What Type of Business Entity Should I Start?
This article will address some of the common types of companies that you can form, including a sole proprietorship, limited liability company, C-corporation, or S-corporation.
Once you are familiar with the benefits of each entity type, it can become much easier to answer the following questions:
Should I file an LLC or S-corp?
Should I file as a C-corp or S-corp?
Should I operate as a sole proprietor or file a single-member LLC?
A sole proprietorship is one of the simplest types of businesses and is very common among individual entrepreneurs. A sole proprietorship is defined as an individual who operates an unincorporated business. Only one member is allowed for this entity type, and an individual can’t be a sole proprietor if they decide to incorporate a business, such as an LLC. This business type is often very attractive because it is less complex to get started. While this is a good fit for many individual entrepreneurs, it is not always the best option for everyone.
Someone who runs a sole proprietorship receives all of the profits from the business activity but is also personally responsible for all of the company’s liabilities.
Filing DBA: If someone decides to begin operating a business, they are immediately classified as a sole proprietor if they do not incorporate another company. However, some individuals who want to formally begin operating under a name can file a DBA ( doing business as), which allows them to operate under their chosen name. If you want to file a DBA, you will need to look at the laws in your state and pay the local state fees to file the DBA. Each state has different laws in terms of the requirements and years that the DBA is valid. Filing a DBA is a relatively cheap option compared to other types of organizations, such as an LLC.
Taxes: It is very simple to file taxes if you are a sole proprietor, as you can include them on Schedule C of your 1040 tax return. This fact is very convenient for individuals who are employed and also operate a business on the side.
Some of the main benefits of filing a sole proprietorship include the following:
Easy to file and maintain: In most cases, you are automatically classified as a sole proprietorship as soon as you start operating a business. It is very simple to file a DBA, and there are no complex annual filing requirements for this entity type. In some cases, you will need to renew your DBA every 3-10 years, depending on the state.
Inexpensive: Filing a DBA can be as low as $22 in Utah and $26 in California. Unlike other entity types, there are no other annual filing requirements, which can be costly.
Tax ID: When you operate as a sole proprietor, you do not need a special EIN, and can use your social security number when filing taxes. Therefore, filing taxes can be less complex when you operate in this manner.
However, there are some issues that you can run into if you operate as a sole proprietor, and this may not be the best entity type for everyone.
Liability: The biggest risk of operating as a sole proprietor is that you are legally liable for all of the company’s debt. If someone decides to sue your company, they would personally sue you, rather than the entity.
Investors: It can be harder to attract investors if you operate as a sole proprietor, so you may need to change your entity type further down the line.
Limited Liability Company
A limited liability company is a type of company that can either include a single member ( single member LLC) or multiple members. The IRS treats the LLC as a corporation, partnership, or disregarded entity. Filing a limited liability company can be a great option for a solo entrepreneur who wants to establish more credibility. Moreover, multiple members can also form a limited liability company but will need to file a special form called Form 8832 to avoid being treated as a partnership. This type of company is relatively cheap to file and maintain and provides business owners with extra legal protection.
Some of the main advantages of filing an LLC include the following:
Easy to file: You can file an LLC within several days, either on your state’s secretary of state website or through a company like Incfile.
More credibility: Filing an LLC can give your business more credibility, as potential customers will be able to look up your business and see that you formally incorporated it.
Protect your personal assets: One of the most important benefits of filing an LLC is that you have a corporate veil, which shields your personal assets from business liabilities. This is very important if your business encounters any financial or legal issues.
However, this may not be the best structure for all entrepreneurs, and there are some issues that you should keep in mind.
Different filing requirements: LLC laws are different for every state, and some states have more complex and expensive filing requirements.
Corporate veil: There are exceptions to the corporate veil law, and some acts of misconduct can result in states piercing the corporate veil and holding the owners of the company personally liable.
Filing an S-Corp
An S-corp is a type of business that can pass its taxable income, losses, and credits directly to its shareholders. S corps are considered pass-through entities, like LLCs, which means that they pass profits directly to shareholders and owners, who are then responsible for filing taxes.
