Taxation, liability, regulations and more
Starting a new business is exciting and there are many things that run through your mind. One important aspect that might not, however, is what type of business entity you should form as. The rules are different, the taxes are different, and it makes a difference – so we’re going to take you on a tour of each of the four business entity types to cover what each one represents and the key factors that you should consider. Buckle up!
The Limited Liability Company (LLC)
LLCs are by far the most popular type of entity and are extremely beneficial for small businesses. The setup is quick and easy, they have a simple business structure, and perhaps most importantly, they are usually inexpensive to get going. In addition:
- They are easier than running a C-Corp or S-Corp
- They have fewer rules, regulations and legal compliance issues
- They are formed and regulated on a state level
Just like C-Corps and S-Corps, LLC owners are protected with limited liability. This means that business assets are owned by the company itself. As an owner, your personal assets are not affected by any liability that your business incurs (debt, equipment costs, depreciation, lawsuits, etc.).
When it comes to taxes, LLCs are similar to sole-proprietorships and partnerships. An LLC doesn’t pay federal income taxes itself, but instead any net profit or loss is passed through to the personal tax returns of the owner(s). The IRS then taxes this as personal income.
LLCs themselves are liable for specific types of taxes so it’s crucial to have your paperwork in tip-top shape. These taxes are typically written off as business expenses and don’t actually affect your personal bottom line. If you’re considering forming an LLC, here’s what we’re talking about:
- Payroll tax on salaries paid to employees (not you – owners pay self-employment tax on their personal tax returns)
- Sales tax on goods purchased by and for the business
- Property taxes on property that the business owns
The C-Corporation (C-Corp)
On the other end of the spectrum, we have the C-Corp which is the most formal type of business entity. These are larger companies with many moving parts that issue stock. They are regulated at a state level and formed by filing “Articles of Incorporation” with the secretary of state within the state of incorporation. These are the details:
- A C-Corp must have a board of directors and hold an Annual General Meeting
- A C-Corp has limited liability, so the investors and owners of a C-Corp are not generally liable for business debts or other liabilities Ownership of a C-Corp is determined by who owns stock in the company
- C-Corps MUST issue stock, and these stocks can be bought and sold on a public stock market if the C-Corp holds an Initial Public Offering, or “IPO”
- These companies can raise more finances by issuing stock
- The ownership can be fluid and transferred depending on who holds stock at a particular time
- C-Corps must meet numerous rules and regulations
- C-Corps file corporate tax returns and pay taxes on their profits unlike LLCs and S-Corps, so money earned may be subject to double taxation. This means that shareholder dividends have personal income tax deducted even though the C-Corp itself has already paid taxes on its annual earnings.
Here’s what C-Corporation tax rates look like at a glance:
Up to $50,000
50 000-75 000 USD
75 000–100 000 USD
100 000 - 335 000 USD
335 000–10 000 000 USD
10 000 000 - 15 000 000 USD
15 000 000 $ - 18 333 333 $
More than $18,333,333
The Subchapter or Small Business Corporation (S-Corp)
S-Corps are similar to C-Corps as you may expect, but they’re a little simpler and easier to run. They are formed at a state level and were enacted into law in 1958 to encourage the creation of small and family businesses – without the double taxation element. That sounds great, right? Here are some of the conditions and qualities of an S-Corp:
- Owners and investors have personal liability that is separate from the S-Corp’s liability, and the owner’s personal liability is limited to the value of their investment (same goes for investors)
- The owners aren’t personally liable for business debts, claims, or other liabilities
- Compared to an LLC, there are more legalities, rules, and compliance requirements for an S-Corp
- The corporate structure is more complex
- S-Corps are capped at 100 shareholders and cannot exceed this limit
S-Corps don’t need to pay corporate income taxes like C-Corps do. S-Corps fall under a different designation with the IRS that is similar to that of an LLC. The net profit or loss generated by an S-Corp will flow through to the owners and shareholders who will file personal returns and pay income tax on these amounts.
Now, if you form an LLC, you can choose to be treated as an S-Corp for tax purposes. This results in the best of both worlds to an extent:
- The rules for LLCs are less of a burden than the rules of an S-Corp
- There may be advantages to being taxed as an S-Corp with regards to owners and members taking money out of the business
- You can choose to pay yourself a modest salary and deduct anything above that amount as share dividend income – income that isn’t reduced by self-employment tax,but personal income tax instead.
The Nonprofit Corporation
Nonprofits are exactly what they sound like – companies that don’t intend to profit but are working to achieve a specific goal that’s of public interest. This means that any revenue generated by Nonprofits goes straight to that goal. They are still allowed to create profit through their efforts, but that profit must go towards the preservation and expansion of the corporation. Nonprofits have the same rights and privileges as other business types as a legal entity is still being formed at a state level.
Nonprofit corporations are exempt from federal, sales, and property taxes. They still need to pay payroll taxes, though, and can be taxed if they make money from activities that aren’t related to their main goal. To get this sort of tax treatment from the IRS, the majority of Nonprofit corporations will file a 501c3 form.
A Word to All the Sole Proprietors and Partners
Right now, your business is really just you (and your partners if you have any). The IRS sees you as an individual, so any revenue that your company generates is essentially personal income that is taxed normally. When you form a legal business entity, you separate your company from yourself and any partners and remove the liability that comes with typical business operations. Think of it this way; if someone wanted to file a lawsuit against your business, they would be filing it against you if you are a sole proprietor. Any loses that your company takes are your losses.
Which Entity Type is Right for Your Business?
Forming a legal business entity separates you from your business and there are significant perks that come with doing so. For homework, take the Business Type Quiz to determine the best entity option for your new company. We’ll then provide some tailored information based on your results!Take Our Business Type Quiz