Which is better? LLC, S Corp, C Corp, or Partnership
April 10, 2024
The information you obtain on this website is not, nor is it intended to be, legal advice. You should consult with an attorney for individual advice regarding your own situation.
The answer of course is, "it depends." There are good reasons to select each type of business entity. I hope to briefly explain the main differences between all of them. For the majority of small business owners, the preferred business entity will be an LLC that elects to be taxed as a partnership or an S Corporation.
The biggest driver behind entity formation is taxation.
For federal tax purposes, a company may be taxed as (1) a C Corporation, (2) a disregarded entity, (3) a partnership, or (4) an S Corporation. Notice, that there is no specific taxation regime for LLCs. That is because LLC's can choose how they are to be taxed. They can also change how they're going to be taxed. For that reason, no matter how you choose to be taxed, I usually recommend an LLC as a business entity.
C Corporations
A "C Corporation," is just a C corporation that does not elect to be treated as an S corporation. The main disadvantage and the reason most small businesses are not set up this way is that they are subject to double taxation by the IRS. C Corporations pay their own taxes at the entity level. In the United States C Corporations pay a flat 21% tax on net profits. When the C Corporation then distributes the leftover earnings to its shareholders, the shareholders have to pay tax on that income again.
Businesses will nevertheless choose to be C Corporations if they are very large or if they are publicly traded. That is because they are required to.
Pass Thru Entities
This double taxation makes C corporations unattractive for most businesses. Instead, most small businesses elect a "pass thru," entity. A pass-thru entity does not pay taxes on the entity level. The owners of the company pay taxes on the net profits of the company only once. There are no taxes on distributions, with some very limited exceptions.
The main available pass-thru entities are: (1) Corporations taxed as S Corporations, (2) LLC's taxed as S Corporations, (3) LLC's that are disregarded entities, and (4) Partnership
S Corporations and Tax Savings
Companies taxed as S corporations are the most popular business entities in the United States. The reason is that they are more tax friendly.
Owners of S corporations are generally required to pay themselves wages. Employment taxes (15.3%) are paid on whatever the wages are. Employment taxes are not paid on any net income not paid as wages to the company. With entities that are taxed as partnerships or are disregarded entities, employment taxes are due on all the net income of the company. No wages have to be paid to the owners but all their wages are subject to employment taxes.
As a hypothetical example, let's pretend Bob and Sarah own a company. That company, before owner wages, nets $500,000. The company is taxed as an S corporation. Bob and Sarah pay themselves wages of $100,000 each. They pay employment taxes equal to 15.3% on those wages. But, they don't have to pay employment taxes on the $300,000 of net income that they have left over. They pay a total of $30,600 in employment taxes. This is separate from federal income taxes which are due as well.
Now let's pretend Bob and Sarah are taxed as a partnership. They again net $500,000. They don't have to and are not supposed to pay themselves wages. Instead they pay employment taxes on the entire $500,000. They would owe a total of $76,500 in employment taxes on the same amount of income. That's over $45,000 more of taxes. That is why S corporations are so popular.
But, it's not all good news. The administration of a S Corporation is a little bit more difficult. It requires payroll to be done and payroll tax reports to be done. That usually means a payroll company will need to be hired. For some very small businesses, this extra effort may not be worth the savings.
Also, there are more rules governing S Corporations. There can only be one type of stock. So, generally, each owner has to be paid based on his/her ownership percentage. S Corporations may not have more than 100 shareholders.
Partnerships and Disregarded Entities
LLC's with only one member are generally disregarded entities for tax purposes. That means that the owner of the LLC would report the income and deduction of the company directly on their own tax return. This type of entity is the least administratively burdensome and may be a good option for very small companies. Single member LLC's have less liability protection that multi-members LLC's, which is another factor to consider.
LLC's with more than one member that do not choose to be taxed as S Corporations are taxed as partnerships. Partnerships have to file their own tax return every year but it is a pass-thru company.
I hope this serves as a little introduction to the types of business entities at your disposal. I'm glad to answer any questions.