Learn about the different corporation types and their advantages and disadvantages for your small business.
Many small business owners consider incorporating their business, and for good reason. From tax benefits to name protection, there are many benefits to incorporation.
There are five types of corporations you can choose from. When you’re trying to figure out which one fits your business the best, consider the following questions:
- To what extent do you need protection from legal liability?
- What form of taxation fits your individual situation and the goals of your business?
- How much are you willing to spend on the formation and administration of your business?
- How much flexibility in ownership structure do you and your business partners need?
- Will you raise capital or need a bank loan?
Consider what your business might look like in 3-5 years. The advantages of some business structures might turn into disadvantages down the line.
Let’s take a closer look at the five types of incorporation for small businesses.
C corporations are the business structure that most small businesses start with when they get incorporated. A small business might get incorporated for the sake of limited liability, raising capital, deduction of certain expenses, or ease of operation.
The owners of C corporations bear no legal responsibility for the liabilities of the company. In addition, C corporations can deduct fringe benefits from their taxes, such as insurance and medical expenses not covered by insurance. Employees are exempt from paying taxes on these benefits as well.
Lastly, C corporations are easy to manage in terms of stock ownership. Stocks can transfer between owners or to new owners fairly easily, and the company doesn’t have to dissolve when one of the owners passes away.
Limited Liability Companies (LLC)
LLCs are a hybrid business structure that has features of both a corporation and a partnership or a sole proprietorship. The owners of an LLC are called members. There are few restrictions on who can become a member. In addition to individuals, corporations, and foreign entities, and even other LLCs can be members.
In general, LLCs offer the following advantages:
- Members are not personally liable for the company’s liabilities.
- No double taxation because LLCs don’t pay taxes. Profits or losses appear on members’ tax returns.
- Good for holding appreciating assets.
LLCs require a bit more paperwork to run, and some states also impose more rules on LLCs compared to partnerships.
S corporations are often recommended to small business owners because it offers the same liability protection and tax benefits as an LLC. Owners may receive dividend payments, which are not subjected to self-employment tax, in addition to their salaries. Additionally, S corporations are simple to manage as stocks are easily transferable compared to ownership in an LLC.
There are, however, many more restrictions on who can form an S corporation, which includes individuals, estates, and certain types of trusts. Companies often start out as some other type of incorporation and then switch to an S corporation once they fit the criteria. Furthermore, S corporations cannot have more than 100 owners or issue more than one type of stock.
While an LLC might be easier to set up, S corporations are the right choice for business owners who plan on getting outside capital or issuing stock in the future. In those cases, the best scenario is to form a C corporation and then make the S corporation tax election.
A sole proprietorship is the simplest business structure. It’s inexpensive to run, has minimal mandatory reporting, and very simple tax reporting. It is ideal if only one person will be running the business. There is no double taxation on sole proprietorships, as all business net income is taxed as personal income.
On the downside, sole proprietors are personally responsible for all business liabilities, meaning their assets might be seized to cover any business debts or legal claims. It’s also difficult to raise capital or get a business loan as a sole proprietor.
A partnership is any for-profit venture undertaken by two or more parties. Governments, nonprofit enterprises, businesses, or private individuals can enter a partnership. There are two types of partnership: general and limited.
In a general partnership, all parties share profits and financial liability equally between themselves. In limited partnerships, each party is held liable individually, meaning you won’t be held responsible for the malpractice of your business partner. Partnerships are a common business model for professionals, such as lawyers, accountants, or architects.
If you are still unsure what type of corporation is right for your business, talk to your accountant and lawyer. They know the details of your business and may be able to advise what business model will benefit your particular business the most.