The S corp is a common alternative to LLC and is available for companies that have fewer than 100 shareholders. Unlike C-corps, this type of corporation does not have double taxation, which is one reason why some smaller companies may choose to file an S-corp.
If you want to file an S-corp, then you need to meet the following requirements:
Incorporation: The corporation needs to be domestically incorporated in one state.
Shareholders: Your company can only have up to 100 shareholders, and you can only offer one class of shares. Moreover, shareholders can’t include certain entities like partnerships and corporations, and they can’t be non-resident aliens.
Business Type: Certain types of businesses, such as insurance companies or financial institutions, can’t file as an S-corp.
Some of the main advantages of filing an S-corp, instead of other types of entities, include the following:
No corporate taxes: Since an S-corp is classified as a pass-through entity, you do not have to worry about paying taxes at the corporate level. Individuals and shareholders pay taxes on distributions.
Lower taxes: Owners who receive distributions can generally pay lower taxes and can count this income as self-employment income. The TCJA also created incentives for S-corps so that they can deduct qualified business income.
Better for investing: Filing an S-corp is a more sophisticated way to incorporate your business and can help you attract shareholders.
If you plan to file an S-corp, you should keep the following factors in mind.
Losing your S-corp status: If you do not keep up with all of the requirements set by the IRS, you can lose your S-corp status. If this happens, then your entity will automatically be treated as a C-corp.
Higher Fees: It is slightly more expensive to file an S-corp, and S-corps also have to pay a 1.5% franchise tax every year depending on which state you incorporate this business in. For example, California has a minimum franchise tax of $800.
Filing forms: You will also have to file multiple forms if you operate an S-corp, including an income tax form ( Form 1120) and employment tax forms ( Form 940 and Form 941).
Filing a C-Corp
A C-corp is a type of business structure where the shareholders of the business are taxed at the corporate level. Therefore, owners of a C-Corp may face dual taxation, as they are taxed at both the corporate and personal levels. C-corps share many benefits with other types of structures, like LLCs and S-corps, in the sense that the owner of the business is not legally liable for any money beyond their initial investment.
C-corps have to pay taxes on any earnings that the business makes before distributing the earnings to owners in the form of dividends.
C-corporations also have other requirements, which include the following:
- Hold annual meetings
- Elect a board of directors
- Keep voting records of the company’s directors
- Must maintain company bylaws
- File annual reports, financial statements, and financial disclosure reports
Some of the main forms that C-corps have to file include an income tax form ( 1120) and employment tax forms ( 940 and 941). A C-corp can carry a net operating loss back 2 years, and can also carry it forward for up to 20 years.
Benefits of Forming a C-corp
Easier to raise capital: If you plan to raise capital for your business, it is most often ideal for you to form a C-corp instead of an LLC or S-corp.
Limited liability: The managers and shareholders of a C-corp have limited liability for the company’s debt.
No limit on shareholders: While other types of organizations may limit the number of shareholders or the class of shares that you offer, C-corps allow companies to have as many shareholders as they want.
Below are some of the main considerations that you should evaluate if you think it is best to file a C-corp over other entity types.
More regulations: You will need to spend more money on filing forms, legal fees, and other fees associated with registering with the SEC.
Double taxation: If you own a C-corp, then you will be double taxed, as the entity is taxed and then owners and shareholders pay taxes on the distributions.
Most people who are looking at all four of these entity types may have trouble deciding between two different entities that could work for them.
Should I file an LLC or S-corp?
One important factor to note is that an S-corp is a type of tax classification, while an LLC is an entity type. LLCs offer flexibility for owners, as they can choose to be taxed as a partnership, or taxed like a sole proprietor if they file a single-member LLC.
