What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business owned and operated by one person or a married couple. The owner reports business income and losses on their personal tax returns. Sole proprietors are legally responsible for the business’s debts and liabilities.
The only documentation you need to open a sole proprietorship is the business permits and licenses required by your home state and local government. You don’t, however, have to register your business with your home state legally. So, if you (or you and your spouse) open a company with no business partners and have not registered with your home state, your business is categorized as a sole proprietorship. Yes, it’s that easy.
Which Businesses Are Sole Proprietorships?
Odds are, you’ve encountered or done business with a sole proprietor at least once. The most common example is a freelancer like a journalist or graphic designer. Most home-based businesses are sole proprietors. Other examples include personal trainers, accountants, or consultants. All these individuals had to do was look up what kind of permits and licenses they need to sell their products or services in their city and state. Once they began offering these products or services, their business was technically open.
What Are the Advantages of Sole Proprietorship?
Aside from the permits mentioned above or licenses, the only other legal documentation you may need to start a sole proprietorship is what’s known as a “DBA,” which stands for “Doing Business As.” A DBA is required by any business (regardless of entity type) that intends to operate under a name other than the owner’s full name. Sole proprietors often don’t have to worry about filing a DBA because even though they are technically business owners, their businesses don’t have names. That personal trainer or graphic designer you hired is probably just referred to by the individual’s name and doesn’t market him or herself in any other way.
But if someone named Steven Clark wanted to open a restaurant called “Steven’s Pasta,” that individual would likely have to file a DBA. Without a DBA, Steven would only be able to market his restaurant using his full name. Even putting up an awning on the building that says “Steven’s Pasta” would technically be considered fraud.
So, sole proprietors need only the required permits or licenses and a DBA. Owners of corporations or LLCs, on the other hand, must continuously store and file additional paperwork, or else they will lose their legal status.
Taxes Are Much Less Complicated
Compared to corporations and LLCs, filing taxes as a sole proprietor is very simple. Rather than filing separate business taxes on top of your own taxes, all you have to do is attach a Schedule C to your 1040 tax return. And since the sole proprietor is the only owner, all the after-tax profits go to you, or you and your spouse. Other business entities have to file for an employee identification number and determine how much of the company is owned by each owner.
No Banking Requirements
Banking is yet another critical element of running a business that is much easier for sole proprietors. This is the only business entity that does not require a business checking account. You can make and accept business payments through your own bank account, which spares you from the tedious process of setting up business banking. A checking account is the only banking requirement you need to start a sole proprietorship. LLCs are not legally obligated to have a business checking account, but this would defeat one of the primary purposes of having an LLC, protecting your assets.
What Are the Disadvantages of Sole Proprietorship?
One of the biggest advantages of being registered as a legal business entity (especially an LLC) is limited personal liability for business-related issues. For example, owners of LLCs are not at risk of having their personal assets seized by creditors in the event of a problem with debt.
None of these protections, however, are available for sole proprietors. Creditors can seize your personal assets if you don’t fulfill your obligations or if an employee personally sues the business owner after suffering physical harm at work. The latter scenario can be particularly dangerous for businesses that have an above-average risk of employee injury. If someone were to sue the business to cover medical bills, the court could seize your personal assets to meet the plaintiff’s needs because you are a sole proprietor. The owner of another business entity would only have to give up business assets in the event of a successful injury lawsuit.
Sole proprietors are often eligible for significant tax deductions (home business expenses, car expenses, etc.) but usually have to pay more taxes than other business entities. The Trump Tax Plan allows some sole proprietors to deduct 20% of their business’s net income from their taxes. But most sole proprietors do not qualify for the full 20% deduction.
To qualify for the full deduction as a sole proprietor, you must make under $315,000 as a married couple or under $157,500 as an individual owner. Your industry is a factor as well. Sole proprietors categorized as artists, athletes, lawyers, accountants, and more will not qualify for the full deduction if they exceed a certain annual income limit.
Another reason sole proprietors tend to pay more taxes overall than corporations or LLC is self-employment taxes like Medicare and Social Security. As a sole proprietor, your income taxes and self-employment taxes are based on your business’s total income. The more money your business makes, the more taxes you pay. Owners of other business entities can make moves to reduce self-employment taxes, like taking money out of the business’s total income as dividends.
Harder to Obtain Financing
Sole proprietorships reportedly have a harder time being approved for business loans from traditional institutions like banks. Other business entities tend to have more time in business and higher bank balances. Sole proprietors also usually cannot build extensive business credit because they don’t have business credit cards. And since sole proprietors usually don’t have business accounts, they cannot produce bank statements from business bank accounts to show exactly how much money their business is earning and spending.
