Many business owners operating as sole proprietorships or general partnerships may be wondering if it would be beneficial to establish a formal business structure. If that describes your current situation, you’ll find that this article provides information about the possible benefits of incorporation. I also featured this topic in a webinar I presented for accountants, CPAs, bookkeepers, business coaches, and other professionals who work with business clients. I invite you to tune into the webinar recording to see and hear everything I covered.
Keep in mind that the information in this blog post and the webinar is not meant as legal, accounting, or tax advice for that, business owners should seek out guidance from licensed professionals in those areas.
Importance of Business Incorporation
Some reasons a small business might decide to incorporate or form an LLC include:
- Establishment of a separate legal entity
- Liability protection of personal assets
- Boost in professional credibility
- Tax flexibility
- Tax deductions
- Perpetual existence
I believe the best way to elaborate on these important considerations is to describe the features of the various entity types.
Popular Entity Choices
Sole Proprietorship and Partnership
Sole proprietorships and partnerships are simple to form and maintain because they require no special entity-specific financial statements or lengthy paperwork to stay compliant. Because all business income is considered income earned by the business owner, it’s fairly simple from a tax perspective, too. Business profits and losses get reported on the business owner’s personal income tax return.
One potential drawback is that there is no separation of personal and business assets—the company and its owners are considered a single entity for legal and tax purposes. Owners generally have to sign contracts and paperwork in their own name because the business does not have a separate identity under the law. This may make it challenging to gain business credit, take out business loans, or raise capital in other ways.
A C Corporation is a separate legal and tax-paying entity from its owners. Generally, owners are shielded from personal liability for the debts and legal issues of the business. A C Corp is owned by shareholders and run by an elected board of directors.
C Corporations are taxed independently of their owners; i.e., the business must file its own tax return and supporting documentation. C Corps are taxed in a way that results in “double taxation” on some income. Although there are exceptions, typically, the C Corp structure isn’t favorable for small businesses, unless they intend to go public or seek funding from venture capitalists.
Limited Liability Company
The limited liability company (LLC) structure combines the elements of a sole proprietorship, partnership, and corporation. Like a C Corp, it shields owners from personal liability, but It’s less complex to manage than a C Corporation. An LLC is a separate legal entity from its owners, but to the IRS, the business and owner are considered the same taxpayer. Business profits and losses flow through to the owners’ personal income tax returns.
An S Corporation (S Corp) is not an entity type in and of itself. Instead, it is an election that a qualifying C Corporation may choose to receive pass-through tax treatment from the IRS. C Corps that elect for S Corp tax treatment are still owned by shareholders and run by a board of directors. They must hold annual shareholders’ meetings and directors’ meetings, file a corporate income tax return, and comply with the other C Corporation requirements set forth by the state where they are registered.
LLCs may also be eligible for S Corporation tax treatment, which still provides pass-through taxation. The difference is that only owners’ income paid as wages and salaries is subject to self-employment taxes; remaining income is not.
I’ll touch on the tax features in more detail later in this article.
Questions to Ask When Deciding on a Structure
There are many factors to consider when selecting a business entity type. A few questions that entrepreneurs should ask themselves include:
- Do you have personal assets?
- Are you concerned about personal liability?
- Do you need to live off of the business’ profits each year?
- Do you want to keep paperwork and administration as simple as possible?
- Do you want to keep the business “forever”?
Tax Advantages and Disadvantages
Taxes and the C Corporation
The positives of C Corporation from a tax perspective include:
- The corporate income tax rate may be favorable for the business. A C Corp’s profits get taxed at the corporate income tax rate. In some circumstances, that might work in the business owner’s favor. Depending on the location and shareholders’ personal tax situation, they might find the corporate tax rate will cost them less than if they were set up as an LLC.
- There might also be more tax deduction opportunities when operating as a C Corporation. The business may be eligible for more tax deductions than if it were an LLC, partnership, or sole proprietorship.
- Eligible C Corps may be taxed as an S Corporation, enabling them to avoid the sting of “double taxation.”
The potential tax downside to being a C Corporation is the double tax hit. A C Corporation’s profits are taxed when they are earned. Then, any of the profits paid as a dividend income to shareholders are taxed again on the shareholder’s individual tax returns.
Taxes and the Limited Liability Company
Single Member LLCs are taxed as sole proprietorships by default. Multi-member LLCs are taxed as partnerships by default.
The positives of the LLC business structure from a tax perspective include:
- S Corporation election is an option for qualifying LLCs. This may enable the business owners to lower their self-employment tax (Medicare and Social Security) burden because owners can be employees of the company, and only their wages and salaries are subject to that tax. Income paid as profit distributions are not.
