Nearly every business owner eventually decides to incorporate their business. After all, corporations are the gold standard when it comes to building a business structure that protects both the business and its investors. In corporate parlance, that protection is called the “corporate veil,” legalese for the separation between the two entities.
There are many benefits to incorporating. Corporations provide owners and investors limited liability protection, meaning an owner or investor’s personal assets can’t become tied up in the business and put in jeopardy, should something go awry. It allows a business the flexibility to offer stock in the company to finance the business. And a “C” corporations provide entrepreneurs with the most financial flexibility, meaning almost anyone can be a shareholder in the company.
The real question a business owner contemplating incorporation needs to answer is “What type of corporation do I want my business to be?” Here are three of the most popular corporation types, including both their pros and cons.
3 Most Popular Corporation Structures
The three most popular corporation structures are C corporations, S corporations and limited liability companies, or LLCs. For the most part, size matters when this decision is made. Larger organizations will likely become a C corporation while smaller firms will form an S corp or LLC. So what’s the difference?
- The C Corporation
As we said before, larger companies will most likely be C corporations. There is typically more paperwork involved when a company decides to be a C corporation, in part because C corporations are doubled taxed.
How so? First, the organization’s income is taxed at corporate rates. Then, once dividends are distributed to shareholders, those dividends are taxed, as well. This is because dividends are considered income once they make it to individual shareholders. Smaller firms who decide to become S corporations avoid this.
- The S Corporation
Taxation on dividends isn’t an issue. Neither is self-employment tax for the business owner. Once the company incorporates, the owner can draw a salary like a normal employee.
Not only that, but an S corporation can be made up of a single employee – the owner. And all the owner needs to do to satisfy the federal government is to submit a standardized letter to the U.S. State Department each month and pay taxes every quarter. Some business owners will choose to hire an accountant to make sure these tasks are completed accurately.
S corporation owners can also elect a board of directors, if they choose. Who should those people be? Well, they can be anyone the business owner chooses – including the owner themselves. Most S corporations will select a board that will help the business grow – advisors, mentors and experts who believe in the organization’s mission and have the time to serve.
- The Limited Liability Company (LLC)
Some smaller companies, particularly those with one or two employees, will choose to become an LLCs. An LLC is a lot like an S corporation, save for one big difference: how the IRS treats distributions, which is IRS parlance for profits. When you run an S corporation, you pay yourself a reasonable salary out of company profits and then receive any excess profits at the end of the fiscal year through distributions.
The benefit is that those excess distributions, or profits, aren’t subject to self-employment taxes. That’s not the case if you own an LLC. But the IRS does give you the opportunity to ask for your LLC to be taxed as an S corporation. You need to fill out the right forms and submit them before the deadline in order to take advantage of this benefit.
LLCs also deal with less paperwork, save for an annual K-1 statement. This lets the IRS know what your share of the LLC’s income and expenses are. That’s transferred to your 1040 and taxed like income.
Incorporating your business is a big step, but often a necessary one with a number of benefits. The only decision you need to make is which corporation type best fits your business. A little research and maybe a chat with an expert can help you decide.