When creating a business, the owners must first decide what type of business they will make.
There are six major types of corporations recognized by most states: C-Corporation, S-Corporation, Non-Profits, Limited Liability Company (LLC), Sole proprietorship, and General Partnership.
Each type has different benefits and limits on what kind of personal assets may pay business debts.
How does your type of corporation or entity affect your business?
When determining the type of business entity you would like to create; several different factors must be considered:
- First and foremost is your level of liability. If you take personal assets and utilize them in a company operation, will those assets be protected from debts and liabilities incurred by the company? There are many business entities where the owners or shareholders may lose all purchases if obligation or liability cannot be paid. Choosing between S-Corporation and C-Corps is essential because each has its benefits but protects certain assets more than others.
- Another consideration is operating flexibility. If you use your business as an LLC, sole proprietorship, general partnership, or non-profit organization, there aren’t many restrictions on management authority, unlike a corporation.
- Tax deductions and tax rates are other factors that must be considered when choosing a type of business entity. C-Corps have the highest tax rate and can take many more deductions than other entities. S-Corporations have lower tax rates but cannot take as large several deductions as a C-Corp can. However, LLCs may not take any deductions at all for operations. This must be taken into consideration when filing your taxes each year with the IRS.
- Finally, choosing between an S-Corp and an LLC is important because they both offer different benefits as far as double taxation is concerned.
Choosing the proper type of business entity is essential for all businesses. The type of business you create will determine which benefits and limits you have.
It is recommended to consult with a professional when choosing to ensure proper protection and flexibility for your company.
Types of Incorporation
S corporations are corporations that elect to be taxed as if they were partnerships. They still enjoy limited liability like a regular corporation but are taxed similarly to an LLC, in that the income “flows through” to shareholders for tax purposes.
An S corporation can be formed in any state by filing articles of incorporation with the secretary of state and paying a filing fee.
The process takes approximately three to five weeks, although expedited service may be available for an additional fee.
An S corporation has only one class of stock, although there are no restrictions on the number of shareholders. The shareholders of an S corporation are not liable for any debts or liabilities of the company, which makes it similar to a limited liability company (LLC).
An S corporation may have non-resident alien shareholders, but resident aliens may not own stock unless they obtain special permission from the IRS.
c) Business operations:
An S corporation must abide by all state laws that apply to regular corporations while also maintaining its status as an S corporation with the IRS. Directors and officers are appointed in the same manner as a traditional corporation, and shareholder meetings must be held at least annually.
An annual report must be filed each year with both state and federal agencies after the annual shareholder meeting.
An S corporation files a federal corporate tax return on Form 1120. After filing, the corporation then pays its share of Social Security and Medicare taxes considered deferred from the previous year.
Shareholders are taxed individually on any dividends they receive from the company and also pay a capital gains tax when selling their stock. An S corporation is a pass-through entity, meaning that all business income or loss “flows through” to shareholders for inclusion on their personal tax returns.
2. C corporations
C corporations have many tax benefits. One of the most significant being the ability to take large deductions for start-up costs, acquiring personal assets and equipment, etc. This is an incentive to incorporate because, after incorporation, expenses incurred are deductible up to the amount of the corporation’s taxable income.
The bad news? C corporations have no limits or restrictions on how much shareholders can be taxed for owning stock in a corporation that operates a business.
The legal requirements necessary to form a C corporation are generally determined by the laws of the state in which it is formed. Generally, initial owners must draft articles of incorporation stating the name of the corporation, how many shares will be authorized for issuance, and its business purpose.
Then, shareholders may meet to establish bylaws that create officers’ positions and set forth other governing rules for corporation operations.
b) Business operations:
A C-corporation is managed by directors who decide what products or services will be offered, how they will be priced, etc. Corporations usually have several meetings each year during which directors make decisions about daily business affairs – while officers operate day-to-day tasks required to keep things running smoothly.
Shareholders are not actively involved in company decision-making and typically receive minimal notice of board and shareholders’ meetings.
A C-corporation is a separate business entity; it files an informational federal corporate tax return on Form 1120 and pays taxes at the corporate level. After filing, the corporation then pays its share of Social Security and Medicare taxes considered deferred from the previous year.
Shareholders are taxed individually on any dividends they receive from the company and also pay a capital gains tax when selling their stock.
3. Non-profit corporations
Non-profit corporations are formed under state law to create a separate legal entity that allows for certain tax benefits and exemptions from federal income taxes.
Depending on the requirements of your proposed non-profit organization’s purpose, any number of people may assemble to form a non-profit organization. Each state establishes its own laws regarding what will constitute an acceptable purpose for establishing a non-profit corporation and these vary widely among states.
You should check with your state office of corporations or secretary of state to determine if your intended business activities are allowable in your state. After completing the initial formation process, you must file articles of incorporation with your Secretary of State’s office along with any required fees, application forms, etc., which are often available online.
b) Business operations:
The board of directors, members, or trustees have the primary responsibility for policy decisions. Generally, a non-profit corporation must make available its Articles of Incorporation and Bylaws to the public upon request.