Owner Salary: One distinction between an LLC and S-corp is that LLCs have to pay a self-employment tax on all income, while S-corps can choose how much money they want to pay in self-employment taxes by adjusting their salary. When S-corps choose to do this, they can lower the company’s overall taxes, as the taxes on the entity are lower. The taxes are lower for S-corps because they only have to pay an income tax on the net earnings, but don’t have to pay social security or medicare taxes.
Owner Restrictions: S-corps have more restrictions in terms of ownership, as you can only have 100 shareholders and they must be US citizens. On the other hand, LLCs can have unlimited owners, and there are not any restrictions on the type of owner.
Finding Investors: If your goal is to find investors, then forming an S-corp is a better option. LLCs are not allowed to issue shares, and must clearly state how owners are paid in the articles of incorporation. While S-corps have restrictions in terms of the number of owners and type of owners, it is still easier to attract investors with this structure.
It is slightly more expensive to file an S-corp, but this is not a major factor in the decision process for most individuals. The biggest factor to focus on is how many owners you plan to have. Once you answer this question, you can compare the tax benefits between the two types of businesses, and choose an S-corp over an LLC if this works for you.
If you plan to file an S-corp based on tax benefits, it is crucial to make sure that you pay yourself a reasonable salary. A typical range to choose from is 50-60% towards your salary while classifying the remaining amount as income.
Should I file as a C-corp or S-corp?
Other entrepreneurs may be unsure about whether they should file as an S-corp or C-corp. An S-corp or C-corp is a tax designation that is available for both corporations and limited liability companies. Your decision to file as a C-corp or an S-corp can be based on a large number of factors, which include the following.
Shareholders: One of the main benefits of a C-corp is that you can have an unlimited number of shareholders, while S-corps can only have 100 shareholders. Moreover, there is no restriction on the type of shareholders, so you can have shareholders from other countries. Finally, C-corps are able to issue multiple types of shares, while S-corps can only issue common stock.
Taxation: Individuals who choose to be taxed as an S-corp rather than a C-corp mainly choose to do so to avoid double taxation. C-corps are first taxed on the businesses’ earnings, and then the owners pay a tax on any distributions.
Maintenance: C-corps are generally more expensive and time-consuming to maintain, so businesses may benefit from choosing an S-corp instead if they do not have many shareholders.
Ultimately, your decision should be based on your preference regarding taxation and shareholders. If you want to attract a diverse pool of shareholders, then it is best to file a C-corp and disregard the fact that you may have to pay more in taxes. On the other hand, if you only plan to bring in a few US investors, it is best to be taxed as an S-corp because of the tax benefits.
If you file as an S-corp for tax benefits, it is crucial to note that the IRS will be monitoring your salary to determine if it is reasonable.
Should I operate as a sole proprietor or file a single-member LLC?
Solo entrepreneurs may often have trouble deciding whether to file an LLC or operate as sole proprietors. While it is much simpler to operate as a sole proprietor, there are many cases where you would be better off filing an LLC.Legal protection: The number 1 reason that someone should file an LLC, even if they are the only member of the company, is because an LLC provides you with legal protection. If you file an LLC, then you are not personally liable for any of the company’s debt. Moreover, if someone decides to sue your company, and you are a sole proprietor, then you could be personally liable for this.
Fees: Many people choose to operate as a sole proprietorship, as there are no fees to operate this business. At most, some individuals may have to pay around $20 if they want to operate under a specific name ( DBA), but this is not a requirement. However, it is not very expensive to file an LLC in many states, and some states do not have an annual report or franchise tax fee. The average annual fee for an LLC is less than $100, and it can be less than $100 to file an LLC as well.
Credibility: Many people choose to file an LLC because it can add more credibility to their business. If you think your customers would feel more comfortable if you formally incorporated a business, then it may be best to form a single-member LLC.
For most small businesses the benefit of the legal protection of an LLC outweighs the cost and time of filing a limited liability company. However, if your business does not have a lot of debt and you think the risk of legal issues is low, then operating as a sole proprietor can be a simpler and more cost-effective option.
Categorised in: Planning, Startups
This post was written by Sean Allaband