Should I opt for an LLC? Or would an S corporation suit my needs better? What about the C corporation?
These questions are asked so often by entrepreneurs. That’s because many start out as either sole proprietors or in partnerships, and there comes a time when it’s appropriate—and more beneficial—to establish a formal entity structure for a small business.
Let’s briefly explore the 3 main types of business entities, along with which ones make the most sense for certain types of business owners.
Limited Liability Company (LLC)
An LLC is one of the most common business entity structures. That’s primarily because it is designed to protect everyone involved in the business, along with personal asset protection for all members. This means if the company gets sued, all personal assets of those in the company will be protected.
In terms of taxes, you can choose how to have the IRS tax your LLC. By default, single-member LLCs are taxed directly like sole proprietorships, while LLCs with multiple members are treated like partnerships by the IRS. So, to reduce your tax liability as an LLC owner, you can choose to structure your business as either an S corporation or C corporation. It will always be an LLC, but as far as how it pays taxes, you can select either of these tax structures for the LLC by making an entity classification election.
So, who should set up an LLC? In general, because of the limited liability protection at play, an LLC is typically the best choice for entrepreneurs looking for added protection of their personal assets. This may include those who are more at risk of lawsuits and judgments against a business. For example, if you operate a brick-and-mortar retail store or an on-demand service in which you deal directly with your customers, an LLC may make the most sense for your small business.
The Subchapter S corporation is another popular business entity formation with unique benefits for a good number of self-employed professionals.
As for tax requirements, S corporations are considered pass-through business entities by the IRS. This means that all taxes, deductions, credits, and losses within an S corp pass directly through to the personal tax returns of the company’s owners. This eliminates the need to be concerned with corporate income taxes.
Since the owner of an S corp can be treated as an employee and paid a reasonable salary within the business, this entity is advantageous in terms of cutting self-employment taxes. In an S corp, FICA taxes are withheld and paid on the money an owner takes as a salaried employee. In turn, corporate earnings after payment of the salary can be treated as unearned income that is free from self-employment taxes.
It’s also worth noting that S corps have a few more restrictions on them than other entities. For instance, an S corp is limited to 100 shareholders and is responsible for certain reporting of business activities in filings to the IRS.
An S corporation is often the best choice for 1099 income earners. This income may come from one source or from multiple companies with which an entrepreneur provides services as an independent contractor. S corps can work well for home-based business owners or freelancers who do not have as much direct contact with their customers or don’t have a separate store or office location with lots of overhead expenses.
The C corporation is a completely separate business entity, unlike a pass-through business structure that is tied directly to an individual. Since corporations are legally separate business entities, they incur taxes at the corporate level and, thus, are on the hook for corporate income tax rates. Corporate taxes are assessed on the profits of a company.
In addition to coming with a unique corporate tax structure, corporations offer other benefits like an indefinite existence, ownership flexibility, free ownership transferability, and liability protection.
C corporations are often the entity of choice for businesses that plan to go public, along with larger firms with hundreds or thousands of employees. This is why going from a sole proprietorship or partnership to a C corporation is less common. Many business owners will convert an LLC or S corporation into a C corporation after substantial business growth over time.