Non-profit corporations are tax-exempt under Section 501(c)(3) of the Internal Revenue Code. To obtain tax-exempt status, an application must be filed with the IRS (Form 1023), along with any required filing fees that typically range from $500 – 1,000.
In addition to federal income tax exemptions, many states grant similar exemptions from state corporate franchise/income taxes and sales/use taxes at both the state and local levels.
4. Limited liability companies (LLCs)
Limited liability companies are relatively new business forms that have gained popularity over the past few years. The benefits of forming an LLC are derived from having both limited liability protection for its owners (members) as well as being taxed as a partnership, which allows profits and losses to pass through directly to its members.
You can register your LLC with the Secretary of State, usually by filing articles of the organization along with any required registration fees. Your articles must include:
- name of the LLC;
- address of its principal office;
- number and type of members;
- duration if not perpetual;
- business purpose;
- name and address of agent for service of process.
b) Business operations:
Ownership interests in an LLC are called “members” instead of shareholders or partners. Members decide on business matters by voting on issues that come before them at meetings or through ballots sent to every member’s mailing address. A single-member LLC generally operates as a sole proprietorship so long as the owner maintains his or her own personal assets separate from the LLC’s.
An LLC may be classified for tax purposes as a partnership, corporation, or sole proprietorship, depending on the number of members and other factors. Although an LLC is not a separate taxpaying entity like a corporation, it must file Form 1065 with the IRS each year, which shows each member’s share of the LLC’s income, deductions, and tax credits.
5. Sole proprietorships
A sole proprietorship is a business owned and operated by one individual. The sole proprietors should be identified on the front of checks (by name or business name) used to pay personal expenses.
A sole proprietorship can be formed through registration with your state’s Secretary of State office, filing for a fictitious name permit, or by operating under an assumed name. The legal requirements are usually minimal when compared to corporations or other business forms.
b) Business operations:
Generally speaking, the only formalities necessary for a sole proprietorship are keeping simple records of financial transactions performed in connection with the business activities that may include but are not limited to accounting journals/ ledgers, bank statements, receipts, invoices, paid bills, etc.
Sole proprietorships are not required to file an income tax. However, you may choose to file Schedule C with your annual individual 1040 tax return reporting profits and losses from the business.
Members of an LLC who work for the LLC may receive “guaranteed payments” or allocations of profits for services rendered to the LLC. These individuals will receive a Form K-1 which is used to report guaranteed payments received by members on their individual 1040 returns as compensation rather than self-employment tax (Schedule C).
6. General partnerships
A general partnership is a business owned by two or more individuals who share in the management and profits of the business. All partners, regardless of how many shares they own, have equal rights to participate in the control and management of day-to-day business decisions and receive an equal share (percentage) of the profits.
The legal requirements necessary to form general partnerships are minimal as compared to corporations or limited liability companies. However, it’s important you choose a name for your partnership that includes “Partnership” or “P.L.L.C.” so creditors and others know it’s not a corporation or another type of entity that limits personal liability for its owners/members/partners.
b) Business operations:
Partners in a general partnership share the authority and responsibility for making business decisions. Decisions concerning the day-to-day operation of the partnership are often made by a majority vote of the partners whose percentage interest entitles them to that decision-making power.
A general partnership does not pay taxes on its income; instead, each partner is taxed directly on his or her distributive share of taxable income from the partnership (Schedule E), regardless of whether it’s actually distributed.
How to Choose the Best Legal Structure for Your Business?
A lot of factors are involved in determining which type of business entity is right for your startup. However, if you keep the following questions in mind when deciding what structure is best for your company, it’ll help you narrow down the options:
- Who are the owners/investors?
- How much control do investors have over company operations?
- What level of risk are they willing to take on?
- How will corporate profits be distributed?
- How many people will work for the company? What positions do they hold (e.g., CEO, CFO)? What roles do outside professionals play (e.g., accountant, lawyer) and how much authority do their positions carry?
- How much liability are the owners/investors willing to accept?
- Are all agreements, plans, and company records kept in writing?
- What are the long-term goals of the business?
- Will it be easier to acquire outside investment capital after being an LLC or corporation for a few years?
- Given your answers to these questions, what legal structure best fits your needs now and will continue to meet those needs in the future.
Keep in mind that no one type of entity is right for every situation. This is why there are several options available from which you can choose. For example, if you’re planning on operating as an Internet business where your customers won’t be able to see what type of entity you are, choosing a business structure with limited liability provisions may not be as important.
However, if the opposite is true and you’ll be selling your products and services to businesses (B2B), you may want to consider incorporating or forming an LLC because of the liability protection they offer.
After deciding what type of business to start, the next step is to choose legal business structures. There are several to choose from and each one has its own benefits and drawbacks depending on your specific needs as an entrepreneur.
It’s important that you take these factors into consideration before making your final decision. This way, you won’t regret later not having made the right decision for yourself and your business because you failed to consider all of the different aspects involved in creating your company.