If you are considering starting your own business, or are already in the process of working on a plan, one of the first decisions you’ll make is how to structure your business. Each business type has its own personal asset protection, tax laws, and operational implications. Understanding your business needs and how these entity types affect your business plays a key role in your company’s overall success.
With this in mind, we’ve organized the pertinent information you’ll need to know regarding how top business structures operate, as well as breaking down some of the top business comparisons if you’re stuck between two.
The LLC business structure, which stands for Limited Liability Company, is widely known as a “pass-through” entity because the profits of an LLC company flow directly to the managers/members. This type of business structure is quickly becoming the most common form of incorporation. LLCs have a relatively flexible structure that provides many of the benefits of a partnership or sole proprietorship, with some of the protections provided by C corps and S corps (more on those business structures soon). They do not require many of the formal processes required by other types of corporations.
However, LLCs are unable to offer stock to the public and are still required to keep a fair amount of internal paperwork. LLCs do still require an owner to follow filing regulations. Companies that abuse the flexibility offered by filing as an LLC can lose their personal liability protection, in a process called “piercing the corporate veil”. If this happens, business owners can retroactively be held liable to pay corporate debts with personal funds.
Easier process for setup
Flexibility on taxes
Difficulty attracting investors for funding
Added formation costs and franchise tax for some states
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A C corp is what most people think of when they hear the word “corporation.” Most large companies are filed under this structure, as it offers the most asset protection and tax-related options for business owners. It is also typically the only choice for owners that would like to be taxed separately from their company.
Choosing the C corp structure for your business isn’t the best choice for everyone. Filing as a C corp requires a great deal of paperwork, as well as formal processes that must be carefully and regularly filed. C corps are often also more closely monitored than other types of businesses, due to the fact that they are one of two types of corporations that can issue stock to the public.
Ability to take the company public and issue stock
More attractive structure for investors
A possible lower tax rate
Double taxation (company and personal income; more on that below)
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An S corp is an election businesses can choose to make whether they form an LLC or a C corp. Making your S corp election does not impact the personal liability protections that come with the formation of an LLC or corporation. It is usually done for tax advantages, but before you decide to make the S corp election, you need to understand the benefits and some of the limitations it may put on your corporation or LLC.
There are a few differences between businesses that opt for an S corp election and those that form a C corp, or Inc., without the election. For one, owners of an S corp can claim operational losses as part of their personal income should the business fail to turn a profit. An S corp can also help business owners avoid what is referred to as the "double taxation" issue impacting C corps. With C corps, taxes are imposed on the profits at the corporate level. Then, when the profits (after payment of the taxes) are passed down to the owners, the owners also have to pay taxes on their dividends. S corps are treated more like partnerships in that all profits or losses are passed through to the owners and aren't taxed at the corporate level. Thus, the profits are only taxed once.
Making the election does put some restrictions on a C Corp. For example, all business owners of S corps must be U.S. citizens, which can limit international growth. Moreover, the shareholders are limited in number and type when you make an S corp election. You cannot have more than 100 shareholders and most incorporated entities cannot be shareholders. Finally, there can only be one class of shares in an S corp.
All the benefits of a C corporation
A possible lower tax rate by avoiding double taxation
Limited ownership rules
Many people don’t know that LLCs can also make S corp elections. After reading the prior section, you may wonder why an LLC would make that election given the primary benefit double-taxation avoidance with a pass-through entity is already the default for an LLC. Yet, an S corp election for an LLC can also provide additional tax benefits to an LLC.
By making an S corp election, the LLCs distributions (the passing of profits after payment of LLC expenses including payroll) are not treated or taxed as wage income to the owners. Let’s say, for example, that you own an LLC and the annual profits are $1M. Without an S corp election, the owner of the LLC would have to pay payroll taxes on the $1M worth of profits. With an S corp election, the LLC owner only pays payroll taxes on a “reasonable” salary that gets paid to the owner. Any distributions after the payment of a reasonable salary are free of those payroll taxes if done correctly.
The same restrictions described above applicable to corporations also applies to LLCs, so there are some restrictions on an LLC that makes an S corp election. Also, if the owners aren’t paid reasonable salaries, the IRS can invalidate the S corp election requiring the payment of back taxes and penalties.
All the benefits of an LLC
A possible lower tax rate by avoiding some payroll taxes for the owners
Limited ownership rules
Penalties if not properly implemented
Nonprofits have a charitable purpose or association with the organization and are eligible for tax exemptions. To receive a tax-exempt status with the IRS, the nonprofit’s purpose must fall under section 501(c)(3) of the Internal Revenue Code:
“... corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.”