- Owners can choose how they will distribute their profits. LLC members may choose how their business will divide the company’s profits and losses among its owners. This allows members to consider not only money invested but time and work invested when distributing profits.
A potential tax disadvantage of an LLC’s default tax treatment is the significant self-employment tax burden on owners.
Taxes and the S Corporation
As I mentioned before, the S Corporation is not a legal entity but rather a tax election option for qualifying C Corporations and LLCs.
The potential advantages entities that elect to be treated as an S Corp might benefit from include:
- It lessens the self-employment tax burden on LLC members – Only income paid to LLC members on the payroll is subject to self-employment taxes. Profits paid as distributions are not subject to Social Security and Medicare taxes, so LLC members may find that the S Corporation election lowers their personal tax burden.
- It enables C Corporations to avoid double taxation – As an S Corporation, a corporation’s profits and losses flow through to shareholders’ personal tax returns and are taxed at the individual tax rates. The corporate entity does not pay income tax. Shareholders that are employees of the C Corporation only pay self-employment tax on the wages or salary that the Corporation pays them. Dividend income paid to shareholders is not subject to self-employment tax; those monies are taxed as either ordinary income or qualified dividends.
Note that there are some possible downsides to the S Corporation election, too:
- It may limit growth potential – S Corps may not have more than 100 shareholders.
- LLC members and shareholders must be careful to pay themselves wages or salaries that are “reasonable compensation.” Owners may find themselves in trouble with the IRS if they pay themselves meager wages and take significantly more of their income as profit distributions. (That could indicate they’re gaming the system to avoid paying their fair share of self-employment taxes.)
- S Corporations are not always treated equally at the state level – States’ tax codes vary in how they apply income tax to LLCs and C Corporations that have opted for S Corp election.
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Which State Should You Choose to Incorporate In?
Many entrepreneurs are unsure of in which state they should incorporate or form an LLC. Most choose their home state while others opt for states identified by many as “business-friendly”— such as Delaware, Nevada, or Wyoming. It’s important to carefully research the pros and cons because each state differs in its fees, taxes, and other details.
Some of the variables to consider include:
- Formation fees – The cost to register a business differs from one state to the next. The filing fees can run from approximately $50 to $455.
- Annual fees and filings – The costs for these vary by state from $0 to $325.
- Franchise taxes – Some states levy these fees, and the amount varies per state from $0 to $800.
- Legal and court system – Some states’ laws are more favorable for businesses than others.
- Investors – Investors may be more interested in investing in businesses in some states more than others.
- State corporate income tax – Some have no corporate income tax, others have a gross receipts income tax, and there may be other fees.
The general rule I share with people is: If a business has fewer than five shareholders, it’s often more advantageous to incorporate or form an LLC only in the owner’s home state. Suppose a business is incorporated in one state, but the owner lives and also conducts business in another state (home state). In that case, they are responsible for state fees and taxes in both locations. This can be a tricky decision, so it’s important to consult legal and tax professionals for expert guidance.
Steps to Get Started
Every business is unique, and state and local requirements differ, so the steps for starting a company may vary. Below, I’ve listed the general tasks involved in the process. There may be fewer or more steps depending on the type of business and where it’s located.
How to Start a C Corporation
- Conduct a business name search to confirm the desired name is available.
- Designate a registered agent.
- Draft Articles of Incorporation.
- File Articles of Incorporation with the state.
- Write up corporate bylaws.
- Apply and obtain Federal Tax ID Number (EIN).
- Start a corporate records book.
- Comply with licensing and zoning laws.
- Hold your first board meeting.
- Complete additional federal and state requirements.
- Complete out-of-state registration if necessary and applicable (i.e., foreign qualification).
- File an Initial Report (and stay compliant by filing Annual Reports).
How to Start an LLC
- Do a business name search to ensure the desired name is available.
- File Articles of Organization.
- Choose a registered agent.
- Decide on whether the LLC will be member-managed vs. manager-managed.
- Create an LLC operating agreement.
- Apply and obtain a Federal Tax ID Number (EIN).
- Comply with other tax and regulatory requirements.
- Complete out-of-state LLC registration if necessary and applicable (i.e., foreign qualification).
- File an Initial Report (and stay compliant by filing Annual Reports).
How to Elect S Corporation Tax Status
- The entity must first be incorporated as a C Corporation or have filed as an LLC.
- A C Corporation electing S Corporation status must submit and file IRS form 2553 signed by all shareholders.
- An LLC electing S Corporation status must submit and file IRS Form 2553 signed by all shareholders.
