Starting a new business can be an exciting, albeit stressful, time. As a potential new business-owner, you have many crucial decisions to make, not the least of which is picking the right business structure, particularly if you plan on using your life insurance as your own bank. S-Corp vs. C-Corp, or perhaps an LLC? Or maybe you’re starting a simple, low-risk, one-man operation, and your best bet is to operate as a sole proprietorship.
No business type is perfect for every situation. Each has its benefits, and each has its drawbacks. It is important to understand the differences and know which will provide you with the maximum benefits, as well as top level asset protection.
Ultimately, the decision should come down to the nature of your new business and your plans for the future. But, to make an informed decision, you’ll need to know your options, and the pros and cons of each type of business structure you can choose to set-up.
We’ll start simple and work our way up to the more complex business structures in our quest to help you gain the knowledge and insight into the best asset protection for business owners.
A sole proprietorship is the most basic business form and the default selection for anyone who goes into business on his or her own. Sole proprietors operate under their own names or under a registered tradename, and the business’s assets (and liabilities) are essentially indistinguishable from the owner’s. A sole proprietorship can have employees, but, by definition, the business is owned by one person.
Sole proprietorships work well for simple, low-risk businesses without too many employees and without much need for raising capital. Sole proprietors can’t sell stock or a stake in the business, so the only effective option for raising money is a personal loan to the owner. All of the business’s debts, along with any tort liability, will be the owner’s personal obligations, so if the business gets sued, the owner’s assets are exposed.
Revenue earned by a sole proprietorship is treated as the owner’s personal income and taxed on the owner’s return at the individual rate. Business expenses or losses can be used to offset personal income, even income derived from another source.
Instead of social security and Medicare taxes, a sole proprietor pays a self-employment tax on top of regular income taxes. The self-employment tax ends up being higher than FICA taxes paid by an employee with a comparable income because a self-employed taxpayer does not have an employer paying half.
Partially compensating for the higher self-employment tax, sole proprietors may be eligible for self-employed healthcare deductions, which allow deduction of health insurance premiums directly from the taxpayer’s adjusted gross income, even if the taxpayer does not itemize. To qualify for the deduction, the self-employed taxpayer must not be eligible for any employer-sponsored plan, including through a spouse’s employer.
Because there are no shareholders or co-owners to answer to, the sole proprietorship structure offers the owner complete control over the management of the business. If a stake in the business is transferred to someone else, the business ceases to be a sole proprietorship and becomes a partnership.
A general partnership is essentially a sole proprietorship owned by more than one person and therefore comes with similar advantages and drawbacks. Business income is included as individual income on the partners’ returns according to their ownership interests in the business, and the partners pay self-employment taxes.
As with a sole proprietorship, partners are personally obligated for any business debts or liabilities, and, even more, one partner can be liable for the actions of another if taken within the scope of the business. So, if one partner causes an accident while working for the partnership, the other partner may potentially be liable.
General partners are not required to enter into a formal partnership agreement, but it is almost always a good idea. The agreement sets forth, among other things, how the business will be managed, the partners’ decision-making authority, and the partners’ respective ownership interests. A good partnership agreement helps to avoid disputes by establishing an agreed method for making business decisions and a procedure for termination.
Like sole proprietorships, general partnerships can find it difficult to raise capital except through loans personally guaranteed by the owners, leaving their personal assets potentially exposed to creditors.
If a general partnership brings on another partner, the new owner will be liable for business debts and liabilities, so selling a stake to outside investors is usually not an option.
And bringing on another general partner requires the existing partners to surrender some managerial control.
However, both of these problems are partially addressed by the limited partnership model.
A limited partnership has two classes of owners: general partners and limited partners.
General partners manage business operations and are on the hook for any business debts or liabilities.
Limited partners (a/k/a “silent partners”) own a stake in the business but are not involved in its management and not personally liable for business debts. A limited partner’s losses are therefore limited to the money he or she actually puts into the business.
Based upon this duel-class feature, limited partnerships can sell ownership interests to outside investors without giving up managerial control and without exposing the investors’ assets.
The income of general partners in a limited partnership is treated the same as in a general partnership (i.e., it passes through to the owners’ individual returns). Limited partners’ income also passes through, though limited partners usually do not have to pay self-employment taxes for income derived from the business.
To establish a limited partnership, the business files a Certificate of Limited Partnership with the state in which it is located, usually with the office of the Secretary of State. Depending upon the state, the business may have to renew the registration annually and pay a fee, though the fees for limited partnerships are usually fairly small.
Limited Liability Company (LLC)
The idea behind the limited liability company model is to blend the straight-forward taxation of sole proprietorships and partnerships with the limited liability protection enjoyed by corporations.
