F. Corporations
Why Incorporate?
Business success may include incorporation. Incorporation gives you pride and credibility and helps you organize your business. As an incorporated entity, you tell the world you’re serious about your business and you’re committed to serving your target market and customers. A corporate entity can help you build your brand and position your company for growth. Investors and lenders typically want to invest/lend money to incorporated businesses rather than individuals.
More important, a corporate entity can help protect yourself and your assets from liability—that’s crucial in today’s litigious society. In addition, businesses are entitled to take advantage of certain tax benefits and conducting your business through a corporation has been shown to reduce the risk of IRS audit.
One of the biggest advantages of incorporating is saving tax dollars. Without incorporating, a one person business (sole proprietor or S/P) or multiple owner business (partnership or P/shp) will be required to pay employment taxes on a substantial amount of net income (over $100,000) while paying tax as a corporation allows the owner(s) to “bifurcate” (split into two) their net income into two or more streams not subject to employment taxation. For example, a net income of $50,000 for a S/P or P/shp would require the payment of around $7,000 in SE tax while corporate taxation where the income is split in half would imply that $25,000 of income would NOT be subjected to SE tax for a net economic gain of around $3,500 EACH YEAR. All of the corporate types below will benefit from this favorable tax treatment IF IT IS ELECTED (in the case of the LLC).
Three Forms of Corporate Entities:
There are three primary forms of corporate entities: the C-Corporation (C-Corp.), the S-Corporation (S-Corp.) and the newer Limited Liability Company (LLC). The ‘S’ and ‘C’ in S-Corp. and C-Corp., respectively, refer to chapters in the Internal Revenue Code or “IRC.”
C-Corporation
Typically, companies that trade on the stock exchange are C-Corporations. Stockholders own a C-Corporation. There are no limits on the number of shareholders. Shareholders have a high level of liquidity in that they can buy and sell shares of stock easily. The corporation can also borrow money without the loan itself impacting the shareholders. If the company loses money the shareholders can lose the value of their investment. A C-Corp. is considered to be a “separate person” legally and for income tax purposes. This means that in almost all cases the individual owners cannot be held liable for the actions of the corporation or its management.
Advantages of C-Corp.: The C-Corporation has an unlimited life, separate from the illness or death of any owners. In other words, when the founders or even a major or controlling shareholder dies, the Corporation’s existence continues.
Disadvantages of C-Corp.: There are several disadvantages to C-Corporations. The main one is “Double Taxation.” This means that the corporation is taxed on its profits (sales revenue minus expenses) and then when it pays dividends (distributions to its owners) the dividends are considered to be a distribution of after-tax profits; the corporation does not receive a tax deduction for dividends it declares while the recipients typically are liable for income taxes on dividends received. In other words both the corporation pays tax on its earnings and the shareholders pay income on dividends they receive, hence double taxation. Another consideration is that recordkeeping can be more involved for a C-Corp. than other forms of entities.
S-Corporation
An S-Corporation is a corporation that stands alone from its owners for liability purposes but is also known as a “pass through entity” for income taxes. Unlike the C-Corp., the S-Corp. does not pay income taxes on its profits but rather passes through those profits to its shareholders. Each shareholder reports his or her share of the S-Corp.’s income and losses on his/her individual income tax return.
The S-Corporation is owned by a limited number of stockholders (a maximum 100) S-Corp. stock is generally not easily transferable but can be sold to raise capital but must be within IRS guidelines. Like the C-Corp., the S-Corporation has an unlimited life, separate from the illness or death of any owners.
Advantages of S-Corp.: The main advantages to S-Corporations include limited personal liability for the S-Corp.’s debts and no taxation of profits to the corporation since the profits are taxed at the individual taxpayer level. S-Corporations prepare an information tax return known as a Form 1120S and a Form K-1 for each shareholder. The S-Corp. owners may receive some income tax deductions for certain business expenses.
Disadvantages of S-Corp.: The main disadvantages to S-Corps. include the fact that it an S-Corp. must distribute its income to the shareholders in accordance with the owners’ ownership interests. While an S-Corp. is typically less complicated to run than a C-Corp., an S-Corp. is typically more complicated to run and manage than an LLC.
Limited Liability Company
A Limited Liability Company or LLC is similar in many ways to an S-Corp., but the LLC is more flexible and faces fewer rules and regulations. Each LLC owner pays income taxes on his/her share of the LLC’s profits at his/her own individual tax rate. For this reason, the LLC is also a “pass through entity” similar to an S-Corp.
LLCs should create an operating agreement which outlines the management and guidelines of operating the entity.
LLCs do not issue shares of stock; instead the LLC issues member units or interests that represent ownership. However, LLC owners benefit from limited personal liability for company debts as with the C-Corp. and the S-Corp. If the company is sued, only business assets, not members’ personal assets, are at risk. Members can sell or transfer their interest(s); however, any sale or transfer is subject to any restrictions that may be in the operating agreement.
Advantages of LLC: First, LLCs offer limited personal liability for the LLC’s debts. LLCs are not typically limited in the number of members the entity can have. LLCs are easier to manage and require less paperwork than the S-Corp. and C-Corp. LLCs offer a relatively high level of flexibility in company structure and management including a choice in taxation approaches. LLCs may therefore choose to be taxed as a C-Corp, an S-corp or even sole proprietor or partnership (depending on the number of owners).
Disadvantages of LLC: It is typically more difficult to transfer ownership of an LLC than with an S-Corporation or C-Corporation. And, as the newest business structure, there are fewer laws governing the LLC’s management, operation and maintenance; and fewer established precedents exist.
There are numerous sound reasons to select a particular form of corporate entity, but once you decide to launch your business, it’s often prudent to incorporate your business. Incorporating offers many benefits and opportunities, including branding and capital raising, and protecting yourself and your family from liability.