Nonprofits are similar to corporations through their structure and process of creation. View our step-by-step guide to forming a nonprofit here.
Personal liability protection
All profits must go to the charitable cause and can't be distributed to people who started the nonprofit
Difficult to raise capital through banks or other typical financing outside of donations
Little-to-no salary offerings (staff are expensive)
A sole proprietorship is the default type of entity when a business is started by one owner. Unlike LLCs or Corporations, states do not require you to file your business initially or file periodic reports. The downside is that the owner is held liable for all losses, legal issues, and/or debt that the business accrues. There is little-to-no distinction between the entity and the business owner.
Examples of Sole Proprietors include freelancers, artists, consultants, virtual assistants, and other home-based owners who have not formally registered as an LLC or corporation.
Easy setup with low fees and little paperwork
Flexible management structure
Personal liability for all debts, legal obligations, and losses of the business
More difficult to raise capital
No ongoing business life (business ends with the owner)
May not have access to certain tax benefits
General partnerships allow for two or more business owners, also considered “partners.” Under this structure, a business cannot issue any type of stock, and partners are held personally liable for any taxes or debts. There is no legal separation between individual assets and business assets. Additionally, like a sole proprietorship, the partnership dies when one or more of the partners exits the partnership. However, provisions can be made as long as 2 or more partners remain in the business.
Easy setup with low fees and little paperwork
Flexible management structure
The business ends when one of the partners exit the partnership
Partners have personal liability for all debts, legal obligations, and losses of the business
Partners are liable for the actions of other partners
Need assistance in registering your DBA? Swyft Filings can help. Learn how we can help you form a DBA here.
The decision-making process for how you’ll form your business isn’t always linear but can go a few different directions. Some decisions lead to even more options you’ll be confronted with. First, you’ll need to decide whether you’ll form a sole proprietorship or an LLC or Inc. This question is fairly simple because the details and functions of your business will all but make the decision for you.
The following business comparisons are arranged chronologically, walking you through each question you need to ask yourself based on the route you take.
Any business that is more than just a hobby needs to form an entity (i.e. an LLC or Inc.) and register with the state. Sole proprietorships are great for those who are wanting to earn some profit from their hobby but don’t intend to turn it into a fully-fledged business operation. It’s less expensive to form a sole proprietorship than to incorporate, with no annual registration fees and lower startup costs. And due to the small size of sole proprietorships, they are not subject to formal registration with the state and can be established or dismantled relatively easily.
With a sole proprietorship, there is no formal filing process and your status as a sole proprietor is automatically granted from accepting your first dollar or other business activities. Additionally, you can continue under this structure until you are ready to organize your business in a more formal manner.
An LLC and Inc., on the other hand, require a formal formation process that involves filing paperwork with the Secretary of State.
The key difference between a sole proprietorship and an LLC/Inc. is that no separate legal entity is created, meaning the owner is liable for all debts incurred by the business. Unlike LLCs and corporations, creditors can pursue personal property from the owner such as cars, homes, and other items to satisfy debts if the business fails.
Unlike a sole proprietorship, an LLC can be owned by more than one person and all parties are shielded from liability.
By default, corps are beholden to double taxation, paying a corporate income tax as well as the shareholders paying personal income taxes. Sole proprietorships and LLCs both have “pass-through” taxation, meaning that business income and loss is reported on the owner’s personal income tax.
Sole proprietors can’t sell stock, which makes it hard to attract investors. Additionally, banks are hesitant to lend due to a higher perceived risk of repayment if the business fails.
LLCs tend to have more factors working in their favor when it comes to fundraising. One being, whereas sole proprietorships require the owner to take out loans in order to raise capital, an LLC member can borrow under the company name without affecting their credit score.
Corps are the strongest business type to receive funding from investors and shareholders, who have a stake in the business.
If your business exceeds a small side hustle or hobby, you’ll need to form an LLC or C corp. Keep in mind that you can transition a sole proprietorship to another business time when or if need be.
Now that you know your business will need to be more than a sole proprietorship, you’ll need to decide whether to form an LLC or an Inc. (i.e. C corp).
Both LLCs and corporations provide personal asset and legal protection for their owners or shareholders and are also both formed by filing paperwork with the state.
LLCs are owned by “members,” who own a percentage of the business. It’s difficult to transfer the percentage of ownership (aka “membership interest”) from one member to another. Membership details and rules, including how membership interest is transferred, are usually organized in the LLC’s operating agreement.