An LLC can be owned by a single person or by multiple owners (referred to as “members”), and the business gets to choose whether to be taxed as a partnership or corporation – because the tax code does not provide a separate category for LLC’s.
If partnership taxation is selected, business income passes through to the members’ returns, with members who manage or work for the LLC paying self-employment tax.
If corporate taxation is chosen, the LLC can either be taxed as an S-Corp or C-Corp (the difference is explained below).
The LLC structure is often a good choice for small businesses because it is simpler and requires less paperwork than corporations, though LLC’s are more structurally complex than partnerships and do require regular filings.
At inception, Articles of Organization are filed with the secretary of state or equivalent state office, and annual reports are required each year the business is in operation.
Though not always mandatory, the LLC should also adopt an Operating Agreement detailing the members’ ownership percentages, distributive shares (the percentage of the business’s profits allotted to each member), rights, and powers, and generally stating how the business will be managed.
An LLC can either be member-managed or manager-managed.
If member-managed, the members govern the business and vote according to their ownership interests. If manager-managed, the members elect a manager or managers to run business operations. The manager can – but does not have to – be a member of the LLC.
Limited liability companies can raise capital by allowing outside investors to purchase membership interests without incurring any potential liability beyond their investment.
However, an LLC cannot sell shares to the public or conduct an initial public offering (“IPO”), which is often an attractive inducement for investment. If a business wants to sell shares publicly, it almost always has to be a corporation.
Corporations are the most procedurally complex and paperwork-intensive of the various business structures. They are the most expensive to form and maintain and have the most onerous requirements under state and federal law.
The federal securities laws and regulations relating to public stock-offerings in particular are tremendously intricate.
But, in compensation for these complexities, the corporate structure is the most conducive to raising capital – both because selling stock is more efficient than selling an LLC membership interest and because most lenders are generally less wary of lending to a corporation than to other business-types.
The corporate form also offers nearly complete limited liability protection to owners and flexible tax treatment through the C-Corp vs. S-Corp election.
Before we break down the differences between C-Corps vs S-Corps, we need to establish what all corporations have in common.
Corporations are formed by filing an Articles of Incorporation with the state in which the business wants to incorporate. The business is owned by “shareholders,” who elect directors to manage business operations and have voting rights as set forth in the corporation’s articles and bylaws. Directors are often also shareholders, but they do not have to be.
During its life, a corporation must hold annual meetings of directors and shareholders, record minutes of the meetings, and file annual reports and pay annual registration fees. If a corporation fails to meet its procedural requirements, it can be terminated, or dissolved, and any business conducted after dissolution will not be protected by the corporate limited liability shield.
Once a business is incorporated, it is treated under the law as a separate and distinct legal entity, including for tax purposes. However, if certain conditions are met, a corporation can choose to be taxed as a partnership, with corporate income passing through to shareholders’ returns and no separate return needed for the entity. This tax election is what distinguishes an S-Corp from a C-Corp.
S-Corporation vs. C-Corporation
By default, every corporation is treated as a C-Corp. This means the business files its own return, and business income is taxed at the corporate rate.
If a shareholder works for the business and draws a salary, the salary is personal income reported on the shareholder’s return and a business expense for the corporation.
If corporate profits are paid out to shareholders as dividends, the dividends are taxed to the shareholders at either the personal income rate or the capital-gains rate, depending upon whether the dividend is “qualified.” This regime has led to complaints of “double taxation” because corporate profits are taxed both as corporate income and as shareholder dividends.
A corporation can avoid double taxation by electing S-Corp treatment.
Under the S-Corp system, business profits are taxed as the shareholders’ personal income, as if the business was a partnership. Business losses can also pass through, allowing owners to offset income earned from other sources.
An S-Corp election is particularly attractive for corporations owned by one or just a few shareholders who do not plan to reinvest much of the corporate revenue into the business.
Of course, C-Corps enjoy certain advantages over S-Corps, too.
While an S-Corp can only have one class of stock, a C-Corp can issue multiple classes, thereby allowing owners to raise capital from investors without relinquishing managerial control.
C-Corps are also allowed to deduct certain benefits to owner-employees, such as health or life insurance, which S-Corps cannot deduct.
Some benefits, when provided to S-Corp owners, are taxable as the owner’s individual income (if he or she holds more than 2% of the business’s shares) – but the same benefit might not be treated as income if provided to a C-Corp owner.
Perhaps the greatest advantage of C-Corps is that any corporation can decide to be taxed as a C-Corp, but not every corporation is eligible to make an S-Corp election.
To be taxed as an S-Corp, a business cannot have more than 100 shareholders, and the shareholders must be U.S. citizens or resident aliens.
S-Corps also cannot be owned by most other entities (e.g., LLC’s, other corporations, certain trusts). As result, S-Corps find it more difficult to raise capital from institutional investors.