You want to ensure you set your business up properly from the start. Choosing the right entity can be one of the most important decisions you make. Corporations and limited liability companies have many differences worth weighing, including how the money earned is taxed. Paying taxes on profits is part of running a business, but how much you pay can depend on the kind of operation you run.
Many businesses will want to consider a C corporation or S corporation structure. Both create an entity that is separate from the individuals who own the business, shielding them from personal liability. But the way they are taxed differs.
C corporations are great for larger businesses that sell products, have a storefront, and have a significant number of employees and desire to retain earnings for future growth. . C-Corps pay corporate income tax on profits. Their shareholders, in addition pay personal income taxes on the profits that are paid to them as dividends.
S-corporations are a good choice for small businesses and those classified as a Personal Service Corporation (PSC) by the Internal Revenue Service (IRS). S-Corps avoid double taxation of C-Corps by passing profits through to shareholders’ personal tax returns, without being subjected to the corporate tax rate.
This benefit requires the corporation to file an election with the IRS to obtain, which can be more challenging than registering with your state, as you would with a C-Corp or LLC. The election has time specific rules you must follow to be effective.
Other kinds of corporations are more situation-specific. A benefit corporation focuses primarily on public benefit but qualifies to make profits. A nonprofit corporation is generally tax-exempt, and must follow specific rules in terms of scope and distribution of earnings.
Limited liability companies
Limited liability companies (LLC) are favored by small, owner-managed businesses. Like corporate structures, a properly structured and managed LLC offers protection for your personal assets. If your business faces a lawsuit or bankruptcy, your personal savings and your property cannot be used as collateral, if organized properly.
LLCs can choose how to be taxed. The IRS will automatically classify your LLC as either a sole proprietorship or a partnership, depending on how many members (owners) there are. That would mean you would only pay the personal income tax rate on profits. Members of an LLC are generally legally designated as self-employed, which means you’d also need to pay self-employment tax contributions to Medicare and Social Security.
Some LLCs elect to be taxed as corporations, like a C-Corp or S-Corp. The most common reason is their business wants to keep a hefty amount of their profits in their LLC and these so-called, “retained earnings” are generally taxed at a lower rate than they would be on a personal 1040 tax return.
As you’re looking into forming a corporation or LLC, you’ll have other factors to consider. Have a frank discussion with your business partners or investors about the pros and cons of the different types of structures, and get everyone on the same page before making a final decision. It is always a good idea to discuss your options with a CPA or legal advisor as well prior to implementation.