As you begin to think about how you want to set up your business, you'll be met with a wide range of crucial decisions. Entrepreneurs and business owners need to be aware of how these decisions can affect their financials, business path, and, most importantly — taxes. There are three primary ways to incorporate a business.
We've covered some of the basic differences between C-Corps and S-Corps before, but today we'll focus on taxation. This alphabet soup may seem confusing for newcomers, but understanding their differences is an important aspect of running a successful business. There are most certainly pros and cons to each, and there's not necessarily a "one size fits all" approach to choosing the model for you. With that being said, there's plenty of preparation you can take to choose the best possible route for your company's future.
A Quick Breakdown
Before we dive into the tax segment, let's get a better understanding of what makes S Corporations, C Corporations, and Limited Liability Company (LLC) different.
Creating a C Corp is a fairly simple process, where a business owner files articles of incorporation through the state. It's considered the default type of corporation and is the most common type of business incorporation. C Corporations get taxed twice, as the company will pay corporate taxes, and shareholders will pay federal income taxes. There are also zero restrictions on ownership or shareholder caps.
At its most basic level, an S Corp is a business that has a limited number of shareholders who must be U.S. citizens. That number cap is 100 and allows anyone to become an owner and have multiple S Corporation owners. Filing for an S Corp is also slightly different, as it requires filing a Form 2553 with the IRS. S-Corps also have what's called "pass-through" taxation, which allows shareholders to report company income or losses on their personal tax returns - eliminating the corporate tax.
An LLC is legally separate from its owners, which are referred to as members. While LLCs are registered with the state, they aren't recognized as a tax entity by the IRS. LLCs aren't built for future acquisition or sale and don't face the same pressure from holders or investors that C-corps typically do. LLCs also undergo one level of pass-through taxation - and it's dependent on how many members it has.
- Single-member LLCs are considered a separate entity and will pay taxes the same as a sole proprietor.
- Partnership LLCs with multiple owners or members are taxed as a partnership.
Note: Pass-through business entities refer to a system of taxation, whereas the business's taxes are reported on a business tax return — but passed through individual owners. Owners or members will get a tax form included with their tax return.
Exploring the Tax Differences Between Corporations
As we've mentioned, the biggest differentiator between S-Corps, C-Corps, and LLCs is taxation — and it will play an important role in how your business operates. There are advantages to each type of corporation, but it's how you capitalize on these advantages that will help you succeed in the long run.
C-Corp Tax Advantages
If you own a C-Corp, you're able to deduct 100% of charitable donations and contributions on your corporate tax return. However, these donations or contributions cannot exceed 10% of your business's income. You're also able to deduct benefits such as health insurance for your employees. Now, many business owners are dissuaded by the double taxation that C-Corporations face; there are safeguards in place. The Tax Cuts and Jobs Act has a 21% limit on taxation.
S-Corp Tax Advantages
When it comes to choosing an S-Corp, taxes are a significant influencer, as owners get to report their business income and loss on personal income tax returns. Owning an S-Corporation means you can deduct up to 20% of your income on personal tax returns, making it an extremely attractive option. Another feature is that you can write off business losses as well.
LLC Tax Advantages
Many business owners go the LLC route to avoid double taxation environments as well. Some states don't require LLCs to pay corporate franchise taxes — which can be an attractive feature depending on where your business is located. There are also tax deductions for LLC owners in the form of a Qualified Business Income (QBI) deduction, which means members can access a 20% deduction from the net business income. Many business owners go the LLC route because you can opt for taxation as an S-corp through the IRS, allowing for the best tax advantages possible.
Making the Best Decision For You
You want to take advantage of all tax benefits possible when forming a business. Taking all of the proper steps and maximizing tax opportunities is crucial for startups or small business owners. The keyword here is proper, as you want to be prepared in the case of an IRS tax audit.
Speak with fellow business owners and learn about their incorporation journeys, and research all of your available options before making any finite decisions about your business's future. Scroll through some business blogs every day to stay in the loop on changing trends, new tax opportunities, or shifts in the business marketplace.
Really, it comes down to planning for your company's future and understanding how your options may impact decisions down the road. S-corps are under far more scrutiny by the IRS than LLCs or C-corps — and breaking guidelines or rules can mean losing your status. Are you building your company up to be sold? Are you looking for the most deductions possible? Do you make significant donations? All of these are questions worth considering — but at the top of the list, is taxation.