When it comes to individuals looking to take the leap of faith into the world of entrepreneurship, they inevitably come across the decision of how to structure their business. Many entrepreneurs have a strong background in their given trade or service but rarely do they understand the tax implications of the decisions that they make.
Getting organized and tax planning for the future can be a great strategy to minimize tax liability and maximize cash flows. But what exactly does all that mean? Well, many business decisions start with the question of how to structure the business itself. In this article, we will focus on the decision of choosing between establishing an S-Corp (subchapter S corporation) or a C-Corp (subchapter C corporation).
The Sole Proprietorship Business
When entrepreneurs begin a business, they typically start as a sole proprietorship. While running a business as a sole proprietorship you do have the business benefit of writing off expenses you are limited. This is good for small businesses but if their business continues to grow, then they will typically outgrow this business structure. A big drawback of this way of operating a business is the self-employment tax that is added on top of the normal tax bracket from one’s income. This adds 15.3 % income tax. This rate is social security and Medicare withholdings. Social Security being withheld at 12.4 % and Medicare at 2.9%. As the company grows this additional tax paid can eat away at the company’s profits.
The next step would be filing articles of incorporation with your state and running your business as a true business. Once you are set up with the state you would need to decide between the S-Corp or the C-Corp.
The Benefits of Incorporating
The primary benefits of both business structures are that they limit the owner’s or shareholder’s liability. This will protect the owner’s personal assets in case the company is pursued legally. It is a separate entity- apart from the individual(s) who own it and usually managed by a board of directors and officers who handle the business operations. Separate entities ensure separate liabilities from their ownership. Separate entities have a corporate shield and protection from liability.
It is especially important at the inception of the business that you elect between the C-Corp or S-Corp. If a decision is not made after the formation of the corporation, then the corporation will automatically be designated a C-Corp. So, if you are setting up the corporation for tax benefit you must make that designation because the major benefit and difference between the two are how the owners are taxed.
Tax Benefits and Differences
There are major tax benefits to each designation. The major benefit is that the owners and shareholders are exempt from self-employment taxes. This is true with both entities. The difference between the two is that with a C-Corp the business income faces a corporate tax and then when funds are distributed to shareholders or owners they are also taxed. In essence, this can be viewed as being double taxed. Fortunately, this is not as bad as it has been in prior years. With the changes in the tax law passed in 2018, the tax rate paid by C-Corps dropped from 35% to 21%. With the S-Corp designation, there are no corporate taxes, so this double taxing is avoided. The income flows through the business and is taxed to the shareholders rather than the corporation itself. With this type of benefit for the S-Corp the IRS does tend to scrutinize filings a lot heavier than with the C-Corp and if mistakes are made the S-Corp designation can be canceled.
A benefit to the C-Corp is losses can be carried over year after year. Because net operating losses can reduce a corporation’s tax bill up to 40 percent of the amount of the losses, companies carrying a net operating loss to a future year typically carry the tax benefit of the loss as an asset on their books. With an S-Corp a partner or shareholder must keep track of their adjusted basis in the business. Partners and shareholders can deduct net operating losses only up to the amount of their basis, carrying only the excess over to another year.
Each designation also has benefits in the filing of taxes. If you have an S-Corp, you also can write off business losses on your personal tax returns. With a C-Corp you can deduct 100% of charitable contributions. Also, a C-Corp allows you to also help employees by deducting certain benefits like health insurance.
Potential for Growth
Another big difference between the S-Corp & the C-Corp is growth potential. The S-Corp while it has its benefits it can limit the growth of a company. A company set up as an S-Corp is limited to 100 shareholders and they all must be US Citizens. With the C-Corp there are no restrictions on ownership. So, if you are planning on major growth or selling stock to potential investors the C-Corp would probably be the best business structure to choose. Also, if you are looking at some point for your company to be acquired an S-Corp cannot be owned by other S-Corps, C-Corps, LLC’s or Trusts. If you are looking to remain smaller or avoid ranking order within the company the S-Corp may be best for your business.
So, Which Is Best for You?
So, at this point, you as the reader might be wondering- which entity is the best one to go with? And the answer? It depends. As we conclude, we can see that each entity has different benefits that might work for some taxpayers but work differently for others. Every new owners’ goals and plans with their companies are different and there are a lot of questions to ask yourself to see which designation is best for your business. C-Corp is the default filing status for companies, but it is not always best for every business.
Are you someone who is establishing this business for the long run to provide income sustainably for yourself or do you have plans of establishing this business and selling it in the future for a profit? If you are establishing the business for the long run and do not mind limiting your growth potential, then maybe the S-Corp formation would be best for you because of the tax benefits. But if you plan on selling this business or adding shareholders to grow the business the C-Corp would probably better benefit you. If you want to keep your company as a small business the S-Corp limits you to 100 shareholders. These corporations tend to put more value on shareholder input.
Another big question you must ask yourself is the extra scrutiny with the S-Corp worth avoiding the double taxation of the C-Corp. You will need to run a squeaky-clean organization and follow the rules under the S-Corp designation. If you do not mind the IRS watching, you and do not think you will have a hard time following the rules then the tax benefits may be well worth it. Not to say that you do not have to follow rules and the IRS won’t be watching with a C-Corp but traditionally S-Corps are more highly scrutinized.
If after you ask yourself these questions and neither of the options works for your business, then there is another option. It requires a lot less paperwork and still provides the benefit of protecting your personal liability. The LLC designation is basically provided for just that. As an LLC your liability is limited to the investment you put into your company. It also protects you against potential lawsuits and gives you a better opportunity of getting funding in the future. An LLC is much simpler to organize and run. The owners of the company distribute income among themselves and they pay individual income tax on any revenue received from the company. An LLC is not recognized by the IRS as a separate entity and is still subject to self-employment tax.
In review of everything, it is obvious that each designation does provide different benefits. It all comes back to you and how you plan on running the business and what your goals are. As we discussed and laid out for you taking this next step whichever option you choose in most cases is greatly beneficial for yourself and the business in terms of protecting yourself and your personal interests as well as benefits in increasing the income retention of the business. The biggest thing is what you want out of your business so in ending which is the best choice… that is a decision that you need to make on your own. If you truly still cannot make this decision on your own seek advice from a local CPA. This is an accountant licensed and educated to advise in the business formation as well as accounting and future year to year tax filings.