory.
- Want a tax-advantaged way to take money out of your company. When you have a C-corp, distributions are designated as dividends, which get taxed. With an S-corp or an LLC, you can distribute extra cash from your business with no additional taxation. However, there are some caveats to doing this, which you should discuss with your tax advisor.
You may want to form a C-corp if you:
- Want to separate your company from your personal finances. C-corp income doesn’t pass through to your individual tax return, so there’s no connection between owning a C-corp and your personal financial situation.
- Desire shareholder flexibility. You can have unlimited shareholders for your C-corp, and shares can be easily bought, sold and transferred between outside parties. Unlike S-corps, investors in C-corps can include other C-corps and S-corps (with some exceptions), LLCs, partnerships and many trusts. If you want to attract outside investors, a C-corp may be a good option.
- Have a high individual tax rate. The maximum individual tax rate is 37%, but the maximum corporate tax rate is 21%. If you have a pass-through company like an S-corp, you could potentially be paying higher taxes on your income.
You may want to form an LLC if you:
- Want fewer restrictions on your management structure. LLC members have more options for how the organization is run than an S- or C-corp. An LLC has an operating agreement where managers decide on its rules, policies and procedures.
- Want a more flexible ownership structure. Unlike S-corps, you can have as many “members” of an LLC as you like. You can also have non-U.S. citizens/residents, corporations, other LLCs, partnerships and trusts as shareholders. Plus, you can have subsidiaries and different classes of stock.
- Want to be taxed at individual rates. Like an S-corp, an LLC is a pass-through organization, meaning your income is taxed at your individual rates. If you have a relatively low individual rate, this can be advantageous. As a pass-through entity, an LLC can also take advantage of the Qualified Business Income Tax Deduction.
- Want to use the cash basis of accounting. Like an S-corp, LLCs can elect to use the cash method of accounting.
- Want a tax-advantaged way to take money out of your company. This treatment is similar to an S-corp as described above.
Your specific situation may require more considerations than provided in this article. Find all the facts about different business entities on the IRS website:
Ready to move forward with the business structure that fits your needs? Work with your financial advisor to get moving and decide which organization is best for your business.
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