Even a more established sole proprietorship might struggle to obtain a business loan because sole proprietors are notoriously busy. They tend to handle various responsibilities on their own, like marketing, business development, or bookkeeping. When you’re this busy, you don’t have the time to shop for different business loans or compile paperwork for applications.
Minimizing Disadvantages Of Sole Proprietorship
As you can see, some of the disadvantages of a sole proprietorship are not legally enforced. No rule says you can only have one bank account or only use personal credit cards. Opening a business bank account and getting a business credit card can offset the problems sole proprietors sometimes experience with legitimacy, business credit, borrowing funds, and organization.
What if You Have Multiple Owners?
It’s fairly common for businesses with multiple owners to structure themselves as partnerships. But you still have to choose between the two main types of partnerships: general partnership and limited liability partnership (LLP).
Like law firms and accounting firms, professional businesses often choose the latter option primarily because of the legal protection it offers. While general partnerships bear more similarities to sole proprietorships, limited liability partnerships bear more similarities to the next step up limited liability company (LLCs).
What Is a Limited Liability Partnership?
LLPs protect each partner/business owner from personal liability for the business’s debts and obligations. Even though the partners may run the business together, legal action against one partner would not automatically bring the other partners (and their personal assets) into the picture.
How Are LLPs Different Than General Partnerships?
Businesses with multiple partners that don’t register with their home states become general partnerships by default. The same concept applies to businesses with one owner, which in turn, become sole proprietorships.
Unlike LLPs, all partners in general partnerships share the same personal liability for business debts and obligations. Creditors can seize your personal assets if you don’t fulfill your obligations. If an employee suffers emotional or physical harm at work due to one partner’s negligence, the employee can personally sue all the partners at once. Since each partner shares an equal amount of liability, lawyers can come after every partner’s personal assets even though only one partner was involved in the incident at hand.
The dire consequences of these scenarios greatly increase the appeal of LLPs. Partnerships that register with the state and fill out the required paperwork gain personal protection from the business’s debts and obligations. One partner doesn’t have to worry about losing personal assets due to another partner’s negligence. Yes, individual partners can still get personally sued, but not for matters related to debts or obligations.
Though most partnerships opt for general partnerships or LLPs, some choose limited partnerships. This entity has a lot in common with general partnerships, with one notable difference: the ability to classify certain partners as “limited.” Instead of running the company with the general partners, limited partners merely fund the business with personal investments. So, while general partners share the same amount of personal liability for debts and obligations, limited partners can only face personal liability for amounts up to or equal to their investments.
Limited Liability Partnership: Pros and Cons
The basic definition of limited liability partnerships doesn’t fully explain its various advantages. And like every other business entity, LLPs do have their drawbacks. So, let’s go over the pros and cons of LLPs and which kind of businesses would reap the most benefits from the pros.
What Are the Advantages of LLPs?
The biggest advantages of LLPs deal with protection, their tax bills, and the ability to change the hierarchal structure without formalities or documentation:
Personal Liability Protection
Much like LLCs, many owners of LLPs view this entity as “the best of both worlds,” especially in regards to personal protection. You get the biggest benefits of general partnerships, like having no single owners and very little paperwork. But while general partners can get sued for all sorts of business-related issues, limited liability partners can only get sued for issues unrelated to debts and obligations.
For example, while owners of LLPs cannot get sued for failing to pay off loans, they most certainly can get sued for things like medical malpractice or anything else related to personal negligence. But because you have an LLP, the lawsuit could only target the individual partner who committed the alleged wrongdoing. To clarify, the plaintiff could not go after the other partners’ personal assets (cars, houses, etc.).
Let’s say your business has three partners, and one of them gets sued for an act of negligence. That partner could lose personal assets following the verdict, but the other two could not.
Lower Tax Bills
The tax code classifies LLPs as “pass-through entities.” Other examples of pass-through entities include LLCs and S-corporations. Compared to C-corporations, pass-through entities pay much less in income taxes. We’ll delve further into this topic in the upcoming section on S-corporations.
C-corporations face what’s known as “double taxation.” First, the business’s entire income gets taxed. Then, each owner’s dividend (their portion of the business’s income) gets taxed as well.
Owners of pass-through entities skip or “pass-through” that first tax. In other words, there’s no tax on the business’s income.
Less Formal Procedures
LLPs have very few structural and financial requirements. Every LLP, for instance, can decide how they wish to distribute salaries for each partner. No rule says only certain types of partners can take home certain percentages of the business’s income. If one partner wants to change something related to management structure or income distribution, they can just ask the other partners to vote on the proposed change.
Even though you and your partners can structure your business any way you choose, you should still document each partner’s degree of ownership. This information belongs on your partnership agreement. We’ll go over how to draft your agreement later on.
