Yes, operating a business as a sole proprietor or general partnership offers simplicity, but that comes at the cost of not having a separation between you as an individual and your company. Are there other options? There are alternate options that include popular entity types like the Limited Liability Company, C Corporation, and S Corporation.
For entrepreneurs who want to protect their personal assets and have tax flexibility, registering as a legal business entity, such as an LLC, oS Corpo, or C Corp, is well worth exploring. Continue reading because I’m going to break down the basics of the LLC vs. S Corp vs. C Corp, so you gain some knowledge of what they have to offer.
Keep in mind that what I share here is for informational purposes only and is in no way meant as legal or tax advice. You should consult an attorney and accountant or tax professional to ensure you understand your options as you decide which structure will be best for your business.
Business Structure Wizard
This free, online tool helps small business owners navigate the process of picking the right business structure for their new business.
Limited Liability Company
What is an LLC?
The Limited Liability Company (LLC) business structure has become popular with many small business owners. It is less complicated and less costly to establish and maintain than a corporation, and it limits personal liability and provides tax treatment flexibility. If being a sole proprietor or partner isn’t giving you peace of mind, becoming an LLC offers some of the benefits that corporations enjoy—without the complexity.
Forming an LLC
To form an LLC, you need to file Articles of Organization with the state in which you wish to operate your business. Although most states don’t require it, I suggest also creating an operating agreement for your LLC—especially if you have more than one owner. An operating agreement will define the responsibilities and roles of owners, so you can avoid misunderstandings about how your company should be managed.
Protection Against Personal Liability With an LLC
When you form an LLC, you legally separate your personal self from your business. So, if someone sues your company or you cannot pay your business debts, plaintiffs and creditors generally may not seek your personal assets as restitution.
Tax Flexibility With an LLC
Whether your LLC has a single owner or multiple owners, it has two tax treatment options:
- Pass-through tax treatment – By default, your LLC will be taxed in the same way as a sole proprietorship or general partnership. For tax purposes, the IRS will view your company as a disregarded entity. In other words, all income and profit or loss will pass through directly to your personal income tax return.
- S Corporation tax treatment – If you elect for your LLC to have S Corp tax treatment, your business income/losses will flow through to your personal tax return, too. But the difference is you will only pay self-employment taxes (Social Security and Medicare) on your owner’s wages and salaries, not on all income.
LLC Ownership and Management Flexibility
Many states allow individuals (including non-residents of the U.S.), corporations, other LLCs, and groups to form an LLC. If your business has multiple owners, you have the freedom to allocate percentages of your LLC’s profits and losses among owners as you see fit. As a multi-member LLC, you can opt to be either member-managed or manager-managed. A member-managed LLC gives all the authority over making decisions, signing contracts, and managing operations to the owners of the LLC. A manager-managed LLC is one in which members elect a manager or managers to run the business operations and have a certain degree of decision-making authority. In this management structure, the owners will often retain the authority to make important decisions, enter into contracts, and fulfill other duties. Unless specified in your formation documents, in most states, your LLC will by default be considered member-managed.
Compliance Responsibilities of an LLC
A nice LLC perk is you’ll have less complicated ongoing compliance responsibilities than if you register as an S Corporation or C Corporation. As an LLC, you won’t have to elect officers and directors to oversee your business. You will have some ongoing compliance tasks to stay in good standing with the state, though. I encourage you to do your homework to learn what they are, so you’re not caught off-guard and risk losing your status as an LLC.
Potential Downsides of an LLC
As with all business entity types, the LLC has some disadvantages to consider. An LLC may not issue company stock, so you’ll have fewer ways than an S Corporation and C Corporation to raise capital. Also, investors may perceive your business as a less reliable investment than a corporation. Another downside to an LLC is that self-employment taxes will typically apply to all your business earnings, not just the money you take as personal draws.
S Corporation
What Is an S Corporation?
The S Corporation isn’t a legal business entity type in and of itself but rather a special election made by either an LLC or C Corporation with the IRS.
Personal Liability and the S Corporation
Because your business is formed as either an LLC or C corporation, it’s considered a legal entity separate from its owners. That means owners’ personal assets have protection against lawsuits and debts of your company.
Income Tax and the S Corporation
An LLC or a Corporation that chooses an S Corp election will have its profits and losses flow through to its shareholders (owners), who then report them on their personal income tax returns. Like an LLC, your business will not pay federal taxes at the corporate level. But unlike an LLC, not all income is subject to self-employment taxes—only owners’ salaries are.
Compliance Responsibilities of an S Corporation
When a business elects S Corporation status, many of the requirements it needs to meet are standard for its underlying business structure. You should check with your state and make sure you understand your obligations as either an LLC or a Corporation with an S Corporation election.
Potential Downsides of an S Corporation
If your business is a C Corporation choosing to be treated as an S Corp, you may only have up to 100 shareholders, and you can issue just one class of stock. That could limit your ability to raise capital. Also, your shareholders must be either citizens or permanent residents of the U.S. United States.
For an LLC, another drawback is higher formation costs and more compliance complexity.
C Corporation
What Is a C Corporation?
Although more complicated to operate, a C Corporation provides the most personal liability protection for shareholders in a company. The IRS considers a C Corporation an independent taxpayer and associates its income and expenses with the business, not its owners (shareholders). Ownership of a C Corporation is established through issuing shares of stock, either held privately or publicly.
Forming a Corporation
To register as a C Corporation, you must file Articles of Incorporation with the state in which you want to operate your business.
Taxes and the C Corporation
A C Corporation (unless it files for the S Corporation election) must pay federal income tax on company profits at the corporate tax rate. In some circumstances, the corporate tax rate may be lower than paying the individual tax rate on business profits (as with an LLC). As a C Corp, your company may be eligible for tax deductions not available to other business structures.
C Corporation’s Ability to Sell Stock
A C Corporation has more potential to raise capital and grow. It can issue multiple classes of stock, and it may have an unlimited number of shareholders.
Longevity of a C Corporation
Unlike with a sole proprietorship (and in the case of some LLCs), a C Corporation will survive beyond its owners’ life spans. You can transfer a C Corporation’s ownership interests by selling, bequeathing, or gifting shares of stock to others.
Compliances Responsibilities of a C Corporation
A C Corporation has more compliance requirements than other business entity types. To retain the benefits of its corporate status and stay in good standing with the state, a C Corporation must follow internal and external corporate rules. Some of the requirements may include adopting bylaws, submitting annual reports to the SEC (U.S. Securities and Exchange Commission), holding shareholder and board of director meetings, and others.
Potential Downsides of a C Corporation
Double taxation (when profits are distributed to shareholders as dividends are taxed again at the individual tax rate on shareholders’ tax returns) deters many small businesses from becoming a C Corporation. The higher business registration costs and more rigorous compliance requirements also may be more than a small business will want to bear.
Remember Ongoing Business Compliance
Regardless of the business entity type you choose, to stay in good standing with the state and maintain the legal protections and tax advantages of that structure you will also need to:
- Keep business licenses and permits current.
- Submit your annual report to the state.
- Notify your state of changes to your business.
- Notify FinCEN of any changes to the business ownership.
- Maintain a registered agent.
- Keep your business and personal finances separate.
- Pay income tax, sales tax, and payroll taxes.
Again, different states have different rules, and requirements can vary depending on the nature of what a business does.
What’s Right for Your Company?
Which business entity type will benefit you and your company? With so much to think about, I recommend talking with an attorney who has expertise in business law and consulting an accountant or tax advisor. The legal and tax considerations associated with selecting an LLC vs. S Corp vs. C Corp can affect your business financially, administratively, and operationally.
