Which business structure you choose for your small business is an important decision from an operational and administrative perspective as well as from a legal and tax perspective. It is important to review your individual situation with the appropriate advisers. We will provide an overview of some of the most common business structures here.
A corporation has numerous advantages. A corporation is typically formed by filing articles of incorporation with the relevant state authorities. A corporation has directors, officers, and shareholders. Shareholders have a representative ownership interest in the corporation, and are able to exercise their rights by voting their shares. Directors are elected by the shareholders, and the directors appoint the officers, who manage the corporation on behalf of the shareholders. In most cases shareholders are shielded from personal liability related to the activities of the corporation. Corporations can be taxed as either a “C” corp or as an “S” corp at both the federal and state level. A C corp files its own tax return and pays its own taxes, whereas an S corp for the most part is taxed by passing its income through to the individual shareholders.
C corporation – taxation overview
Corporations, which are organized and filed under state law, can elect to be treated as either a C corporation or an S corporation for federal tax purposes. Corporations typically must have officers and directors who supervise and direct their business activities. Each corporate structure has advantages and disadvantages related to taxation and shareholder composition. We will provide a very basic overview of the C corporate structure here.
C corporation earnings are subject to corporate taxes at the federal level. A corporation must file its own federal tax return, and must pay its own taxes. Corporate taxes are levied at a progressive rate according to the corporation’s total earnings. An exception to this is the personal service corporation, whose earnings are taxed at a flat rate regardless of total income.
When corporate earnings are distributed to shareholders via dividend payments, the shareholders are taxed on the income received as a result of these dividends. As a result, these earnings are taxed twice: once to the corporation and again to the shareholder. This is frequently referred to “double taxation”, and is a major disadvantage of the structure of c corporations from a taxation perspective.
Advantages of c corporations include an unlimited number of shareholders as well as minimal restrictions related to the composition of these shareholders. This is in contrast to S corporations, which have more stringent rules. For example, S corporations can not have more than 100 shareholders, and those shareholders can only be U.S. citizens and residents, and must be natural persons.
In certain cases, non dividend distributions can be made by a corporation to its shareholders. This would occur, for example, in the case of a liquidation of the corporate assets. Such distributions would be treated as either return of capital or capital gains to the shareholder, depending on the circumstances.
S corporation – taxation overview
As discussed previously, corporations, which must be filed under state law and have both officers and directors, can elect to be taxed as either an S corporation or a C corporation at the federal level. We discussed the basics of C corporations previously. Here we will discuss the basics of S corporations and their advantages and disadvantages related to taxation, shareholder composition, and stock classification.
S corporations are considered pass through entities from a taxation perspective. Accordingly, the S corporation itself does not pay any taxes on its earnings, but instead passes those earnings (and gains) directly through to its shareholders. The S corporation must file its own tax return, however typically there is no tax due at the corporate level. As the income is passed though, the shareholders are responsible for paying taxes on their share of the income. This is a major advantage of the S corporation structure as there is no “double taxation” as is the case with C corporations.
S corporations have several disadvantages, however, mainly related to restrictions on the composition of their shareholders and classification of their stock. An S corporation can have a maximum of 100 shareholders, and these shareholders can only be natural persons who are U.S. residents. A married couple would count as a single shareholder. Additionally, S corporations can only issue one class of stock, and economic interests must be allocated proportionally in relation to ownership interest. Voting rights may be allocated disproportionately, however.
Limited liability company (“LLC”)
A limited liability company is a business structure which is comparatively simple and easy to administer. Limited liability companies are formed by filing articles of organization with the relevant state authorities. LLC’s have members who possess ownership interest in the LLC, and managing members supervise, manage, direct and operate the LLC. In general, LLC formation and administration is less complex than that of a corporation. The simplicity of formation and administration and flexibility of tax status are some of the main advantages of the LLC structure. LLCs must elect whether to be taxed as a C corporation, S corporation, partnership, or sole proprietorship (in the case of a single member LLC).
Limited liability companies typically utilize what is known as an operating agreement to designate the ownership structure and relationships between members as relates to capital accounts, earnings and management of the LLC.
The main disadvantages of the limited liability company structure as compared with a corporate structure relates to the entity’s lifespan as well as issues related to raising capital. For example, a corporation will continue in perpetuity upon death of one of its shareholders, while an LLC will typically be dissolved. Corporations, in particular C corporations, are advantageous for raising capital in that their shares can be registered and the company can become publicly traded. This is typically not the case with LLC membership interests.
Another advantage of a limited liability company when compared with an S corporation relates to shareholder composition. An S corporation has numerous restrictions on shareholder composition as relates to the number of shareholders and the nature of those shareholders. An LLC, on the other hand, has few of such restrictions. LLC shareholders can be unlimited in number and can be individuals, corporations, partnerships, and other LLC’s.
A partnership is a business arrangement where the individuals or entities involved share in the profit and loss of the business. Unlike a corporation, and depending on the particular structure of the partnership, partners may or may not have liability related to the business activities. Earnings and other gains are typically passed through to the partners who are then responsible for reporting these gains on their individual tax returns. Similarly, expenses, assets and liabilities are assigned to the partners.
A major advantage of a partnership is that the income passes through to the partners and is thus taxed only once. This is on contrast to a c corporation which, as discussed previously, is subject to taxes once at the corporate level and again at the shareholder level, resulting in “double taxation”.
In one structure, known as a limited partnership, there are two types of partners: limited partners and general partners. Limited partners do not actively participate in the business activities of the entity and are not liable for the activities of the partnership to any extent that exceeds their ownership interest. General partners are typically responsible for managing the business activities of the entity and are subject to liability. This is in contrast to an LLC, where both the managing members and non managing members are typically protected from liability in most cases.
There are other partnership structures, including limited liability partnerships and general partnerships, which will not be discussed in detail here.
A sole proprietorship is a small business structure where the business owner has no legal entity to separate his/herself from the business. The business is operated under the business owner’s name or a trade name and the business owner is personally responsible for the debts and obligations of the business. This is in contrast to a corporation or a limited liability company, which is separate and distinct from its shareholders or members and typically provides some amount of liability protection to the owners and operators.
A sole proprietorship may or may not have its own employer identification number (EIN). As EIN is required in certain circumstances, for example where the proprietor wishes to hire employees.
While a proprietorship may have a trade name, such a name does not create any legal distinction between the business owner and the business.
Due to its being indistinguishable from its owner, a proprietorship does not file its own tax return. Instead it typically reports business income and expenses on schedule C of the business owner’s personal tax return.
The main advantage of a sole proprietorship is simplicity and ease of formation and administration, while its main disadvantages are lack of protection from liability as well as limited ability to raise capital.