What Are the Disadvantages of LLPs?
The biggest disadvantages of LLPs deal with eligibility, differences in protection from state-to-state, and the lack of formal processes:
Only Certain Businesses are Eligible
Only certain types of businesses can register as limited liability partnerships. But most businesses that don’t fulfill these stringent requirements would probably be better off choosing another business entity, anyway.
Each state has its own requirements for eligibility. Earlier, we mentioned that LLPs make the most sense for professional firms like architects, lawyers, accountants, or real estate agents. In some states, like New York, California, and Nevada, do not grant eligibility to any business aside from professional firms. It’s not so much the nature of these businesses but that their owners need occupational licenses that make them eligible.
Protection Varies from State to State
When we first defined an LLP in this guide, we referenced the definition used by most states. Some states, however, offer different forms or levels of protection. For example, while most states give LLPs protection from debts and obligations, others only offer protection against acts of negligence. In this case, you couldn’t get personally sued for malpractice, but you could get personally sued for failing to pay back business partners. Creditors could also seize your personal assets.
These differences can make it very complicated for LLPs to do business in multiple states. Some states don’t even recognize LLPs from other states and might instead view them as general partnerships. For this reason, LLPs may have to consider “upgrading” to another entity before putting their expansion plans into action.
No Hierarchy = Power Struggles
Since LLPs don’t have single leaders or formal hierarchal structures, disagreements between partners can go on and on, wasting precious time in the process. General partnerships have multiple leaders, but they usually don’t do as much business (or make as much money) as LLPs. In other words, general partnerships have less big decisions to make and therefore have less risk of partners getting into excessively long disagreements.
Owners of LLPs must get along and prioritize the business over their egos. If this sounds difficult (which it should), you might want to consider another business entity that leaves certain decisions in the hands of one person.
How Do You Form an LLP?
Since eligibility requirements vary from state to state, the same concept applies to the registration process. The following general steps, however, apply to all 50 states. So, once you get through these, you can move on to state-specific requirements. To make the registration process easier for you, consider using these formation services for your LLC. These services can provide you with step-by-step guidance and ensure that you meet all the necessary requirements for forming an LLC in your state.
Check Your Eligibility
You should not even consider forming an LLP without checking your state’s eligibility requirements. This business entity may very well have the strictest requirements of them all, so you can’t just assume that your business fits your state’s criteria. If you look at requirements online but still have some doubts, contact your state directly to obtain 100% certainty.
Choose Your LLP’s Name
Names of LLPs must meet two requirements: First, your name cannot closely resemble another business in your state. You can check your desired name’s availability by visiting your Secretary of State’s business database.
Second, your business’s name must end with “Limited Liability Partnership” or “LLP” (i.e., “Rizzoli and Isles, LLP”).
Choose Your Registered Agent
Your registered agent, or “resident agent”, receives legal documents and other official mail on your LLP’s behalf. Business owners can get extremely busy, so much so that they misplace or forget to open important paperwork. The registered agent can handle these documents with little if any involvement from the business owner. You could even say that the registered agent exists primarily to prevent the business owner from claiming they were “too busy” to respond to legal notices.
If you reside in the same state as your business, you can name yourself (the business owner) as a registered agent. But remember: appointing yourself would mean that in addition to your other day-to-day responsibilities, you would have to respond to virtually all important paperwork personally. If you don’t want this responsibility, you should give the job to your business attorney. You can change your registered agent as long as you inform the state of the new agent’s identity and home address.
Obtain the Required Licenses and Permits
Almost every type of business must obtain some sort of license and permits. Applying for the required documentation essentially represents your first major step towards legitimacy.
At the very least, you’ll need local and state business operating licenses, which allow your business to operate in your city and state legally. Then you have your sales tax permits, which will enable you to collect, report, and pay sales taxes on your products or services. If you’re unsure which licenses and permits your business requires, contact your city’s business license department and visit your state’s government website.
File Your Certificate of Limited Liability Partnership
As the name denotes, all registered business entities must register with their home states to do business. The following documents are essential applications for the business’s legal status. Corporations have their articles of incorporation, LLCs have their articles of organization, and LLPs have their certificate of limited liability partnership.
Required information includes your business’s name, address, the names of each owner, and your registered agent’s address. The fee depends on your state, but you can expect to pay anywhere from $50 to $100.
Draft Your Partnership Agreement
Most states do not legally require LLPs to draft partnership agreements. But since partnerships have no rules for hierarchal structure, you need this document to clarify each owner’s responsibilities. Your partnership agreement will also explain the level of personal protection you have in your state.
