C-Corp VS S-Corp VS LLC – Which Business Entity Structure Should You Choose?
Do you have a new startup or small business, you might be wondering what are the differences and advantages to incorporating your business as a Limited liability company (LLC), S corporation (S-corp), and C corporation (C-corp). Whether you’re just starting a business or thinking of changing your business structure, a common first step is comparing the LLC vs. the S corporation.
Key differences between C corporations (C-corps), S corporations (S-corps) and noncorporate business structures have profound implications on taxes and business owners’ liability. A few years ago I wrote a blog post about “choice of business entity selection” related to the 2017 TCJA reform.
When it comes down to it, looking at the difference between a C-Corp and S-Corp is a matter of structuring the business properly for tax purposes. Both business tax structures provide reduced personal liability, an important part of running a successful company. The LLC is a low-maintenance legal entity that can be used for a simple small business. An S corporation is a tax status created so that business owners can save money on taxes. A C corporation is a more complicated legal entity that’s best for startup businesses looking to raise funding capital from investors. Before we get into an in-depth explanation of the LLC vs S-corp vs C-corp, here’s a simple table cheat sheet of the three business structures and what they do:
|Protects Personal Assets
|Protects Personal Assets
|Taxes: None on Dividend ($)
|Taxes: Double ($$)
|Can’t Reinvest Profits
|Can’t Reinvest Profits
|Can Reinvest Profits
|Little Paper Work
|Some Paper Work
|Lot More Paperwork
|100 Shareholders or Less
What is an S-Corp?
An article in Fit Small Business mentions that it’s good to start with an explanation of the S-corp because the S-corp is technically not a business structure—it’s a tax status. In 1958, Congress created the S corporation, also called the small business corporation, so that smaller businesses could get similar tax advantages as a corporation, but without the double taxation.
One common thing people sometimes get is that S-corp is a business structure—it’s not. Again, it’s a tax status, sometimes called a tax designation.
To receive the S-corp tax status (whose benefits we’ll explain below), you first register as an LLC or C-corp with the state you’re primarily doing business in. Then, once registered, send Form 2553 to the IRS to indicate you’d like to tax the business as an S-corp and all the guidelines must be met. The S-corp is a designation at the federal level (IRS), not the state level. If you’re registering your business with the state, such as an LLC or C corporation, don’t be surprised if you don’t see any information about S corporations.
A Forbes article points out that the most defining characteristic of an S-corp is the so-called “pass-through” tax structure it offers. S-corps are exempt from a federal corporate income tax—instead, income from dividends is taxed only at the individual level. The tax difference is profound between individuals and companies; the tax rates for individuals may be much lower after deductions and losses are taken into consideration. This also means if shareholders can meet certain criteria, corporate losses can offset income from other sources. S-corps receive all the same protection from liability offered by corporation status as a separate entity.
A number of strict stipulations to operate as an S-corp can disqualify or disincentivize a business that might otherwise seek the status. S-corporations can’t exceed more than 100 shareholders, effectively ruling out corporations that want to go public. Ownership is restricted largely to individuals, who must also be citizens or permanent residents of the U.S., and to certain domestic trusts, estates and tax-exempt organizations. The single layer of taxation is why some businesses choose an S-corp. If you are planning on attracting investor capital, a forming C-corp has its advantages, since an S corp cannot have more than 100 shareholders, meaning it can’t go public and limiting its ability to raise capital from new investors. Another disadvantage of an S-corp is that its shareholders must be individuals (with a few exceptions) and U.S. citizens or residents. This also makes it harder for an S corp to obtain equity financing, particularly because venture capital and private equity funds tend to be ineligible shareholders. An S-corp also does not allow cannot have different classes of stock such as preferred stock, of which some investors want preferences to distributions or other privileges that an S-corp cannot provide. One final caveat of an S-corp is that in most cases it restricts their shareholders’ ability to sell or transfer their shares. That’s to make sure they don’t end up with an ineligible shareholder which will cause the IRS to terminate its S corp status. This makes it harder for the shareholders of an S corp to exit the corporation.
What is a C-Corp?
A C-corp is the most common corporate tax status. Like the S-corp, it gets its name from the subchapter of the Internal Revenue Code under which it’s taxed. Tax requirements are the key attributes that make a C-corp a C-corp and an S-corp an S-corp.
A corporate income tax is first paid by a C-corp with a federal return (Form 1120) required by the IRS. Shareholders must then pay taxes on personal income at the individual level for any gains from dividends or stock sale. This arrangement is referred to as “double taxation” because of the taxes levied on dividends at both the corporate and individual levels. C-corp shareholders are not allowed to write off corporate losses to offset other income on personal income statements.
C-corps are desirable because there’s no restriction on who can own shares. Other businesses and entities both in and outside the United States can hold ownership of a C-corp. There is also no limit to the total number of shareholders. C-corp shareholders are also afforded the full liability protections of any corporation.
