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Corporations vs. LLCs Simplified
Business owners can find lots of information on starting a business entity from the internet, their accountant, their attorney, even their neighbor down the street. Sometimes all of that information can be a bit confusing. Even seemingly a bit contradictory.
How do you know which business entity is right for your business? How can you possibly have enough time to filter all of the available information? And which information is right?
Here I'd like to offer you a simple explanation of each entity type, and as you can all look up definitions, I'll keep it more about when you might consider it. I'll also include comments on any of the common things that you might have heard.
And from there, I welcome any questions you might have. I know deciding on which business entity to use can be a bit stressful for many business owners, so I hope this helps!
Sole Proprietorship: If you are in business for real, this is a bad choice. You are the business. One and the same. You have the worst choices in tax advantages; the only way to save in taxes is to lose money. Most of us are not in business to lose money. Also, because you are the business, if you have any liability, if you ever get sued, you personally can lose everything in the event of the business lawsuit. Additionally, if you die, your business dies. This is simply not a good choice if you are serious about being in business. Remember: other wise business people know this as well.
C-Corporation: The C-Corporation is what we call a "stand-alone" entity. Simply put, it does business, collects money, pays expenses, and then files a tax return at the end of the year. The corp does have officers and directors, and it does have stock. (It doesn't matter how small you think your company is, you will have stock.). This entity separates the business from the stockholders and officers/directors from the business. (Keeping in mind that the individual states have different statutes regarding liability).
This can be a good entity to use if you will have substantial profits in your business. Remember to think about the big picture: you might show a loss the first year or two, but in the long run, most of us are in business to profit. So if the business profits, a stand-alone tax return for the business is usually a good idea. This is also a good choice if your business is taking on investors, as many times investors are looking for a traditional-type situation with stock, as opposed to the LLC discussed in a bit.
Double Taxation is the big buzz word here...doesn't have to the problem that it's cracked up to be. This corp can be a great choice if you use it well, as this corp has the most potential tax write-offs.
S-Corporation: The S-Corp is what we call a "Flow-through" entity. That means that the business makes money, pays expenses, and then the profits/losses flow through to the individual stock-holder's tax return. It does not retain profits or losses. Again, you have stock and officers/directors with this one. Once you have elected S-Corp status, you are stuck for five years (currently), meaning you can't change your mind and switch it back to C-Corp.
This is a good choice for someone that will be showing losses in the business. The losses will then flow-through to your personal tax return, off-setting other income that you have. For example, if you have a W-2 job, then you have losses from a side business that flow through, your W-2 income bracket can be reduced. Good planning. (If you show profits, the profits will go to your personal tax return and can bump up the other income bracket you're in as well).
This is also a good choice if your goal is to build the business and sell it. This can reduce the taxes you pay when you sell the business.
Not a good choice if you want to have stockholders that are not US citizens and this S-Corp is limited to only US citizens and natural people. Which makes it a poor choice in estate planning, as another entity cannot hold the stock, either. (You can hold the stock in your Living Trust).
LLC (Limited Liability Company): This entity is kind of a hybrid of a corporation and a Limited Partnership. It takes good stuff from each of them and crams it together. The best parts are that you have the capability of limiting the liability of the owners of the business as well as the people running the business, and you also have the choice of how to have the business taxed with the Feds. So, again, you separate the business from the individuals, and you have lots of potential tax write-offs.
Good to use in a partnership situation, as you have an operating agreement that delineates how you run the partnership. That helps you avoid problems with your partners down the line. It's all spelled out in the beginning.
This can also be a great tool in tax planning, if you use other entities in your mix.
This entity is also great for asset protection, particularly when you have assets that bring lawsuits to you, i.e. real estate, machinery, boats, etc. It's a great choice for any business with a lot of potential liability, like real estate investors, limo companies, restaurants, etc.
MYTH: It is not a good idea to think that with the LLC you won't have to do paperwork like with the corporations. If you want to take advantage of tax write-offs, you will have to document financial decisions or the IRS won't let you have them in an audit!
Limited Partnerships can be a good choice for a number of different things, but most business owners won't be using them. The LLC does what is needed most of the time and is usually a better choice. If you have questions regarding the LP, I will be happy to answer them later.
One more note: In some states, your profession will determine which entity you can use. For example, in CA if you hold state licensing of any kind, you must be a corporation, not an LLC. And some states have state-level taxation that might push you towards one entity over the other.
How do you know which business entity is right for your business? How can you possibly have enough time to filter all of the available information? And which information is right?
