Corporation Types: Everything You Need to Know
Before forming any business entity, you need to research and decide on the designation that makes the most sense for your business.3 min read
The different corporation types are important when going into business. Before forming any business entity, you need to research and decide on the designation that makes the most sense for your business.
A corporation is an entity established legally under state jurisprudence with the intention of protecting the assets of shareholders/owners from any claims of creditors. A C Corporation may have an unlimited number of shareholders, and any earnings distributions and profits are treated as dividend under the U.S. tax code.
Once you incorporate your entity, you will automatically become a C corporation. A C corporation is structured in a manner that separately taxes the corporation rather than its shareholders/owners. C Corporations have greater flexibility to disperse earnings from the business between the corporation and any of its shareholders/owners. Many smaller corporate entities will not opt to form a C corporation given this tax treatment. However, a majority of larger companies are incorporated as a C corporation under the federal income tax provisions.
Upon filing your incorporation paperwork, your entity may elect to become an S corporation by simply filing the required paperwork with the IRS and state taxation department. By becoming an S corporation any profits, losses and other tax related items will pass through your corporation for reporting by you on your individual tax return form. The S corporation will not be subject to taxation. More simply, S corporations are formed to allow entities to pass through any:
- Earned income
- Incurred losses
- Deductions taken
- Credit earned
to their corporate shareholders under the federal tax code. This form of taxation closely resembles that of a partnership.
Who Should Consider an S Corporation?
An S corporation may be the preferred mode of incorporation for your entity if you would like to avail yourself of the benefits that forming a corporation provides, while also allowing your entity to benefit from all the advantages of pass-through taxation.
S corporations can also take advantage of certain desired accounting methods. Generally, corporations are required to follow the accrual accounting method unless the corporation is small enough to have gross revenue of less than $5,000,000. Additionally, S corporations without inventory do not need to use the accrual accounting method.
Limited Liability Company
A LLC is a type of business formation available under state law that allows you as the owner to protect yourself from personal liability. Tax-wise, an LLC is similar to an S corporation with business income and expenses reported on your personal tax return. It should be noted that if you are the sole owner of an LLC, the tax code will view you as a “disregarded” entity. As a “disregarded” entity you must report income and expenses of the LLC on the Form 1040 (Schedule C), which happens to be the same form used by sole proprietors.
Advantages and Limitations of LLCs
Members of an LLC are classified as self-employed and are required to pay Social Security and Medicare taxes. Generally, these taxes are paid through self-employment taxation on the net income business share of the member. In addition, limited liability provides the LLC member with personal assets protection. Moreover, LLCs allows members greater flexibility in all aspects of organization and management of the LLC. Lastly, LLCs are able to avoid the ownership restrictions imposed upon S corporations, which makes them ideal structures preferred by foreign investors.
Disadvantages of LLCs
Generally, LLCs have a limited life expectancy (typically the life expectancy will not exceed 30 years in most states). In addition, several states will require a minimum of two members to form a LLC. LLCs, which are not corporations, cannot issue stock and therefore cannot offer the benefits of stock ownership.
Forming a Corporation or LLC
Formation documentation, Articles of Incorporation or Articles of Organization, must be filed with the appropriate state agency whether you choose to incorporate your business as a corporation or a LLC.
C Corporations Taxation
C corporations are set up as separately taxable entities that must file a corporate tax return to report any profits or losses. C corporation profits are taxed at the level of the corporation, while losses cannot pass through to offset other taxable income of the shareholders. In addition, C corporation profits are subject to possible double taxation during shareholder dividend distribution.
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