Purchase Required Insurance Plans
In addition to state-required plans like worker’s compensation, you may have to purchase professional liability insurance, a.k.a. Malpractice insurance. Professional liability insurance covers financial losses due to your business’s negligence or malpractice. Typical policyholders include doctors, lawyers, real estate agents, accountants, and IT (Information Technology) professionals.
Some states also require doctors and lawyers to have professional liability insurance. But anyone who provides expert advice or services should consider this coverage. We all make mistakes, right?
Comply with Federal Regulations
All registered business entities must have an employer identification number (EIN). This number allows the IRS to tax your business as an LLC. There’s no charge, and you can complete the application on the IRS website in just a few minutes.
Should You Upgrade to an LLC?
The only real difference between LLPs and LLCs is the ownership and management structure. In an LLP, all partners can manage the business together. LLCs can manage the company in this same manner or choose what’s known as “manager management.”
In this structure, the owners hire or appoint specific people to manage the business. Manager management wouldn’t make sense for LLPs since the whole point of being a “partner” is to help manage the business. And remember, most LLPs are firms (law firms, accounting firms, etc.). A lawyer wouldn’t start a partnership if he or she didn’t intend to practice law anymore.
What Is an LLC?
As far as business entities go, none may top the advantages of an LLC, or Limited Liability Company. Owners of LLCs get the personal protection and lower taxes of corporations without the tedious paperwork and legal obligations. LLCs have much fewer requirements for formation as well. Corporations must issue stock, draft bylaws, file reports, and hold several meetings to start doing business. The journey of establishing an LLC, on the other hand, technically amounts to just one task: filing your articles of organization.
But once you receive approval, you must also take measures to maintain your legal status year after year.
Below, we’ll explain how to complete and file your articles of organization along with how to remain organized and legally compliant.
What Are Articles of Organization?
If you intend to form an LLC, you must file articles of organization to your home state’s business filing agency and pay the required fee. Usually, just two to three pages in length, articles of organization include general information about your business, such as its name, address, and business purpose.
What’s Included in the Articles of Organization
Each state has its variation of the document with its own minor details. But regardless of your business’s location, you will need the following general information at the very least:
- Your LLC’s name
- Your LLC’s address
- Business purpose: The level of specificity for this section varies from state to state. You’ll probably just have to provide an overview of your products or services. Some states might ask for more detail, while others allow you to simply choose “for all legal purposes” as your description.
- Start date: It’s possible to have already begun selling your products or services even though you have not earned the status of an LLC. If so, contact your state’s business filing agency and explain the situation. Some businesses leave this section blank to denote that they will start doing business once the state approves the document.
- Name and address of the registered agent: This person or company must have an address in your business’s home state and be able to receive standard mail during regular business hours. We’ll delve further into the registered agent’s responsibilities later on.
- Name and signature of the organizer: This refers to the individual responsible for filing the actual document. You can choose to hire someone to file or leave it up to one of the business owners.
Depending on your state, you might have to include the names and addresses of each owner or “member” (the technical term for owners of LLCs).
Some states also have separate articles of organization for professional LLCs (LLCs owned by licensed professionals like doctors, lawyers, accountants, etc.) If your state does not have this separate form, you must specify this categorization somewhere in your articles of organization.
What to Know Before Filing Your Articles of Organization
At first, the information mentioned above seems fairly simple to come up with. But at least two sections require considerable thought. And since filing marks the final step towards becoming official, you must check off every other requirement for legally selling your products and services before completing the document.
Here’s everything you need to know by the time you sit down and fill out your articles of organization:
Choose Your LLC’s Name
Most states have the same three requirements for the name of an LLC. First, the name must end with “LLC” or “Limited Liability Company.” The name also cannot include words associated with highly regulated industries, like “insurance.” And lastly, your LLC cannot have the same name as another LLC located in your home state.
To ascertain if your desired name does not already belong to another business, check your state’s online database of available business names. These days, however, you can probably find your answer by checking popular directories like Yelp or the Better Business Bureau.
Next, reserve your desired name by contacting your state’s business filing agency and paying the required fee. The length of the reservation (i.e., 30 to 60 days) may depend on your payment size. You can skip this step if you’ve already completed your articles of organization.
Choose Your Registered Agent
If you have an LLP, you should already have a registered agent. Scroll back up to the LLP section for a full description of this personally selected individual’s role.
How Do You File Articles of Organization?
At this point, you should have your LLC’s name, registered agent, and all of your required licenses and permits. This means you’re finally ready to send your articles of organization to your state’s business filing agency.
Your state might have specific rules for filing. So, contact the agency mentioned above (or your secretary of state’s office) to ensure there’s nothing else you have to do.
Then, you can either file your documents online or via standard mail. For the former option, most states have systems that let you input information in an online form and file afterward. You must also pay the required filing fee, ranging from $50 to $200, depending on your state.
