Choosing a Business Entity: LLC, S Corporation, or C Corporation?
Starting a business is exciting; it’s an opportunity to control your own destiny, build wealth, and add value to your community. It can also be daunting to be the person making all the decisions. And while you are knowledgeable about the goods or services you are providing, you may not know as much about business formation law, including choosing a business entity.
Deciding on a business entity is one of the first decisions you will make for your business, and it is one of the most important. Your business structure impacts numerous other aspects of your business: how, and how much, will be paid in taxes; day-to-day operations; and not to be overlooked, your personal liability for business debts.
How do you choose a business entity? Let’s discuss some basic differences between limited liability companies (LLC), S corporations, and C corporations.
C corporations are called that because they are governed by subchapter C of the Internal Revenue Code. Although a C corporation is not the only form of corporation, chances are when you think of a “corporation,” a C corp is what you are picturing. Most large companies are C corporations.
A C corporation is legally separate from its owners. For this reason, it also gives owners the strongest protection from personal liability. But that protection comes at a cost. Of the three entities, C corporations are the most costly and complicated to establish. As with other business entities, formation documents for C corporations (Articles of Incorporation) must be filed with the state.
C corporations have shareholders, directors and officers. Shareholders, of which there can be any number, own the corporation; the corporation owns the business. Shareholders elect the directors of the corporation. The board of directors oversees major decisions regarding the corporation, but not daily operations. Those are managed by the corporation’s officers, who are appointed by the board of directors.
Advantages of C corporations, aside from the strong liability protection they provide, include the ability to raise capital through the sale of shares of stock. There can be multiple classes of stock, and there are no restrictions on stock ownership. Disadvantages of C corporations include the need for more complicated record-keeping and reporting than other entities, and potentially the more complicated structure. But what most people might find the biggest disadvantage is how C corporations are taxed.
C corporations pay tax on their profits, and may be taxed twice: at the corporate level, when the business makes a profit, and again by individual shareholders when they report dividends on their personal income tax returns. Employees of the C corporation, of course, must pay personal income tax on their salary as well.
For most smaller businesses, the complicated structure, reporting requirements, and double-taxation of C corporations are not worth the benefits. They tend to be a better choice for businesses that expect to grow and go public, or medium-to-high-risk businesses.
S corporations are governed by Subchapter S of the Internal Revenue Code. They have many similarities to C corporations. They are formed by Articles of Incorporation filed with the state and are separate legal entities. They have directors, officers, and shareholders, although they can have no more than 100 shareholders, and those shareholders must be U.S. citizens or residents. S corporations may also offer only one class of stock. Like a C corporation, an S corporation offers limited liability for owners, who are typically not able to be held liable for acts of the corporation.
The most significant difference between a C corporation and an S corporation is how they are taxed. An S corporation is a “pass-through” entity for purposes of taxation. The corporation files a tax return for informational purposes, but is not taxed at the corporate level. Instead, corporate income that is distributed to owners is taxed on their personal tax returns. Subject to certain restrictions, corporate losses also pass through to owners and can be used to offset income on their personal income tax returns.
S corporations offer another tax benefit as well: under the Tax Cuts and Jobs Act of 2017, eligible S corporation shareholders are entitled to claim a deduction of up to 20% of net “qualified business income.” S corporation shareholders must pay self-employment tax on salary received from the corporation, but not on distributions.
Disadvantages of S corporations include limitations on the number and type of shareholders, making stock less transferable than with a C corporation. An S corporation is a good option for a business that could be a C corporation but qualifies to be an S corporation.
Limited Liability Companies
Last, but not least, let’s consider limited liability companies: LLCs. As the name implies, LLCs protect owners from personal liability. Personal assets like homes, vehicles, and bank accounts are generally safe from the reach of business creditors in the event of a lawsuit or bankruptcy.
LLCs are relatively simple and straightforward to form, and have less burdensome reporting requirements than both S corporations and C corporations. The operating structure is simpler as well; owners of the LLC are known as members, and managers oversee day-to-day operations.
Like an S corporation, an LLC is a pass-through taxation entity; members pay income tax on distributions and may claim losses on their personal income tax returns. Members of an LLC are considered self-employed and must pay self employment tax.
There are other business entities as well, such as sole proprietorships and partnerships. While even simpler in structure and easier to establish than C corporations, S corporations, and LLCs, they do not provide protection from personal liability. If you have questions about New Mexico business formation, please contact our law office.