C corps have the most flexible ownership structures, in that they can sell stock in their company to anyone by “going public”. As a result, this gives the C corp many more funding and financing options than any other type of business. Venture capitalists typically prefer to deal with C corps. There are no restrictions on the number of owners (shareholders) that they can have, and they can be owned by individuals from any country. This makes them prime candidates for quick exit strategies, and rapid growth models.
LLCs have somewhat flexible tax structures. Single-member LLCs are taxed like a sole proprietorship. Multi-member LLCs, on the other hand, are taxed like a partnership, which means all profits and losses pass through to the owners.
By default, C corps are separately-taxable organizations, which means their owners must file both a corporate tax return and personal tax return. This often means that they will be taxed twice on their businesses profits, once when the business claims the income and again when they claim profits as personal income.
The ways in which an LLC can be managed vary and are flexible. If the LLC’s members are involved in managing the business, they tend to be very involved. There are also LLCs, however, that opt to be managed by a management team of directors or managers.
Corporations are much less likely to be managed by shareholders and are most typically managed by a group of directors and officers.
Regardless of whether you form an LLC or a corporation, you can expect for a decent amount of paperwork to be involved. That’s why some businesses opt to work with an online filing business like Swyft to cut down on manually filling out and filing documents.
When comparing LLCs to corporations though, corporations are subject to more requirements and regulations than LLCs. Corporations, for instance, often hold shareholder meetings annually, which require preparation and organization of reports. LLCs tend to have less formal recordkeeping requirements and, in some states, don’t require the filing of an annual report.
When trying to decide whether to form an LLC or corporation, in addition to the level of administrative paperwork and requirements, you should consider the ownership, financing, and tax advantages that make the most sense for your business.
Once you’ve chosen to form an LLC or a corp, you can then choose to make an S corp election.
The main reason to choose an S corp election is for taxation purposes, as they can save the owners on taxes. The possible tax savings may vary for an LLC versus a corporation and each is explained below. One note of caution, if not implemented correctly, the IRS may invalidate your S corp election resulting in back taxes and possible penalties.
S corps trade their tax benefits for strict ownership restrictions. They are limited to only 100 owners (or shareholders), and these individuals must all be legal U.S. citizens. Trusts and other subsidiary companies are not eligible to become part of the ownership structure. This can be a serious limitation, depending on the nature of the business and how it plans on generating its funding or financing.
In addition to the typical incorporation documents, S corps must file a special form with the IRS, Form 2553. This can be a relatively complicated and time-sensitive process; it is encouraged that you contact a business filing professional for assistance when taking care of this step.
S corp election makes sense for LLCs that are highly profitable and want to save on payroll taxes. Let’s say, for example, that you own an LLC and the annual profits are $1M. For an LLC without an S corp election, those profits flow through to the member’s personal income, which the member pays personal taxes on, as well as some payroll taxes.
In this same scenario, if the member makes an S corp election, the IRS requires that the members pay themselves a reasonable salary subject to payroll taxes. Any additional income is passed through to the individual owners subject to their personal tax rates, but no additional payroll taxes if done correctly. So by choosing an S corp election, the member isn’t paying additional payroll taxes on the LLC’s profits.
Corporations make an S corp election so that they can be treated as a pass-through entity for federal income tax purposes and avoid double taxation. Without an S corp election, the corporation pays taxes on the profits. Then, when the profits are distributed to the shareholders, the shareholders also have to pay taxes; hence, double taxation. With the S corp election, all of the profits and losses are passed through directly to the owners and only taxed once at the personal level.
Some owners try to avoid double taxation by bonusing themselves large sums at the end of the year so there is no corporate profit to be taxed. While that may save on the double taxation, the owner is paying more in payroll taxes than they might if they make an S corp election. With an S corp election, as long as the owner is receiving a “reasonable salary,” the profits distributed to the owner of a corporation may avoid both double taxation and some payroll taxes.
An S corp isn’t appropriate, however, if an inc has a lot of shareholders or wants to go public given the ownership restrictions discussed above.
An S corp election is a great option for LLCs that are profitable and for corps that don’t plan on going public or having many shareholders. And if your business won’t really reap the benefits of an S corp election, it may not be worth it as there are additional filing requirements. You may want to visit with a tax professional to determine which route is best for you.
Making an informed decision regarding the ideal structure for your business ensures you’re launching on the right foot. With Swyft Filings, you can file your business online and apply for your S corp election in just a short few minutes, or you can speak with one of our friendly account managers to walk you through the process.
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