Creating LLC’s, S Corps, and C Corps

When starting a business, there are a few different ways to form an entity. The type of entity a business forms is based on how their business is set up to operate, who is involved and what type of tax treatment the business desires. Deciding which business entity to form is an important step to start a business and entrepreneurs need to understand pros and cons of each type of entity.

Sole Proprietorship

If you do not officially register your business; it is by default a sole proprietorship. Business owners who choose to stay a sole proprietorship generally have a very low-liability business (very unlikely to be sued) and a small operation. However, this is generally a bad idea.

This is a bad idea because if anyone were to ever sue the business, the business owner’s individual personal assets subject to any judgment against the business. This means that if a judge rules against your business, then the judge could order the liquidation of personal assets or garnish wages to pay damages. Not only would the business be destroyed, but the owner too.

Because of this, registering your business as an LLC or corporation is a vital step in protecting yourself. On top of this, depending on the scale and size of your operations, the different ways of registering provide advantages in other areas such as taxes.

This article will cover three popular options among businesses that you should consider.

3 types of businesses to form

LLC’s

An LLC is the most basic and easy way to register your business. It is low maintenance and likely the best option for smaller businesses not looking to scale operations.  They provide solid personal asset protection, need less paperwork, and can bring on unlimited members. In this sense, they are almost a hybrid between a sole proprietorship and a corporation.

However, there are also many downsides that come with LLC’s, especially if your business is a larger operation. For starters, all net profits of the business are taxed. These profits are subject to all state and federal taxes like social security and Medicare. Because of this, as a business grows and net profits climb, many LLC’s often end up paying significantly more taxes than their corporation counterparts. On top of this, the salaries of an LLC are also taxable.  

Along with the heavier tax burden, LLC’s are generally unfavorable for those looking to scale their business by bringing on investors as they make is challenging to bring on outside capital. This is compounded by the inconvenient fact that an LLC dissolves completely if a member leaves the business. This doomsday button looms large over any potential investors’ interest in the business.  Because of these challenges, many small but growing business decide to form as an S-Corp instead.

S-Corps

The S-Corp while a popular tactic is technically not a business structure. It is a tax status or tax designation that was created by congress in 1958 to encourage small business growth by affording them the same taxation status as a full-blown corporation.

S-Corps allow a business to technically file as an LLC but avoid the double taxation discussed above and carry it over as a tax-free dividend. A dividend is just any money that is left over after paying yourself a reasonable salary.

Let’s say your business makes a gross profit of $100,000. If you pay yourself a salary of $80,000, then your business would have a $20,000 tax free dividend left over that is paid out. In the same situation with an LLC, your business would pay the tax on your salary and the left-over dividend as well. Again, filing as an S Corp makes sense if your business is small but growing at a regular rate.

However, there are a few downsides to filing as an S-Corp. For starters they require ore paperwork including the filing of Schedule K-1s in your business tax returns. Along with this, you are also required to set up a payroll system where you document paying yourself a salary and deduct self-employment taxes each month. For many freelancers or small businesses whose profits do not equal more than a regular salary, this paperwork is not worth the headache as no dividend will exist.

If you file as a corporation and declare S Corp status, S corporations are limited to 100 shareholders who must be U.S. citizens or residents.

C-Corps

C-Corps have their own tax advantages and are best suited for businesses that are looking to expand their operations and investors. In an LLC or S-Corp, all monthly profits are paid out immediately. However, with a C-Corp, profits can be kept inside the business as retained earnings that can be invested into capital or other avenues of growth. These retained earnings are held inside of the company and are tax exempt. Building up retained earnings obviously makes your business more valuable and attractive to investors. C-Corps also have no limit on shareholders (including their nationality) and will continue to exist even if the original owners exit the corporation.

Like the LLCs and S-Corps, C-Corps come with their own distinct set of disadvantages. They are subject to double taxation on the corporate and individual level unlike S-Corps. They also require much more paperwork and organization including yearly recorded meetings of the board of directors. Because of this extra paperwork and organization registering as a C-Corp is often much more expensive as it requires the expertise and assistance of CPA’s.

What to Do

If you are planning on forming a business, whether as an LLC with an S-Corp status or as an investor-ready C-corporation, it is wise to hire a local business attorney who can help guide you through your options. At Tyler Law we advise many clients on these matters and would love to assist you and your business.