- An LLC electing to be taxed as a C Corporation must submit and file IRS Form 8832 signed by all shareholders.
Business Entity Conversions
Sometimes business owners discover that their present entity type is no longer ideal for their current situation. Therefore, they may want to convert their company to a different business structure. There are different ways to accomplish that; the methods a business may choose depend on their state’s requirements.
- Some states allow an entity change via a statutory conversion filing with the Secretary of State.
- Some states require a dissolution (formal closing) of the original business and a change to the company name.
- Another option is an inter-entity merger.
Changing From a C Corp to S Corp
Technically, this is not a change in the business’s entity type. It is choosing a special tax election with the IRS. Some C Corporations want to avoid double taxation but want to retain liability protection, so they file as an S Corp. S Corps can pass corporate income, losses, deductions, and credits through to shareholders for federal tax purposes. To file for S Corp status, a C Corp must file IRS Form 2553 by the IRS deadline (usually on or around March 15th). If the deadline is missed, businesses can get an extension via IRS Form 7004. Otherwise, the business will be taxed as C Corp until the next tax year.
Changing From an LLC to C Corp
Some of the reasons why entrepreneurs switch from operating as an LLC to a C Corp are to sell stock and attract investors. Members of the LLC must agree to change the business structure. If a state allows statutory conversions, a certificate of conversion document is filed with the state and all assets are transferred. Therefore, no new entity needs to be formed.
In other states, the way to change might involve creating a new C Corp and then making the original LLC a subsidiary or a DBA of the newly formed corporation.
Another option is dissolving the original entity and forming a new one. As you can imagine, this can get complicated as assets and liabilities also must be dissolved and reformed.
After changing to a C Corp, the business must follow the corporate laws in the state where it’s registered.
Changing from C Corp to LLC
Although this means going from a more formal entity type to a simpler, more flexible one, the change from C Corp to LLC is usually a complicated transition. The IRS considers this switch a monetary transaction. In other words, it’s looked at as the C Corporation “selling” its corporate assets, which means it will get taxed on any assets that have appreciated in value. After switching from a C Corp to an LLC, it may be difficult to go back to being a C Corp in the future.
States That Allow Statutory Conversion Filings
As I shared earlier, each state has its own rules about how to make an entity change. Business owners should check with their state for details. Currently, Statutory Conversion filings are allowed in the following states:
- Vermont (LLC to C Corp)
How Accountants and Tax Advisors Can Help
Professionals and firms that offer tax guidance to businesses mustn’t overstep their bounds by giving legal advice if they’re not licensed to do so.
For example, some of the topics to avoid when talking with clients include:
- The personal liability advantages of changing from a sole proprietor to an LLC
- What they need to include in their operating agreement
- Which state will offer the most favorable legal environment for their business
Things that certified accountants and tax advisors may offer advice on are those involving the effects a business structure will have on clients’ tax obligations. For example:
- Will pass-through taxation, S Corporation tax treatment, or taxation as a corporation be most beneficial financially to a client who is forming an LLC?
- What options does a general partnership have if its owners want to lower their self-employment tax burden?
- Which states offer the most favorable tax rates for a corporation?
Another way that accountants, CPAs, bookkeepers, business coaches, and other professionals can help clients is by preparing and filing business registration documents for business owners. The person transferring that information into the filing forms and sending it off to the state is merely acting as a scribe. Examples of those types of forms are below:
- Articles of Organization
- Articles of Incorporation
- DBA (Fictitious Name) applications
- Trademark applications
- Annual reports
- Registered agent renewals
I recommend turning to the resources in CorpNet’s Learning Center for information about state filings. Also, professionals who help business owners can find a wealth of knowledge in our Checklists, Guides, and Tools for CorpNet partners.
Speaking of CorpNet partners, I encourage accounting, tax, legal, and business coaching professionals to join our CorpNet Partner Program. We’ve set it up as a way for you to expand your revenue stream by offering business formation and corporate compliance services to your clients in all 50 states. Best of all, your clients remain “your clients” as you sell CorpNet services under your brand while we work as your silent fulfillment partner. Or you can choose to refer clients to us and let us handle the rest. Either way, we provide you with dedicated support and resources to help ensure your success.
Learn More and Grow Your Business
You’ll find more details about the important topics I covered in this article in my webinar recording. Whether you’re an entrepreneur or a professional who helps entrepreneurs, I believe you’ll find it insightful.
To all of the accountants, bookkeepers, business coaches, lawyers, and other professionals reading this, I invite you to contact us for more information about the opportunity to increase revenue by signing up for the CorpNet Partner Program.