Forming a business is a strategic decision, and the legal structure you choose can impact everything from taxes to liability. Even for someone who’s started a business before, knowing which one to choose for a particular situation is tricky.
In this article, we’ll discuss the differences between a Limited Liability Company (LLC), an S-Corporation, and a C-Corporation. We’ll also cover why you might choose one of these business structures over the others.
What Is an LLC?
A limited liability company (LLC) is a business entity designed to offer owners limited personal liability for the actions and debts of the company. It also provides pass-through taxation, meaning that it passes any profits (or losses) directly through to the owner’s personal tax return.
It’s the most popular choice for entrepreneurs, as it offers the flexibility of a partnership without the liability risk that comes with a sole proprietorship. There are currently over 21 million LLCs in the United States.
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Regarding taxation, “pass-through” means the company is a disregarded entity for federal income tax purposes. That means that all taxes related to the business pass through to the individual members of the LLC. This can be beneficial because it allows you to take advantage of certain deductions and credits that may not be available to other businesses.
An LLC can have one or multiple members, but each member must meet certain requirements to be included. They need to file the appropriate paperwork. Depending on the state in which they do so, this could be complex and require professional help. Creating and managing an LLC in Wyoming, for example, is extremely simple and cost-effective compared to other states (like New Jersey). Here is a guide for forming an LLC in New Jersey.
What Is an S-Corporation?
An S-corporation (or “S corp”) is a type of corporation recognized by the IRS for tax purposes. An S corp works like any other corporate entity, in that it’s its own separate legal entity. However, it’s treated differently in regard to taxation.
The biggest benefit of an S corp is that profits and losses are “passed through” to the shareholders instead of being taxed at the corporate level. This means that any taxes related to the business will be paid on each shareholder’s personal tax return, rather than the company’s. This can help reduce the overall tax burden of the business, since corporate taxes tend to be higher than individual taxes.
This tax benefit is available to LLCs that elect to be taxed as S corps as well, but an S corp offers additional benefits. These include increased credibility and the potential to pay yourself a salary (which is not allowed with an LLC). The downside is that S corps have more complex rules and regulations than other types of businesses, so it’s important to make sure you meet all the requirements before forming one.
What is a C-Corporation?
A C-corporation (or “C corp”) is the most common way to incorporate in the United States. A C corp is a separate entity from its owners, meaning it has its own taxes and liabilities. When the company incurs tax liability from doing business, this tax liability is paid at the corporate level, rather than by its owners.
C corps can have multiple shareholders and issue stock to those shareholders, so it’s easy to bring on additional capital or investors if needed. It’s also relatively easy for the business to issue additional shares of company stock. Due to this structure, C corps typically offer more credibility than other types of businesses, as they are viewed as having more legitimacy in the eyes of lenders and customers.
However, C corps also have significant drawbacks, such as double taxation and compliance costs. This means that if you want to form a C corp, you’ll likely need to hire an expert to help with filing all the paperwork and taxes.
When to Form an LLC
LLCs are the most common business structure for a reason. They’re generally the best choice for entrepreneurs who are just starting out, as they offer flexibility and limited liability protection. Plus, LLCs are almost always less expensive and less complicated than other types of businesses. In short, they’re versatile and able to meet the needs of more types of business owners.
An LLC is best for sole proprietors and partnerships that want liability protection. It’s also a good choice for small business owners who need to keep personal assets separate from their business and stay organized when it comes to taxes (i.e., expenses).
Examples of businesses that work best as LLCs include freelancers, digital marketing agencies, restaurants, retail and e-commerce stores, local labor and service providers, and other small- to medium-sized businesses.
When to Form an S-Corporation
S corps are unique. It’s a corporation that has elected special tax status, which comes with benefits and drawbacks.The biggest benefit of an S corp is the potential for tax savings. LLC owners profiting over $40,000 to $60,000 per year can usually save a significant amount of money by forming an S corp and paying themselves a reasonable salary, since an S corp is generally tax-exempt at the federal level.
Those deciding between a C corp and an S corp sometimes prefer the latter to avoid double taxation. Let’s say a C corp has five shareholders with an equal number of shares and reports taxable income of $1,000,000.
In a C corp, the profits are taxed first at the corporate level at a marginal rate of 21%, or $239,387 (plus franchise tax, depending on the state). If it chooses to distribute any of the remaining $760,613 to its shareholders, they would then be taxed again at their individual marginal rate.
However, S corps cannot have more than 100 shareholders or issue more than one class of stock. Aside from small business owners with certain strategic goals, the S-corporation is best for businesses that don’t plan to scale heavily or go public.
When to Form a C-Corporation
C corps are the traditional way to incorporate, but they’re usually only ideal for larger businesses or established companies that plan to stay in business for many years. They have much stricter management structure, requiring a board of directors and officers to oversee daily operations.
C corps are also the only entity to offer “fringe benefits,” which can be attractive to potential employees. These benefits include employee health insurance, retirement plans, stock options, and other incentives that can help attract talent. Plus, this structure allows as many shareholders as needed and enables the business to issue multiple kinds of stock. For these reasons, many tech startups choose to form a C corp instead of an LLC or S corp.
Final Thoughts
When deciding which type of business to form, it’s important to consider both the short-term and long-term goals. No matter which type of entity you choose for your business, it’s important to do your research first. Speaking with a lawyer or accountant can help answer any remaining questions and ensure you make the right decision for your company.