By Joel J. Ohman
June 10, 2010
One of the challenges that can seem overwhelming for many business owners and entrepreneurs is the issue of choosing the best form of business entity for their small business. Countless numbers of key startup hours are spent agonizing over the intricacies of the IRS tax code and/or shelling out large fees to accountants and other tax advisors during the business formation process. While having a qualified tax professional on board to assist with choosing a new form of business entity is important; paying them loads of money need not be a part of the process. Here are the nuts and bolts of what you need to know when comparing the three most popular forms of business entities:
The Limited Liability Company (LLC) is a creature of the state. This means that LLC's, though recognized by the IRS as a legal form of business entity, are regulated at the state level. As such, there are some differences in how LLC's are treated depending upon the state of formation but generally speaking an LLC can be set up for minimal cost and is very flexible as LLC members have the option to elect how they would like to be taxed (one member LLC's can elect to be taxed as a sole proprietor, C Corporation, or S Corporation, and LLC's with two or more members can elect to be taxed as a partnership, C Corporation, or S Corporation - the default tax treatment if not election is made is that of sole proprietorship for one member LLC's and partnership for two member LLC's).
A "C Corporation" is the preferred type of business structure for almost all large companies. C Corporations fit nicely as an entity choice for any company that is planning on having a large number of shareholders (especially given the fact that the maximum number of S Corporation shareholders is limited at 75 - imagine if one of the Fortune 500 companies could only sell stock to 75 people!). One of the major benefits to the C Corporation form of business entity is the IRS allowance of certain tax free benefits (insurance, travel, etc.) that are unique to C Corporations. The most often noted negatives for the C Corporation, as it applies to small businesses, is that C Corporation formation is typically much more expensive than forming an LLC. And in turn a quasi S Corp as well that is called an "LLC Envelope;" that is, an LLC that has elected to be taxed as an S Corporation. There are many more state and federal regulations and filing requirements for C Corporations, and C Corporations are subject to the infamous "double taxation" where the C Corporation owes federal tax on the company profit at the corporate level and then once any profits are then distributed to shareholders as dividends then the shareholders each owe federal tax on their dividends received at the personal level.
Subchapter S Corporations (S Corporations) are technically the same type of entity as a C Corporation except for one very important difference: they have elected for, and received, special tax treatment from the IRS (IRS Form 2553 for those of you who just love to know these kinds of things). This special tax treatment essentially allows S Corporations to avoid being subject to the "double taxation" issue mentioned above. S Corporations do not pay federal tax at the corporate level but rather pass through any profit or loss to their shareholders who then pay taxes only once at the shareholder level rather than twice at both the corporate level and again at the shareholder level as with the C Corporation. Certain types of companies are ineligible to elect Subchapter S treatment, there is a limit of 75 S Corporation shareholders, no more than 25 percent of an S Corporations profits may be derived from passive income, and S Corporations may only issue one class of stock. These issues and other restrictions make many larger companies ineligible for S Corporation formation but may prove an S Corporation an ideal business entity for a small business.
Which to Choose?
Every company is different and so care should be given to weigh the pros and cons of each of these three popular forms of business entities before making a decision. However, one of my personal favorites for a type of small business entity selection is that of the aforementioned "LLC Envelope", which is simply anLLC that has elected to be taxed as an S Corporation. This gives the small business owner all of the flexibility and low startup costs of an LLC and also all of the tax benefits of the income pass through of the S Corporation. Who says you can't have your cake and eat it too?
Joel Ohman is a Certified Financial Planner and the owner of four small businesses based out of Tampa, Fla.. Some of his most recent projects include consumer personal finance education websites that include a website for researching car insurance and finding the best credit cards. He can be contacted via the contact form on either of the above websites.