Depending on the entity type, your company will have a variety of legal protections, tax treatment and paperwork requirements. These can vary widely by region and industry.
A corporation is a legal entity that has rights independent of its owners; it can sue or be sued, own property and sell the rights to ownership in stock shares. It also pays taxes and can borrow money.
C Corporations
C corporations have a lot of legal, financial and administrative paperwork to manage. These include a detailed record of shareholder meetings, detailed minutes and a comprehensive list of all owners along with their ownership percentages. Annual reporting to the state and filings are also required. Third parties like banks and suppliers are often willing to do business with C corps.
One major benefit of this entity type is that its separate legal status shields owners from personal liability if the business fails. Another advantage is its sky’s-the-limit funding apparatus, facilitated by freely transferable shares that can be sold on the stock market. Finally, C corps offer investors an array of options for reinvesting profits including dividends. C corporations also impose fewer restrictions on shareholders, unlike S corporations. This flexibility allows for greater growth potential. The only drawback is the double taxation, with a company paying corporate taxes and its owners then paying personal income tax on their dividends.
S Corporations
S corporations are a popular choice for small business owners because they allow profits to pass through to owners’ personal tax returns. However, not all companies are eligible to be S corps and there are rules that must be followed.
One major rule is that S corp shareholders must be family members, meaning spouses, children and their parents or lineal descendants. Also, the corporation must have only one class of stock, which means that voting rights are based on share ownership rather than on who owns how many shares.
Another key rule is that the IRS will scrutinize how S corp owners pay themselves. For example, if you as an owner disguise a salary for yourself as a corporate distribution, the IRS will treat it as income and may require the corporation to pay Medicare and Social Security taxes on those amounts.
Finally, if an S corp does not follow all the rules for maintaining its S status with the IRS, it may lose that status, which could result in serious penalties. However, errors such as not electing S corporation status, not observing formalities like organizational meetings or not filing required reports can usually be corrected before any issues arise.
LLCs
LLCs are a popular choice for many business deals. They offer some of the advantages of corporations, such as limited liability and pass-through taxation, while also allowing members to enjoy the flexibility of a partnership. They can also be structured to allow for a flexible management structure and profit sharing arrangement.
LLC owners can elect to have their entity taxed as a C corporation or S corporation. When they choose the latter, it allows them to hire employees and participate in company benefits programs. This is beneficial for companies that expect to make significant profits or want to grow their investor base.
Corporations have a separate life from their owners, which allows them to attract outside investors and raise funds. They are also ideal for businesses that plan to go public or sell.
Partnerships
Partnerships allow companies to reap the benefits of multiple owners’ diverse expertise and resources. A partner can be a general partner who manages and exercises control over business operations, or limited partners who make capital contributions but do not assume management duties and liability. Partnerships do not require the formal incorporation process that S and C corporations do, and their profits are taxed at a pass-through rate.
Some companies prefer partnerships for their ease of set-up, and because they are often more tax-friendly than S and C corporations. However, it is important for partners to discuss their objectives and values upfront in order to ensure that they are a good fit.
It’s also a good idea to have a clear agreement in place about profit-sharing, the role of non-operating partners and any other areas where differences may arise. Otherwise, conflicting goals or differing perspectives may erode a deal over time. Partnerships that recognize and address such differences tend to be more successful than those that do not.