Choosing the right legal form for your business
| Sole Proprietor | S-Corporation | C-Corporation | Partnership |
NOTE: The legal information on this web site is intended as an overview. It is not intended to substitute or replace the advice of an attorney, accountant, or other similar professional. Before making any critical decisions regarding the setup of your business, you should consult the appropriate licensed professional.
After you start your business, even if you don't fill out one official form, your business automatically takes on a legal form. Many people start out accepting the default, sole proprietor legal form. But, before you settle for this, you should understand the basics about the other forms a business can take so you can leverage the advantages of the appropriate form of business when you're ready.
There are five basic legal forms your business can take: sole proprietor, partnership, S corporation, C corporation, and Limited Liability Corporation (LLC). Because LLCs are relatively new, this article doesn't cover them, but since LLCs are a combination of S corporation and partnership, you can get an idea how they work by reading about those two forms of business.
The types of business structures available to you are shaped by two main factors: liability and taxation. A sole proprietor and partnership assumes more personal liability risk than a corporation. This means that the chances of a lawsuit awarding damages against the personal assets of a sole proprietor or partner is greater than that of a shareholder of a corporation.
Taxation is a fact of life for any type of business. Depending on the type of business, the IRS charges taxes against the business owner's personal income or against the profits of the business. Contract employees, sole proprietors, partnerships, S corporations, and LLCs pay taxes based on the owner's net income from the business. C corporations pay separate taxes based on the net profits of the business. Each business type has various liability and taxation advantages and disadvantages.
When considering which legal form you will ultimately choose for your business entity, consider how the business pays you, how the IRS gets paid, and the effort required to set up the business. For more information about any of these legal forms, click on the links below:
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Sole Proprietor
If you do not work for someone as a temporary employee and you do not set up a corporation or partnership, your business legally defaults to a sole proprietorship. After you do work for a client as a sole proprietor, the client issues you and the IRS a 1099 statement describing how much the client paid you during the year.
Sole Proprietor: How do I get paid?
You get paid by withdrawing as little or as much as you want from the profits of your business.
Sole Proprietor: How does the IRS get paid?
The IRS tracks their cut when you report the net profit of your business on your personal income taxes using Schedule C. You must file a declaration of estimated income tax (Form 1040 ES) each quarter. When you file Form 1040 ES you pay estimated federal income taxes and self employment taxes for the quarter. The self employment tax includes both the employer and employee portions of the Social Security and Medicare taxes totaling 15.3 percent. If you do not have employees, the IRS tracks the business for tax purposes using your personal Social Security number. If you hire employees, you must file for a Federal Employer ID number using form SS-4.
Sole Proprietor: What paperwork is required?
Although you do not have to fill out any paperwork to establish a sole proprietorship, you may need to register with your local government. This may include filing a fictitious name statement or Doing Business As (DBA) name. You may also have to apply for a local business license from your county or municipality.
Sole Proprietor: What are the advantages?
As a sole proprietor, you can deduct your business expenses including at least a portion of your health insurance costs. You apply the deduction to your adjusted gross income, not to the Schedule C for your business.
Sole Proprietor: What are the disadvantages?
A sole proprietorship does not protect your personal assets from damages assessed as the result of a lawsuit against your business.
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S corporations
The term "S corporation" refers to Subchapter S of the Internal Revenue Code. An S corporation is a cross between a standard corporation and a partnership. It's like a corporation because ownership is vested in shareholders and it provides limited liability protection to the company stockholders. It's like a partnership because it accommodates multiple owners and all the profits of the S corporation pass through to the shareholders where the IRS taxes the profits as personal income.
S Corp: How do I get paid?
There are two ways to receive money from your S corporation. You can pay yourself as an employee of your corporation complete with payroll deductions and W-2 form at the end of the year. The second method is to withdraw profits in the form of a distribution. The primary advantage of paying yourself a salary (despite the cost of payroll deductions) is that it qualifies you for your company retirement plan and you continue to participate in the federal Social Security program. When you pay yourself a distribution, the IRS taxes it as part of your total income on your personal income taxes. You avoid payroll taxes, but none of the money from the distribution can participate in a retirement program.
S Corp: How does the IRS get paid?
The IRS requires you to withhold taxes from your paycheck the same as any other employer. When you deposit the withheld funds, you must add the 7.65 percent employer side taxes for Social Security and Medicare. The S corporation must file an income tax return (Form 1120-S). Any taxable income the business earns (in excess of your salary and expenses) pass through to you on your personal income taxes using Schedule E.
S Corp: What paperwork is required?
Each individual state, not the federal government, registers and licenses corporations. No two corporations can have the same name within the same state, so you have to reserve your corporate name then file articles of incorporation and pay a licensing fee. Usually the articles of incorporation is a standard form that you fill out. Every year you file an annual report and pay a yearly franchise tax.
The S corporation designation is an IRS issue and as such is not handled by the states. To register your corporation as an S corporation, you have to file Form 2553 with the IRS prior to the taxable year for which it will be effective, or by the fifteenth day of the third month of the current taxable year. Also, you must get a Federal Employer Tax ID number from the IRS (Form SS4). Finally, you must set up a corporate checking account separate from your personal checking account.
S Corp: What are the advantages?
The most often-sited advantage to incorporating is the limited liability. However, if a lawsuit can show that you incorporated for the sole purpose of avoiding liability while acting recklessly, or if you donut maintain your corporate status (such as neglecting to file your annual report and paying the franchise tax), the lawsuit may expose your personal assets. This is known as "piercing the corporate veil." Despite this possibility, incorporating does provide an additional hurdle for someone seeking damages beyond the assets of the corporation itself.
