There are several forms of business entity to choose from when starting a business in the U.S. It is important to note that each of the different forms have different tax implications, along with different levels of liability. The four types of business entities that will be discussed are the C corporation, S corporation, general partnership, and limited liability company (LLC).
C Corporation
A C corporation is what most people know as a regular corporation. This is the “dominant form of business organization” (Spiceland et al.). A C corporation is considered a separate legal entity which has the right to buy property, hire employees, and sign contracts. The C corporation is owned by its stockholders. However, stockholders have limited liability and are not personally liable for any business debts, torts, or other liabilities.
C corporations are not flow-through entities. The C corporation form of entity results in double-taxation. The reason for this is as follows. First, the C corporation is taxed as a separate entity using corporate income tax rates. The C corporation must file a Form 1120 with the IRS each year to report the income. Then, any dividends paid to stockholders are taxed again at the stockholders’ tax rates, and each of the stockholders must report this income on their year end individual income tax returns.
Also important to note is the benefit of perpetual existence. A C corporation is capable of continuing indefinitely. Its existence is not affected by the death or incapacity of shareholders, directors, or officers of the corporation.
S Corporation
A business entity must first become a C corporation before it can become an S corporation. Corporations may elect S corporation Status by submitting IRS form 2553 to the Internal Revenue Service. S corporations are taxed in a manner similar to a partnership (to be discussed later) or a sole proprietorship. S corporations are flow-through entities; because each shareholder’s individual tax return will report his or her share of income or loss generated by the S corporation. S corporation shareholders are taxed based on their pro-rata share of corporate income, regardless of whether the corporation actually distributes the income to its shareholders.
There are several rules that must be followed in order to become, and remain, an S corporation. An S corporation may have a maximum of 75 shareholders. ALL shareholders must be individuals who are either U.S. Citizens or Permanent Resident Aliens. The corporation may only have one class of stock, and a maximum of 25% of the corporation’s gross income may be derived from passive investment activities.
General Partnership
A general partnership is a business entity in which two or more co-owners engage in business. The partners own the business assets together. Unless a partnership agreement states otherwise, business profits are shared by the partners equally, and each general partner has an equal right to participate in management and control of the business.
In a general partnership, business profits are shared by the partners equally and each partner is taxed on the net profits of the business. In addition to income tax on the profits, each partner must pay self-employment tax up to the FICA limit.
Each partner is personally liable for business debts, torts, and other liabilities. Each partner is, jointly and severally, personally liable for the debts of the partnership. If the partnership cannot pay its debts, the partners’ personal assets are subject to attachment and liquidation to pay the business debts. Partnerships do not have a perpetual existence, because the partnership terminates upon the death, disability, or withdrawal of one partner.
Limited Liability Company (LLC)
A limited liability company (LLC) combines the tax advantages of a partnership with the liability protection of a corporation. Members of an LLC can elect to be taxed as either a partnership or S corporation. However, the LLC is usually treated as a partnership for federal tax purposes, meaning that income, losses, deductions, and tax credits flow through the LLC to the individual members, who report this on their individual income tax returns.
Owners of the LLC have limited personal liability for business debts, torts, or other liabilities. Additionally, there is no limit on the number of stockholders of an LLC. Other advantages include flexible ownership, the ability to issue several classes of stock, and the choice to personally manage or elect a management group.
References
Spiceland, J. D., Sepe, J. F., & Tomassini, L. A. (2007). Intermediate accounting. (4th ed.). Burr Ridge, IL: McGraw-Hill/Irwin.
