LLC's, and S Corps, and C Corps! Oh My!
In the mind of many entrepreneurs, there is nothing more dreaded then spending many of their key start up hours agonizing over which form of business entity is best for their new company. But like Dorothy in the Wizard of Oz, most small business owners have nothing at all to worry about if they prepare and just start down the path. (Yes, I was tempted to say "start down the Yellow Brick Road" but American classic notwithstanding, let's avoid anymore clumsy Wizard of Oz references shall we?)
The First Mistake
One common mistake for many new entrepreneurs is to select a type of business entity for their new business based off of the recommendation of a non-professional friend. Different types of businesses with different goals run by different people may not necessarily share the same type of business entity as an ideal match. When I started a company with informational websites about car insurance, for example, it would not have been smart for me to just assume that I should choose the same type of business entity as a friend's landscaping business. While it is admirable that you understand the importance of forming a business entity, it's also important to know what the right business entity is for your company.
Limited Liability Companies (LLC's)
An LLC is a beautiful thing, because it is so flexible. When forming an LLC, the members have the option to either be treated by the IRS for tax purposes as either:
- A Partnership (or a sole proprietorship if there is only one member of the LLC)
- C Corporation
- S Corporation.
If no selection is made, then the default treatment of the LLC is that of a partnership for multiple member LLC's and sole proprietorship for single member LLC's.
In addition to its flexibility, an LLC also has the added benefit of being cheap to set up, as compared to a C Corporation or an S Corporation. It is important to note that Limited Liability Companies are creatures of the state, and as such, there are some differences depending upon the state where the LLC is formed. For the most part, however, the paperwork requirements for both filing and ongoing reporting are less complicated for an LLC than for a C Corporation or S Corporation.
The last benefit to an LLC is that S Corporations and especially C Corporations have a number of requirements that tend to be characterized as simply corporate formalities. While things like issuing stock, recording stock transfers, and adopting and maintaining bylaws are all very important and serve a useful function in many large companies, chances are good that your typical small business owner is not so concerned with any of these types of things.
You have likely heard of many self-employed individuals raving about the tax benefits of being set up as an S Corporation. Technically a Subchapter S Corporation is exactly the same type of entity as a "regular" C Corporation except for that it has met certain IRS qualifications and has made a special election to the IRS (IRS Form 2553 for those of you who just love to know these types of things).
This special S election is designed specifically for small businesses, as the maximum number of S Corporation shareholders allowed by law is 75 — which is why large companies that are publicly traded are formed as C Corporations and not S Corporations. (Just imagine if Google, Apple, or some other large company in the Fortune 500 with highly desirable stock could only sell their stock to 75 people!)
While there are other differences between S Corporations and C Corporations, it is fairly certain that if you took a poll of tax professionals, they would say that the No.1 "extra special" thing about the S Corporation is its avoidance of "double taxation" that the C Corporation is subject to (which we will get to below). They would also mention the additional tax savings that are available to S Corporation owners. The IRS has stated that S Corporation owners are required to pay themselves "reasonable compensation." After paying themselves "reasonable compensation" the S Corporation owners can take distributions from the S Corporation that are not subject to FICA taxes or Self Employment taxes. The absence of these two taxes can add up to substantial amounts of money for many S Corporations.
C Corporations are the "regular" corporations used by virtually all large companies that have publicly-traded stock. One of the major benefits to the C Corporation form of business entity is the IRS allowance of certain tax free benefits (insurance, travel, etc.) that are unique to C Corporations. An additional benefit is the fact that, whether you plan to sell stock in your company to 30 or 30,000 people, the C Corporation is designed to accommodate those goals.
One of the major negatives of the C Corporation is the aforementioned issue of "double taxation." This means that the C Corporation owes federal tax on the company profit at the corporate level, and once any profits are then distributed to shareholders as dividends, the shareholders each owe federal tax on their dividends received at the personal level.
Some additional things to note about C Corporations, as compared to S Corporations, is that C Corporations can make their profits from any classification while no more than 25 percent of an S Corporation's income may be derived from passive income. C Corporations may issue different classes of stock (common, preferred, etc.), while S Corporations may only issue one class of stock.
Which to Choose?
The standard disclaimer for any and all tax information certainly applies to this article, but in this case it REALLY applies. Hopefully you have learned a few tips and some helpful things to discuss with your CPA, tax attorney, or other tax professional, but above all: Be sure to work with a qualified tax expert so that you can set your company up for success by choosing the right business entity. You will be skipping along in your ruby slippers* in no time at all!
* Sorry, I just couldn't resist!
This is a guest post by Joel Ohman. Joel is a Certified Financial Planner™ and the founder of a website for learning more than any one person could ever care to know about car insurance as well as a website for comparing insurance quotes.