Another advantage is added prestige. Many independent consultants feel they can access more clients by having "Inc." or "Corp." after the name of their company because it reinforces that theirs is a "serious" business.
An added advantage of S corporations is in the area of taxes. S corporations do not pay corporation taxes like standard corporations. If your S corporation sustains a loss in the first year of operation, the losses can "fall through" to you offsetting your personal tax burden.
S Corp: What are the disadvantages?
In general, the biggest disadvantage to incorporating is increased paperwork and cost. As noted previously, you have to file annual reports with the state and a corporate tax return with the IRS. Additionally, you have to handle all the employer paperwork to pay yourself a salary.
S corporations also have many specialized restrictions. S corporations are limited to 75 or fewer stockholders and must use the same tax year as their shareholders, which is January 1 through December 31. More significant, however, are the restrictions on deductions. An S corporation cannot deduct the cost of any employee fringe benefits (health, accident, life, disability insurance, and so forth) for any employees who own 2 percent or more of the company's stock. This excludes most independent consultants who typically own 100 percent of their company's stock.
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C corporations
When you incorporate, if you don't register as an S corporation, the IRS automatically classifies your corporation as a "C corporation." Actually, there is no official term "C corporation," but the designation makes it easier to separate this type of incorporation from an S corporation. The primary difference between S and C type corporations is that C corporations pay corporate income taxes on any profits leftover after salaries and other expenses. If you want to receive a dividend in addition to your salary from the C corporation, you receive income that the IRS already taxed at the corporate level. You must report that dividend as income on your personal taxes where the IRS taxes you again. This double taxation encourages most independent consultants to start with S corporations and then convert to C corporations when they want to take advantage of the added deductions.
C Corp: How do I get paid?
Technically, as with S corporations, there are two ways to receive money from your C corporation. You can pay yourself as an employee of your corporation and/or you can pay yourself a distribution in the form of a dividend. If you pay out dividends, you get double-taxed. The advantage of paying yourself a salary is that it qualifies you for any corporate employee benefits based on your salary, including retirement funding.
C Corp: How does the IRS get paid?
The IRS requires you to withhold taxes from your paycheck the same as any other employer. When you deposit the withheld funds, you must add the 7.65 percent employer side taxes for Social Security and Medicare. The C corporation must file an income tax return (Form 1120). The IRS taxes any profits the business earns (in excess of your salary and expenses) at the corporate tax rate. C corporations must also deposit estimated income taxes every quarter.
C Corp: What paperwork is required?
Each individual state, not the federal government, registers and licenses corporations. No two corporations can have the same name within the same state, so you have to reserve your corporate name then file articles of incorporation and pay a licensing fee. Usually the articles of incorporation is a standard form that you fill out. Every year you file an annual report and pay a yearly franchise tax.
C Corp: What are the advantages?
The most often-sited advantage to incorporating is the limited liability. However, if a lawsuit can show that you incorporated for the sole purpose of avoiding liability while acting recklessly, or if you don't maintain your corporate status (such as neglecting to file your annual report and paying the franchise tax), the lawsuit may expose your personal assets. This is known as "piercing the corporate veil." Despite this possibility, incorporating does provide an additional hurdle for someone seeking damages beyond the assets of the corporation itself.
Another advantage is added prestige. Many independent consultants feel they can access more clients by having "Inc." or "Corp." after the name of their company because it reinforces that theirs is a "serious" business.
The biggest additional advantage that C corporations have is the ability to deduct the cost of any employee fringe benefits. This includes items such as health, accident, life, and disability insurance, regardless of the level of employee ownership. Also, C corporations can select what constitutes their tax year. This could provide some advantages when trying to balance the interplay between corporate and shareholder cash flow and taxes.
C Corp: What are the disadvantages?
The biggest disadvantage of C corporations is the double taxation. Also, there's additional paperwork in the form of quarterly estimated taxes.
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Partnerships
A partnership is the only form of business that requires multiple owners. Even a corporation can be owned by only one person. As an alternative to a partnership, most consultants create a corporation and distribute shares to other owners when they want to add people to their business. Or, they choose the new Limited Liability Corporation (LLC) option.
Partnerships: How do I get paid?
The way you get paid is determined by a partnership agreement. Typically, the agreement divides profits equally between the partners.
Partnerships: How does the IRS get paid?
The IRS taxes the profits of the individual partners. The IRS requires partnerships to file a partnership income tax return (Form 1065) even though the partnership itself does not pay any taxes. Form 1065 includes an attached form K-1 that shows the changes in each partner's share and the taxable share of the partnership's income or loss. A partnership must also obtain a Federal Employer ID number even if it has no employees.
Partnerships: What paperwork is required?
Other than the IRS forms mentioned above, the government does not require any formal paperwork to set up a partnership. However, though it is not required by law, most partnerships create a written partnership agreement, usually drawn up by an attorney.
Partnerships: What are the advantages?
One advantage to a partnership is it relieves you from doing everything yourself. If you allocate the work load properly, you can have one partner do marketing full-time while another delivers the service.
Partnerships: What are the disadvantages?
Similar to a sole proprietorship, a partnership is legally connected to its owners. This means that a court can order the partners to pay the damages of a lawsuit from the partners' personal assets.
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