Most small business owners are not also experts in corporate and tax law, but to choose the best corporate structure for your small business you need at least some basic knowledge on these subjects. If you chose to incorporate your small business instead of operating under a Sole-Proprietorship you have several choices.
The major choices are LLC, or Limited Liability Corporation, S-corp, and C-corp. To explain all the differences between these types of corporations I would need to fill dozens of pages with legal jargon. Instead I boiled the differences down to the essentials that will impact your day-to-day operations.
The major reason to form a LLC is to reduce the legal liability of the owners. In a sole-proprietorship all the losses of the business along with any legal action against the business is the direct responsibility of the owner. In an LLC the corporation is responsible for the losses of the business and legal action would generally focused on the corporation and not the individual.
For those that like the simplicity of taxes with a sole-proprietorship no federal tax changes are made by becoming a LLC. Single-owner LLCs are taxed just like sole proprietorships, and multiple-owner LLCs are taxed just like partnerships. You should, however, be aware that forming an LLC might subject your business to additional state taxes. Certain states (California for instance) subject LLCs to “franchise taxes” in addition to a typical income tax.
S-Corporations, on the other hand, have the ability to provide some tax savings as a result of the fact that profits from an S-Corp are not subject to Self-Employment Tax. However, before you’re allowed to distribute any profits, you are required to pay any owner-employees a “reasonable salary.” This salary will be subject to social security and Medicare taxes (which total the same amount as the Self-Employment Tax). As such, the tax savings only take effect once the business has a pretty sizable income. S-Corps owners still file taxes in basically the same way as sole-proprietorships and the business does not pay taxes as its own entity.
S-Corps are significantly more complicated from a legal and financial perspective. Unless you have a background in accounting or law it is recommended that you consult a lawyer and accountant before setting up an S-Corp and yearly to make sure all legal requirements are fulfilled.
Unlike the previous two business structures, C-corporations are taxable entities. This means that the corporation itself is taxed on its income (as opposed to other structures which simply pass the income along to the owner(s), who are then taxed on it). This means that the profit from the business is essentially taxed twice; once as business and then a second time as personal income. Also, like S-corporations, C-corporations are more complicated from an accounting, tax, and legal standpoint than sole proprietorships, partnerships, or LLCs and in most cases will require outside consultants.
While I focused on tax differences between these corporate types there is also considerable differences in the business structure and how individual are paid within the business. In general, the type of corporate structure can be broken down based on the size of the business. The smallest businesses benefit from the simplicity of a sole-proprietorship, partnership, or LLC. Mid-sized business benefit from the potential tax savings of an S-Corp. While generally only larger businesses with a group of shareholders use the C-corp structure. Of course, the decision of corporate structure can only be decided on an individual basis depending on the unique needs of that business.