Here I'd like to offer you a simple explanation of each entity type, and as you can all look up definitions, I'll keep it more about when you might consider it. I'll also include comments on any of the common things that you might have heard.
And from there, I welcome any questions you might have. I know deciding on which business entity to use can be a bit stressful for many business owners, so I hope this helps!
Sole Proprietorship: If you are in business for real, this is a bad choice. You are the business. One and the same. You have the worst choices in tax advantages; the only way to save in taxes is to lose money. Most of us are not in business to lose money. Also, because you are the business, if you have any liability, if you ever get sued, you personally can lose everything in the event of the business lawsuit. Additionally, if you die, your business dies. This is simply not a good choice if you are serious about being in business. Remember: other wise business people know this as well.
C-Corporation: The C-Corporation is what we call a "stand-alone" entity. Simply put, it does business, collects money, pays expenses, and then files a tax return at the end of the year. The corp does have officers and directors, and it does have stock. (It doesn't matter how small you think your company is, you will have stock.). This entity separates the business from the stockholders and officers/directors from the business. (Keeping in mind that the individual states have different statutes regarding liability).
This can be a good entity to use if you will have substantial profits in your business. Remember to think about the big picture: you might show a loss the first year or two, but in the long run, most of us are in business to profit. So if the business profits, a stand-alone tax return for the business is usually a good idea. This is also a good choice if your business is taking on investors, as many times investors are looking for a traditional-type situation with stock, as opposed to the LLC discussed in a bit.
Double Taxation is the big buzz word here...doesn't have to the problem that it's cracked up to be. This corp can be a great choice if you use it well, as this corp has the most potential tax write-offs.
S-Corporation: The S-Corp is what we call a "Flow-through" entity. That means that the business makes money, pays expenses, and then the profits/losses flow through to the individual stock-holder's tax return. It does not retain profits or losses. Again, you have stock and officers/directors with this one. Once you have elected S-Corp status, you are stuck for five years (currently), meaning you can't change your mind and switch it back to C-Corp.
This is a good choice for someone that will be showing losses in the business. The losses will then flow-through to your personal tax return, off-setting other income that you have. For example, if you have a W-2 job, then you have losses from a side business that flow through, your W-2 income bracket can be reduced. Good planning. (If you show profits, the profits will go to your personal tax return and can bump up the other income bracket you're in as well).
This is also a good choice if your goal is to build the business and sell it. This can reduce the taxes you pay when you sell the business.
Not a good choice if you want to have stockholders that are not US citizens and this S-Corp is limited to only US citizens and natural people. Which makes it a poor choice in estate planning, as another entity cannot hold the stock, either. (You can hold the stock in your Living Trust).
LLC (Limited Liability Company): This entity is kind of a hybrid of a corporation and a Limited Partnership. It takes good stuff from each of them and crams it together. The best parts are that you have the capability of limiting the liability of the owners of the business as well as the people running the business, and you also have the choice of how to have the business taxed with the Feds. So, again, you separate the business from the individuals, and you have lots of potential tax write-offs.
Good to use in a partnership situation, as you have an operating agreement that delineates how you run the partnership. That helps you avoid problems with your partners down the line. It's all spelled out in the beginning.
This can also be a great tool in tax planning, if you use other entities in your mix.
This entity is also great for asset protection, particularly when you have assets that bring lawsuits to you, i.e. real estate, machinery, boats, etc. It's a great choice for any business with a lot of potential liability, like real estate investors, limo companies, restaurants, etc.
MYTH: It is not a good idea to think that with the LLC you won't have to do paperwork like with the corporations. If you want to take advantage of tax write-offs, you will have to document financial decisions or the IRS won't let you have them in an audit!
Limited Partnerships can be a good choice for a number of different things, but most business owners won't be using them. The LLC does what is needed most of the time and is usually a better choice. If you have questions regarding the LP, I will be happy to answer them later.
One more note: In some states, your profession will determine which entity you can use. For example, in CA if you hold state licensing of any kind, you must be a corporation, not an LLC. And some states have state-level taxation that might push you towards one entity over the other.
Replies to This Discussion
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Permalink Reply by Larry Brauner on
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Dana,
I've read that LLCs are relatively less expensive to establish and maintain than "regular" corporations. Is that true?
What are some of the disadvantages of forming an LLC compared to corporations?