If the state approves your document, you will receive a certificate of formation in addition to another copy of your articles of organization. The state will keep the original copy on file. It usually takes the state approximately one to two weeks to process articles of organization. For an additional fee, however, you can trim that time frame down to under one week.
Businesses located in New York and Arizona must take one extra step for legal recognition: publishing the establishment of their LLCs in local media. Most states require new corporations to do the same thing.
What to Do After Filing Your Articles of Organization
Maintaining your status as an LLC requires at least one annual task: filing tax reports. And though you have no legal obligation to adhere to the best practices for running an LLC, it’s much harder to get your business off the ground without them.
Here’s everything you have to do after receiving approval for your articles of organization:
Draft Your Operating Agreement
This legal contract outlines each owner’s responsibilities, along with the amount of money each owner has invested and the executive chain of command. You could even say that after their articles of organization, the operating agreement is an LLC’s most important document. For that reason, it’s recommended to draft the document with your business lawyer’s help and use extreme detail when explaining the organization’s structure.
Apply for an EIN
If your LLC has employees, you need to apply for an employer identification number (EIN). This number allows the IRS to tax your business as an LLC. There’s no charge, and you can complete the application on the IRS website in just a few minutes.
Comply with Annual Obligations
Each state has its own laws for LLC reporting and tax filing. In most states, LLCs must file annual reports and pay an annual fee. The report states your LLC’s income, financial activities, and the names of the owners.
And despite their status as pass-through entities, some states do have an LLC tax on the business’s income. In most states, owners only pay taxes on their allocated shares of the business income and their personal income tax rate.
As you can see, filling out and filing your articles of organization doesn’t take much time. The real paperwork comes when you decide to upgrade to a corporation. LLCs and corporations have numerous similarities as well as stark differences. Corporations require significantly more effort to set up and maintain, but they also offer tremendous rewards when it comes to your personal finances and goals for expansion.
Before explaining how to set up a corporation, let’s go over the primary differences between a corporation and LLC.
What Are the Differences Between LLCs and Corporations?
Significant differences between LLCs and corporations emerge when it comes to formation, taxes, legal obligations, and the business owner’s role. As you can probably imagine, these topics become more complicated with corporations. But that doesn’t mean all LLCs have to follow the same rules, with no room for flexibility. Here are the main differences between LLCs and corporations:
The legal journey of establishing an LLC ends once the state approves your articles of organization. You don’t have to meet any other legal requirements. Most LLCs draft operating agreements after filing the paperwork to outline each owner’s responsibilities. It’s beneficial to have this information on paper before opening for business. But that’s just best practices. Pretty easy setup, right?
On the other hand, with corporations, the legal journey does not end after the state approves its articles of incorporation. And this document takes much more time to complete than articles of organization. In addition to necessary information like the number of shares and the business’s purpose, your articles of incorporation must name your incorporator, officers, and directors. Once the state approves your paperwork, you must also file initial reports, draft corporate bylaws, hold their first board of directors meeting, and issue stock shares at their first shareholder’s meeting. None of these steps are required for LLCs.
The owners of LLCs and corporations are not technically referred to as “owners.” Instead, LLCs have “members”, and corporations have “shareholders” or “stockholders.” Both entities, however, can have single owners.
With LLCs, the members can choose to run the business together, appoint one member as the main director, or select an outside individual to run the business.
Even though corporate shareholders own the company, they do not make decisions about management, strategy, or company policy. They instead elect a board of directors and leave these decisions up to them. The board of directors then hires officers (CEO, COO, CFO, etc.) to handle day-to-day operations.
The ability to own stock makes it much easier for corporations to attract investors than LLCs. Investing in an LLC requires much more effort from the investor than buying, retaining, and selling corporate stock.
Standard corporations (as opposed to S-corps) can also offer preferred stock along with the common stock. Venture capitalists and angel investors heavily favor preferred stock due to the lower risk and higher yield. So, if your business plan revolves around raising money, it’s very hard to argue against the corporate structure.
The previous section mentioned S-corps. The “S” stands for Sub-chapter of S of the Internal Revenue Code, or tax code. This section of the tax code deals with “pass-through” entities, which brings us to the main difference between S-corps and standard corporations, or C-corps.
Earlier, we briefly described the “double taxation” system for C-corporations. Not only does business income get taxed, but shareholders get taxed personally as well if they receive dividends from business income. To escape the second tax, shareholders must take only what the IRS would consider a “reasonable” salary and reinvest all other profits back into the business.
S-corps do not get taxed at the business level. Shareholders only pay taxes on their allocated shares of the business income and their personal income tax rate. Since there’s so much more money to go around, S-corps shareholders usually stand to take home substantially higher salaries than C-corps shareholders.
