Q: This year my partner and I want to change our business structure from a general partnership to some sort of corporation. I have heard of S Corporations and LLCs, but which one is best for a small business?
Mary M., Bolivar, Tenn.
A: First let me say that I like your thinking. The problem with general partnerships and sole proprietorships is the personal liability that accompanies business debts and liabilities. That is not true for corporate entities. In fact, one of the main reasons to incorporate is to legally shield your personal assets from business debts.
Say for instance that you owned a delivery service and that one of your drivers negligently killed someone one day. If you were not incorporated, it would be your personal assets that would be at risk (above and beyond your insurance limits.) However, if you were incorporated, creditors would be limited to the assets of the corporation only for payment and may not collect directly from the shareholders. That is a big deal.
Other benefits of incorporating are:
But there are downsides as well, including:
Nevertheless, for most small businesses, incorporating makes sense, which begs your question: What sort of corporation is best?
It depends. There are several types of corporations. The main two are the S and C Corporation (S and C are subsections of the IRS Code.). There is also the Limited Liability Company (LLC) which is like a corporation in many respects.
While there are several differences between the S and C corporations, there are two main ones. The first is that C corporations are taxed twice: First when profits are earned, and a second time when those profits are passed onto the shareholders. The advantage of the S corporation is that because it does not pay any corporate tax, its shareholders report profits and losses on their personal tax returns, and therefore, profits are only taxed once.
The so called “double-taxation whammy” of the C Corporation pushes many small business owners towards S corporations which are, generally speaking, intended for and used by smaller businesses. Another great advantage of the S Corporation, aside from single-taxation and limited personal liability, is that a sole owner of an S corp does not have to pay FICA tax — Medicare and the self employment tax — which is roughly 15% on the first $75,000 you earn.
Finally, there is the Limited Liability Company. LLCs are a hybrid, combining the best of corporations, sole proprietorships, and partnerships, and have become very popular among entrepreneurs. First, and best, like S and C corporations, LLCs protect their owners (called “members”) from personal liability for business indebtedness. Second, like partnerships and sole proprietorships, LLCs are fairly informal — there is no need for a board of directors, etc. Another advantage of the LLC is that its members can choose to be taxed as sole proprietorships and partnerships or they can choose a corporate tax structure if that is more advantageous.
Whether you should choose an S or C corp, or an LLC, depends upon a variety of factors and usually is a decision best made in conjunction with your lawyer an accountant. At least now however, you can have a well-informed discussion on the matter.
Today’s tip: “We don't want to push our ideas onto our customers; we simply want to make what they want.” — Laura Ashley.