Creating a legal entity for your startup will establish much-needed separation between you and your business. Shielding your personal assets is the first and foremost reason to think about incorporating.

But let’s face it. When it comes down to choosing a business structure, small business owners are typically concerned about one thing: taxes.

There are a whole host of reasons to incorporate as a C Corporation. For example, the C Corp is the preferred structure if you intend on seeking VC funding or taking the company public. But forming a C Corp involves more paperwork, legal fine print, and potential double taxation.

Key Differences to Consider

The biggest differences between forming an LLC and incorporating as an S-Corporation arise when you start to look at the more complex issues of taxation, corporate structure, and regulatory compliance.

If you’re a new entrepreneur or longtime small business owner who’s trying to figure out how to choose between an LLC and an S-Corporation, here are a few considerations to keep in mind:

S-Corporations require extra paperwork

If you choose to form an LLC, your day-to-day experience of running your business is not likely to change. If you’re a sole proprietor who forms an LLC, you still can keep doing business the same way as before, you keep paying taxes the same way as before, and in general, you get the protections of incorporating without a lot of extra hassles and red tape. This is not the case for an S-Corporation. If you form an S-Corporation, you need to assign a Board of Directors, hold annual shareholders meetings, file multiple business filings throughout the year, set up formal payroll processes, and deal with various other paperwork, accounting and regulatory hurdles that you don’t need to worry about with an LLC or sole proprietorship. Many sole proprietors should think hard about setting up an S-Corporation: are you really ready for the extra complexities and costs that go with incorporating as an S-Corporation? Depending on the nature of your business and your goals, you might be better off with an LLC.

S-Corporations can be tricky for sole proprietors

Many sole proprietors want to get the tax savings of an S-Corporation to avoid paying that dreaded extra share of self-employment taxes. (If you form an S-Corporation, the company does not pay any taxes and the earnings can be passed through to the individual owners/shareholders – and those earnings are then taxed as “employee income,” without incurring the extra 7.5% of self-employment taxes.) However, there can be a few hurdles for solo entrepreneurs who want to incorporate as an S-Corporation. As a sole owner of an S-Corporation, you need to pay yourself a salary and also assign a “distribution” of the company earnings. The distribution amount is free from self-employment tax. However, you need to be careful about how high to set your salary – if you pay yourself too low of a salary (hoping to minimize your self-employment taxes), you might get audited by the IRS and have to pay tax penalties. But if you set your salary too high, you run the risk of overpaying your self-employment taxes. This situation is complicated and we encourage you to talk with a professional tax advisor prior to deciding to incorporate as an S-Corporation.

S-Corporations require owners to be U.S. citizens or permanent residents

The business world is more international than ever before – so if you’re starting a business with partners from other countries (or located in other countries), an S-Corporation is probably not the best choice. Under U.S. tax laws, owners of an S-Corporation must be U.S. citizens or permanent residents – but this restriction does not apply to LLCs or other business structures. This is a small but important consideration if you or your business partners are not U.S. citizens or permanent residents.

Understanding the Pitfalls of Double Taxation

From a legal stance, a C Corp is a separate entity that can sue and be sued. When it comes to taxes, a C Corp is a separate taxpayer that files its own federal and state (where applicable) tax returns. This means that profits are first taxed with the corporation. Then, if the corporation decides to take that profit and distribute dividends to shareholders, the dividends are taxed again (this time, on each shareholder’s personal tax statement).

To better understand the potential of double taxation, let’s look at an example: Carl owns a graphic design business and formed a C Corporation (he’s the only shareholder at the moment). His business took in $90,000 in profit in 2011. As a C Corporation, the business would first be taxed on the profits, paying $19,000 (assuming $13,750 plus 34% of the amount over $75,000).

Carl wants to take that money home and decides to distribute it to himself as a dividend. He will also owe taxes (at the 15% qualifying dividend rate) on the dividend payment.

Carl’s total tax payments amount to $19,000 (corp) plus $13,500 (personal), totaling $32,500.

Avoiding Double Taxation: Pass-Through Tax Treatment

Two business structures are often preferred for small businesses since they avoid this double taxation burden: the LLC (limited liability company) and S Corporation. With these business structures, the company is taxed more like a sole proprietor or a partnership than as a separate entity, like the C Corporation.

Company profits are “passed through” and reported on the personal income tax return of the shareholders.

Here’s what it would mean for Carl and his graphic design business: Carl incorporates his graphic design business as a C Corporation, then chooses to elect “S Corporation Status” by filing form 2553 with the IRS in a timely manner (note: the S Corporation deadline is 75 days from the day your company is formed, or March 15 for existing companies).

His company earned $90,000 in profit in 2011. As an S Corporation, the business itself pays no income tax. Since Carl is a shareholder and also works in the business, he must pay himself a reasonable wage for his activities. This will be subject to his personal income tax rate.

Then, he can distribute the rest of the profits to himself as a dividend, which is taxed at a 15% qualifying dividend rate.

Please bear in mind that these examples are over-simplified to introduce the concept of double taxation at the highest level. As expected, nothing is ever so simple when it comes to the world of business taxes. Discussing your particular situation with a trusted tax advisor or accountant can go a long way to helping you determine which business structure and tax treatment is optimal for you.

The LLC and S Corporation

Both the LLC and S corporations offer the pass-through tax treatment explained above. And both will protect your personal assets from any potential liabilities of the company (whether from an unhappy customer, unpaid supplier or anyone else who might pursue legal action).

Yet, the LLC and S Corp feature some key differences as well. Stay tuned for my next post, when I explore these differences and how they impact your business.

Your choice in business structure will ultimately depend on all the unique aspects of your business. But regardless of which business type you choose, taking a serious look at your legal structure is essential to set your business up for success.