Owners of LLCs can choose whether to be taxed as C-corps or S-corps. Most LLCs choose the former since it’s the default option. But that might not be the norm for much longer due to recent changes in tax laws for corporations and LLCs. Only your accountant, however, can confirm which system makes sense for you.
Periodic Obligations and Annual Fees
Unlike LLCs, corporations must fulfill myriad legal responsibilities periodically throughout the year to maintain their corporate status. This includes holding regular board of directors meetings, holding regular shareholder meetings, issuing stock certificates, and more. Holding regular meetings would be much less tedious if corporations weren’t required to document all critical decisions that transpire.
Both types of businesses must pay annual fees to their home states, with LLCs paying the lower of the two. And since LLCs have a less complicated tax system, they usually don’t have to shell out hundreds of dollars in accounting and tax filing fees.
Should You Upgrade to a Corporation?
At the beginning of this article, we established that this decision would likely come down to your future goals. Unless your goals involve massive growth, it’s difficult to justify choosing a corporation instead of an LLC.
Corporations are more complicated and expensive to manage because they put your business in a position to earn more money. Owners of LLCs would argue that their structure allows them more freedom to grow their businesses through their own efforts instead of attracting investors. Which of those scenarios sounds more appealing to you? If you’re looking to turn your business into a nationwide (or even worldwide) sensation, you must first consider which type of corporation you wish to set up: C-corporation or S-corporation.
How Are C-Corps Different Than S-Corps?
Establishing an S-corp undoubtedly requires more paperwork than a C-corp. In addition to the standard paperwork required for all corporations, S-corps must also fill out an IRS Form 2335 and meet several requirements set up by the Internal Revenue Service (IRS). For example, the corporation’s shareholders must be US citizens or residents, and there can be no more than 100 shareholders.
It’s also clear that the most significant difference between C-corps and S-corps is how shareholders are taxed. The following sections will delve further into this difference, along with the other main difference, the ownership structure.
Many C-corps were converted to S-corps solely to pay fewer taxes.
The only C-corps that escape double taxation are operating at a loss or reinvesting their profits back into the business, rather than distributing dividends to shareholders. C-corp shareholders do not pay taxes on wages and salaries, which are considered deductible expenses. However, if the wages are deemed “excessive” by the IRS, that money can be considered a taxable dividend.
With an S-corp, shareholders only have to pay taxes at their personal income tax rate. So, from an individual shareholder’s perspective, an S-corp will allow you to keep more money than a C-corp.
C-corps are much less restrictive than S-corps when it comes to ownership and expansion. There’s no limit to the number of shareholders and classes of shareholders. The latter policy makes it possible for venture capitalists and angel investors to hold preferred stock in C-corps.
With an S-corp, on the other hand, there can only be one class of shareholders. All shareholders must also be US citizens or residents, whereas a C-corps can have foreign investors. Raising funds for an S-corp is, therefore, much harder than a C-corp.
If your long-term goal is to sell your business, a C-corp is most likely the better option. An S-corp can’t be owned by a C-corp, LLC, general partnership, or even another S-corp. On the contrary, a C-corp can indeed be owned by another C-corp, LLC, and most types of trusts.
C-Corp vs. S-Corp Tax Example
Since taxes are the most significant difference between the two options, let’s take a look at a hypothetical scenario to see how much money a business would pay in taxes if it were a C-corp versus an S-corp.
The only figure you need for this scenario is your taxable income. To figure out your taxable income, subtract your deductible expenses from the revenue you receive from your business.
Say, for example, you have a taxable income of $300,000.
If the business were a C-corp, you’d first have to apply that new 21% corporate income tax rate. That gives you $63,000. Most shareholders would likely claim all of that money as a dividend. The dividend tax rate is 15%, which leaves you with $9,450. Add that to your corporate tax of $63,000, and you’ve got a total tax bill of $72,450.
Now, let’s apply the same taxable income to an S-corp. According to the new tax law, owners of “pass-through” entities can deduct 20% of their business income before determining which tax rate to apply. That leaves you with a $240,000 taxable income after the 20% deduction. The 2019 tax brackets put you in the 35% range, which gives you a total tax bill of $59,689.50 for a single filer provided they had no other income for the year.
As you can see, the S-corp shareholder saves significantly more money than the C-corp shareholder. But this might not be the case for all businesses, so, once again, remember to ask your accountant or lawyer about how you’d fare with each option. For instance, a corporation with fewer profits might save more money if it was a C-corp.
Pros and Cons of Each Type
At this point, we’ve gone over all the important differences between a C-corp and S-corp. To help your decision, let’s break down all of the reasons someone would choose either option. The answer largely depends on your priorities, like saving money or selling the business.