With the tax advantages of the S-corp, why would anyone choose to register their business as a C-corp—especially with its double taxation?
One of the main reasons a business creates a C-corp is again, to save money on taxes—but through a different avenue. With an LLC or S-corp, all profits are paid out. With a C-corp, profits can be kept within the business.
As a simple example, if your business earns $100,000 in net profit, you could pay yourself $75,000 and keep the $25,000 within the business (also called “retained earnings”). The retained earnings are held in a separate account and are tax-exempt. C-corp has a lower maximum tax rate compared to the maximum personal tax rate that would apply to S-corps, sole proprietorships and partnerships. The 2017 tax reform act lowered the corporate tax rate to a flat 21% and eliminated the alternative minimum tax. Even with the personal income tax rates being slightly lowered, this rate is lower than the maximum personal tax rate (which is currently 37%).
A buildup of retained earnings increases a company’s net worth. For example, until COVID-19 hit, for the past five years, Apple retained around $80 billion a year in profits. One of the benefits is that the C-Corp can have an unlimited number of shareholders. This is very important if there are plans to take the company public or to bring in a greater number of shareholders in the future. An additional benefit includes that C-Corps may have multiple classes of stock, making it easier to fundraise and maintain decision control. It can keep profits in business without being taxed, the business entity will exist without the original owners still running it. A C-corp is investor-friendly since it’s easier to sell, buy, or transfer shares in order to essentially control the power each shareholder has overall. If you are not a startup looking to bring on investors, then some of the disadvantages of a C-corp include yearly board of directors meetings, double taxation (at the corporate and individual level), and more complex paperwork which will need assistance from lawyers and CPAs. So if you don’t plan on an IPO and are not looking to sell shares to more than 100 people or any other investors that are not permitted by Subchapter S., or issuing preferred stock then an S-corp can be a better way to go.
What is an LLC or Partnership?
LLC stands for Limited Liability Corporation, and it is actually a separate legal entity instead of just a designated tax status. The LLC has members instead of shareholders, and each member shares in the profits of the business. One downside of designating your business as an S corporation, compared to only an LLC, is that it does require additional paperwork. Your taxes are a little more complicated, as well. You will need to include Schedule K-1s in your business tax returns—you may need a tax professional’s assistance. LLCs straddles the border between the corporate model and the partnership model. LLCs can be taxed like a C-corp or an S-corp if so elected and owners (known as “members”) enjoy limited liability protection but are not bound to the same regulations and administrative requirements as a corporation. While LLCs are easier for small business owners to form and manage, these structures aren’t as friendly to easy outside investment.
Additionally, you will need to set up payroll with an S-corp. You need to document paying yourself a salary and also take out self-employment taxes every month. For simplicity’s sake, many business owners, such as freelancers, and solopreneurs, choose the LLC to avoid this additional work. Some companies that can work well within the limitations of the LLC format find that the low level of paperwork makes it worth it to stay as an LLC instead of converting the company. Some of the disadvantages of an LLC can be:
- All net profits are taxed
- Challenge to raise outside capital
- LLC dissolves if a member leaves
Partnerships are similar to sole proprietorships when it comes to taxes and liability but involve an agreement between two or more owners. A limited partnership (LP) or limited liability partnership (LLP) may also be considered depending on the industry and other qualifying factors. Something you may need to know is the difference between a limited liability company and a limited liability partnership (LLP). The LLP is typically for professional businesses with multiple partners that carry liability (aka can get sued), such as doctors, lawyers, and accountants.
If you’re a doctor and open a clinic with two other docs, you wouldn’t want your share of the business to be at risk because of malpractice by another doctor. An LLP separates risk among each partner—the error of one doesn’t affect the finances of the other.
What are the Differences Between a Corporation and LLC?
Both protect owners so they’re not personally on the hook for business liabilities or debts. One key difference is how they’re owned. The owners of LLCs are called members, and their ownership is divided into membership interests. Corporations have shareholders, and their ownership is divided into shares, which are units of stock.
Another difference is how they’re maintained. Corporations generally have more formal record-keeping and reporting requirements, less management flexibility, and require a board of directors. Even though LLCs are considered easier to start and maintain, investors tend to prefer corporations.
There’s no substitute for advice from licensed legal and tax professionals, but an overview of some of the pros and cons can help new and existing business owners ask the right questions about forming a corporation or electing a different corporate designation status. There is no one best option among the possible business structures and tax treatments. Choices regarding incorporation or business registration should be based on the specific situation of each business and owners should consult with legal and tax professionals during the business formation process. Regardless, it’s important to have a basic understanding of the options available and to remember many businesses evolve from one structure to the next as growth occurs. Have questions Huckabee CPA is experienced and knowledgeable at analyzing what choice of entity is suitable to meet your business needs. Feel free to reach out for a free consultation.