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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View Comments (17)
Hi, Saw this article at the right time. I am an IT professional with a fulltime job. I am considering doing consulting work or contracting on the side. This would mean I'd work for another consulting company at an agreed per hour rate for a few hours... eventually I'd quit my full time job and just do contract work. I've read opening my own company will also allow me to claim tax deductions for business owners. Which type of Corp would you recommend?
As a startup you’ll be fine just filing a Schedule C with your individual tax return and claiming your business expenses there. As you grow you should next create a Subchapter S election so there’s more formality and legal protection.
Hi,
I'll be a single member company, myself, no one else, I will be selling goods on Amazon.com.
Which structure you think would be the best choice for this?
I also have a Living Trust.
You mentioned a Trust can also be added to the LLC as shareholder?
My CPA suggested to have LLC & elect to be taxed as S-Corp, as someone else (Bryant Tolles) has mentioned here below.
I agree with both your CPA and the commenter below. Having a pass-through setup would be your best approach. You don’t need to add the trust as a shareholder.
What are the documentation requirements related to annual meetings and minutes for an S-Corp vs. a LLC?
For an S-Corp you need to adopt bylaws, issue stock, and keep meeting minutes and corporate records for all board of directors and annual meetings. For an LLC the requirements are pretty similar, but would be based on your operating agreement. You would still need issue shares for your members, record minutes for annual meetings and any meetings of partners/shareholders. Both would require you to document all major company decisions.
Hope this helps.
We are a small independent church. We want to end our non profit status. We pay no salaries and owe no debt. What is our best option.
You should consult a local attorney experienced with setting up business organizations. You have state/local and federal considerations and multiple options depending on your organization’s structure and aims.
The article states that for an S-Corp., "Assuming your compensation is reasonable, you would also avoid being taxed on any distributions you take from the business."
Can anyone elaborate on this? I was under the impression that any "profit" left on the S-Corp's books at the end of the year must be distributed to the shareholders as a taxable personal income.
Sure. An owner should be taking a reasonable salary out of the business. That compensation would be subject to employer taxes, etc. and be considered W2 income. After that expense, and all other expenses, the remaining income of the S-Corp than passes through to the owner’s personal tax return and is taxed at individual rates. Hope this helps.
A very good article. Passed it on to business partner.
That's great to hear, Sharon! Thank you for commenting!
Have been in business for sometime and this was the simplest explanation I have heard.
But with a C corporation, one would pay BOTH the corporate income tax and then the personal income tax when a dividend is declared. So, wouldn't the C corporation cost more even though the individual rate is more?
The C Corporation suffers from the double taxation cost that you mention above. But only if you take dividends.
An S-corp is not a legal entity. It's a tax election. An LLC can make an S election and be an S-corp (my firm does this). It's easier to think of this as a matrix - legal entities on one side and tax treatment on the other.
Correct, S-Corps are a tax entity. But they do represent a corporate entity as well because an S-Corp is a form of corporation.