- Less complicated: If you know the definition of a corporation, you know a C-corp definition. You don’t have to learn any new tax laws or fill out additional paperwork. There are also no restrictions for expansion, so you don’t have to change your growth-related goals.
- Easier to raise venture capital: If raising money is integral for your business’s future, it’s hard to argue against structuring your business as a C-corp. Most venture capitalists and angel investors favor preferred stock, which is not an option for S-corps.
- Easier to sell your business: Most types of companies can only own part of an S-corp instead of owning the whole company. With a C-corp, almost every kind of business can purchase the entire corporation.
- Easier to do business overseas: Unlike S-corps, C-corps can have foreign shareholders. Offering ownership to overseas shareholders can be a great way to begin doing business in their home countries.
- Higher taxes: In most cases, C-corps pay higher taxes than S-corps thanks to the “double taxation” rule. This means less net income for the company as a whole, along with individual shareholders.
- No personal write-offs: C-corps shareholders cannot write off business losses on their personal tax returns. What they can do, however, is deduct the cost of “fringe benefits.” This includes disability and health insurance. C-corps that offer the same fringe benefits to at least 70% of the company do not have to pay taxes on these expenses.
- Lower taxes: The advantage of avoiding double taxation, or having to pay two sets of taxes on the business’s income, cannot be emphasized enough. Individual shareholders make more money, as does the company as a whole. This can be massively beneficial for smaller corporations that are not seeking external funding nor looking to be bought out.
- Personal write-offs are permitted: S-corps shareholders can write off their business’s losses on their personal tax returns. Once again, this is particularly advantageous for younger, smaller corporations, which are typically not profitable for their first few years in business. Many S-corps shareholders use this rule to offset their income from sources outside of the corporation.
- More complicated: Establishing and maintaining an S-corp takes more time and effort than a C-corp. First, you have to learn all the new responsibilities and tax procedures associated with S-corps. Next, you have to file an IRS Form 2553 along with state paperwork. Once you’re in business, you must always make sure you comply with regulations, such as the type of shareholders you can work with. Violating specific rules could result in penalties and fines.
- Harder to do business overseas: All S-corps shareholders must be US citizens or residents. The inability to have foreign shareholders could make it difficult to do business abroad or reach your true growth potential.
- No preferred stock: If funding is a concern, it might be best to put S-corp aspirations on hold. S-corps cannot offer preferred stock and can only have one type of stockholder. All shareholders must adhere to the same regulations and essentially have the same role. Acquiring funding from venture capitalists and angel investors is, therefore, very difficult.
- More substantial penalties: The reward of paying fewer taxes comes with a higher risk of IRS penalties. If an S-corp and C-corp were to violate the same regulation, an S-corp might face more severe punishment. The IRS may even terminate your S-corp status if you violate a key provision, like the limit for the number of shareholders.
Making Your Decision
One thing C-corps and S-corps have in common is the significance of their pros and cons. Certain advantages and disadvantages of both are huge enough to be deal-breakers. With startups, for instance, the top priority is often acquisition. Another business’s top priority might be minimizing tax payments since high taxes can be a severe burden to growth. Some business owners might simply choose the simpler option, possibly because they have less time on their hands.
Once you’ve decided which type of corporation to establish, you can move on to filing your articles of incorporation.
What Are the Articles of Incorporation?
Articles of Incorporation contain basic information about your business, such as the corporation’s name, address, names of directors, and the number of shares. You can file them yourself, with the help of a business lawyer, or through an online legal service.
What You Need to Know Before Filing
Choosing a name for your corporation seems like a quick and easy task. But according to legal regulations, your corporation’s name cannot be identical or even similar to another corporation. Regulations also state that the corporation’s name must end with “Inc.,” “Corp.,” or some other corporate identifier.
You can check if your desired name is available through your state’s online database. In most states, their database allows you to reserve a name for several days while you prepare to file your articles of corporation. In New York, for example, you can reserve a name for up to 60 days, but you have to send your reservation request by mail.
Name reservations are only necessary, however, if you are not prepared to file your articles of incorporation at that very moment. If your desired name is available and your articles are ready, you can go ahead and file.
Choose A Registered Agent
We’ve made it clear that complying with legal obligations is a significant aspect of owning a corporation. Failing to do so can result in severe penalties, even lawsuits. Thanks to their significantly lower tax bills, S-corps have a higher risk of penalties. For example, if an S-corp fails to respond to an annual reporting notice, the state could terminate its legal status.
It is therefore recommended to choose an experienced business lawyer as your registered agent. This individual must have a physical address in your business’s state and be available to receive mail during standard business hours.