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Permalink Reply by Dana Kramarenko on -
Larry, many states have the same filing fees for LLCs and corporations. The difference in cost can be that many accountants charge less for the tax return on an LLC than with a corporation. The other difference on cost maintenance is usually from people thinking that an LLC doesn't need regular maintenance, i.e. Meetings, Resolutions and Minutes. While it is true that you can legally set up your LLC to not require these things, if you want to take advantage of tax write-offs, the IRS expects you to maintain those "corporate formalities" in order to get the write-offs. So the savings wouldn't really apply.
A couple of disadvantages of LLCs: In some states, the state-level taxes can be higher for an LLC. Also, investors many times don't like LLCs, as LLCs don't have traditional stock. The other problem is many people neglect the importance of the operating agreement (kind of like bylaws with a corp) and the LLC is not legally valid without it.
(Personally, I like the LLC best and use it whenever it fits...)
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Permalink Reply by Jeffrey Dietsche on -
Dana,
Incredible topic for discussion!
The Sole Proprietorship is absolutely the WORST way to go, for sure, ( Unless you are having checks written to you personally and cashing them at the bank that issued the particular check ). This is another topic of discussion.
What you failed to mention about the S-Corp and the C-Corp is that you are given the SAME tax advantages. And unlike an LLC, "LIMITED" Liability Company your PERSONAL assets are COMPLETELY separate and "protected" from your BUSINESS assets. From what I have experienced, there is no difference in cost for filing either way. In the case of a lawsuit, the Corporation is a much better choice than an LLC. The LLC being "LIMITED LIABILITY". And in the case of an "S" Corp vs. a "C" Corp, the IRS isn't too interested in an "S" Corp filing MINUTES. Let your tax accountant or CPA take care of this for you. My own personal choice: INCORPORATE.
On the other hand, Personally Guaranteeing loans and credit for your business is not a real good idea. Unfortunately, most creditors will require you to do so. NEVER link your personal credit to your business credit! Do your best to BUILD credit for your BUSINESS if you intend to do so. If not, the end result may not be PRETTY.
Jeffrey Dietsche, President, J.E.F. Electrical, Inc.
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Permalink Reply by Dana Kramarenko on
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Hi Jeffrey, glad you like the topic!
As to the S-Corp and the C-Corp, they actually do have differences in the tax advantages available, for instance, with an S-Corp the business owner will not be able to write-off health insurance like with a C-Corporation.
With both corporations and the LLCs, you keep your personal assets separate from the business. The business assets are the assets that are held inside the entity. You keep your personal stuff outside the "bubble" of the entity. This is so that if anyone sues the business, the assets that are attacked are the assets inside the bubble. The reason that an LLC is a better choice in a lawsuit regarding assets is the law of "Charging Order Protection". I'm working on a blog explaining that one, but the jist is that in the event of a lawsuit, the assets inside the LLC cannot be liquidated to pay off the winner of a lawsuit. (Note: in Nevada, we actually have Charging Order Protection for corporations, as well. NV is the only state as of yet to adopt this statute.).
And you're right: it's a great idea to have help with the upkeep of your internal docs.
As to credit, great tip! So often we have to use our personal guarantees to get business credit, but then you're back to being personally liable. We have lots of help available to build business credit, but the most important thing is that it just takes time along with any work you do.
Thanks for the great thoughts!
Dana
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Permalink Reply by Jeffrey Dietsche on
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Dana Kramarenko said:Hi Jeffrey, glad you like the topic!
As to the S-Corp and the C-Corp, they actually do have differences in the tax advantages available, for instance, with an S-Corp the business owner will not be able to write-off health insurance like with a C-Corporation.
With both corporations and the LLCs, you keep your personal assets separate from the business. The business assets are the assets that are held inside the entity. You keep your personal stuff outside the "bubble" of the entity. This is so that if anyone sues the business, the assets that are attacked are the assets inside the bubble. The reason that an LLC is a better choice in a lawsuit regarding assets is the law of "Charging Order Protection". I'm working on a blog explaining that one, but the jist is that in the event of a lawsuit, the assets inside the LLC cannot be liquidated to pay off the winner of a lawsuit. (Note: in Nevada, we actually have Charging Order Protection for corporations, as well. NV is the only state as of yet to adopt this statute.).
Dana,
Thank you for the info. about the C.O.P. I never knew this statute existed. I have another tip: INCORPORATE in the state of NEVADA! The tax advantages are better than anywhere else. I have actually looked into doing this, but have not got ALL the information associated with it.
And you are ABSOLUTELY correct about writing off the medical with an S-CORP! I have learned that this is not supposed to be an option, but somehow my tax accountant gets around it, don't ask me how? ( LOL )
And thank you for the great topic of conversation!
Jeff
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