Brief Overview of Organizational Forms
Note regarding C Corporations versus S Corporations:
With some limited exceptions the S corporation is not taxed at the corporate level. Instead it is permitted to pass income and losses through to its shareholders who report the income on their federal tax returns. A business must meet certain eligibility requirements to qualify for incorporation as an S corporation. S corporation status is established under federal income tax law and, therefore, is not necessarily available for purposes of state income tax law.
So, how do you determine whether a C corporation or S corporation is best for your business? You should consult with your tax advisor about the best tax election for your business, but here are some common situations that may also factor into your decision:
A "C corporation" might be the right business type for you if:
- you may need to finance your business operations through venture capital.
- you want flexibility to spread the business earnings between the corporation and shareholders for tax-planning purposes.
- you want flexibility to set salaries for employees/owners to minimize Social Security and Medicare taxes.
- you want flexibility to provide (through the corporation) substantial health and medical benefits and other fringe benefit programs for things like education, life insurance, and transportation costs.
- you want flexible profit-sharing among owners.
- you want to be able to easily sell your business.
- you want to be able to offer stock options to employees.
- you prefer to lower your risk of IRS audit exposure (there is a higher audit rate for business income that is reported solely on Schedule C of Form 1040).
An "S corporation" might be the right business type for you if:
- you want to take advantage of benefits that the corporate business type holds, but you want to take advantage of pass-through taxation.
- you want flexibility to set salaries for employee/owners to minimize Social Security and Medicare taxes.
- you desire flexibility with respect to accounting methods (corporations must use the accrual method of accounting unless they are considered to be a small corporation, meaning they realize gross receipts of $5,000,000 or less; S corporations typically don’t have to use the accrual method unless they maintain inventory.
- you want to lower the risk of IRS audit; S corporations file an informational tax return (Form 1120 S) and there is a lower audit rate than for business income that is reported solely on Schedule C of Form 1040.
Limited Liability Company
An LLC might be the right type of business for you if:
- you want management flexibility, since LLCs offer more flexibility than corporations in terms of how the management of the business is structured.
- flexibility for accounting methods is desired, because LLCs are not required to use the accrual method of accounting as C corporations typically are.
- your business may own real estate.
- you wish to minimize ongoing formalities; unlike corporations, which are required to hold annual meetings of directors and shareholders and keep detailed documents and records for all corporate meetings and major business decisions, LLCs do not have strict ongoing meeting and documentation requirements.
- you want flexibility for sharing profits among owners.
Importantly, A general partnership offers no liability protection to the partners. Each partner is personally liable for the partnership's debts and all the partners are liable for debts and obligations resulting from the wrongful acts of another partner if that partner acted in the ordinary course of partnership business or acted with the authority of the other partners.
Limited Liability Partnership
Choosing Your Business Structure
The management and control of the business is another big consideration. Corporations are not actually operated by the owners (shareholders) of the business. Instead, the shareholders elect a board of directors and officers to manage and control the business. By contrast, the partners in a general partnership have complete control over business operations, as does the sole proprietor. The general partners manage a limited partnership, and an LLC may be managed either by its members or by managers selected by the members.
Personal liability for the obligations of the business is critical. The protection of the owner's personal assets from the claims of business creditors is generally not available to a general partner in a limited partnership, all partners in a general partnership and the owner of a sole proprietorship. In these business forms the owners are all subject to unlimited personal liability for the debts of the business. This means that the owner's personal bank accounts, investment accounts, real and personal property and other assets are at risk.
Because different organizational forms are taxed differently, the tax consequences of the chosen organizational form should be explored. As a separate entity, the C corporation is subject to what is known as "double taxation." First, the corporation pays income tax on its earnings. Then, if the corporation chooses to distribute its after-tax income to the shareholders in the form of dividends, the shareholders must pay tax on that income as well. The same income is taxed twice at the corporate and at the shareholder level. Money passing through partnerships, limited partnerships, limited liability companies and S corporations are not taxed as separate legal entities. Instead, the profits and losses of the business flow through to the owners themselves. There are many other factors to be considered, such as, how the owners will be compensated, whether benefits will be offered to owners and employees, whether there will be more than one class of stock, and, whether there will be restrictions on the transferability of ownership.
As a small business owner and a business attorney, Jeana Morrissey has the experience to help you sort out these factors and form your business entity. Contact us today by email or by phone at (602) 556-1902.