Information Required For Articles of Incorporation
Each state has its own requirements for its articles of corporation. Most states, however, ask for the same information. You can check your state’s requirements by visiting the website of your secretary of state or attorney general.
Here’s the basic information required for your articles of incorporation:
The legal name of your corporation must not be identical or similar to another corporation in your state. It must also end with a corporate identifier.
This is the address of the physical location in which your business operates. The business’s home state must be the same state that is receiving the articles of incorporation.
Your registered agent will receive legal and financial documents concerning your business by mail.
This is a description of your business’s products and services. The level of detail required for this section varies from state to state. Some states require a highly specific description, while others only ask for a general overview.
Directors and Officers
Some states require the names and addresses of each director and officer.
Number of Shares
C-corps have no limit for the number of shares they can issue. An S-corp, on the other hand, can only issue up to 100 shares. This section asks for the number of shares currently available, excluding those that have already been sold. Most corporations do not issue every available share right off the bat, usually because they intend to attract more shareholders.
Class of Shares
This section asks for the classes of stock offered by your corporation. C-corps can issue both common and preferred stock, while an S-corp can only issue one stock class. Hence, an S-corp has just one available answer to this section, whereas a C-corp has two.
Your incorporator is the individual or company that fills out and files your articles of incorporation. Yes, your incorporator can be your registered agent. Their responsibilities are very similar and therefore tend to overlap. But unlike your registered agent, your incorporator signs your articles of incorporation and typically plays a more significant role in assembling your board of directors. In some cases, the incorporator essentially runs the corporation until the newly-formed board of directors takes over.
How Do You File Articles Of Incorporation?
There are three ways to fill out and send articles of incorporation to the state. You can file yourself with the help of a business lawyer or through an online legal service.
The first option is the fastest and cheapest because, in most states, you can file online. Depending on your state, the filing fee can range from $100 to $300.
The second option only makes sense if you have a business lawyer on retainer or issued over one thousand shares. Still, it is perfectly understandable to hire a business lawyer solely to be 100% sure that you have filled out the documents correctly. The consultation probably won’t be too expensive because, as you can see, the document isn’t long at all.
Online legal services (LegalZoom, Rocket Lawyer, etc.) fill out the document for you by having you complete a questionnaire about your business. The service will then submit the form for you as well. Most online legal services charge approximately $150, but you also have to pay your state’s filing fee.
What Happens After I File Articles of Incorporation?
After you file your articles of incorporation, your state will file the document as long as every question was filled out correctly. You should receive a formal certificate of incorporation via mail approximately 3-6 weeks later.
What to Do After Filing
Filing articles of incorporation is the first of several steps required for establishing a corporation. Additional obligations must be followed shortly after filing and revisited periodically throughout your career. Here are the next steps to take after filing your articles of incorporation:
Initial reports are only required by certain states and, depending on the state, must be filed within one or two months after your official incorporation. Required information includes your business’s location, registered agent, and basic descriptions of your directors and officers.
Most states require new corporations to publish a notice in a local newspaper that, once again, contains much of the same information in your articles of incorporation. This includes your business’s name, address, and the number of shares.
Due dates for annual reports vary from state to state. They are usually due the next March or April after your first year in business. Required information depends on your state as well, but they mostly contain financial data for potential shareholders.
Corporate bylaws are the most important legal document of any corporation. Only certain states require corporations to have bylaws in place for legal recognition. But even if your state does not have this requirement, you should still draft and adopt corporate bylaws before operations begin. Formal adoption of corporate bylaws shows that your board of directors has officially agreed to management structure. This includes the responsibilities of shareholders, directors, and officers, along with the company’s primary goals.
Board Of Directors Meeting
Your first board of directors meeting should take place shortly after your official incorporation. You must document the length of the meeting along with all of the board’s business-related decisions.
Your first shareholder meeting revolves around issuing shares of stock. Like the previous meeting, you must document all business-related decisions.
Standard Setup Procedures
Amidst all these other obligations, corporations must also find the time to handle the responsibilities required by any new business. This includes obtaining any required licenses, opening a business bank account, and applying for an employer identification number. That last task is a legal requirement of all US corporations.
Business Structure: Invest in Good Help
Earlier, we explained that the biggest downsides of corporations are paperwork and obligations. Well, there you have it. To benefit from the various advantages of corporations, you must adhere to a slew of commitments. If you fall out of compliance, you may face steep fines and even have your corporate status revoked.
You won’t have to worry about penalties as long as you can count on your business lawyer and accountant. These individuals will make sure you stay compliant and never fall behind on taxes. Much like any other major business endeavor, the only truly effective way to steer clear of danger is to surround yourself with the right people.