Choosing between a C corporation, an S corporation, a Partnership, and a Limited Liability Corporation

Business operations may be conducted in a number of different forms.  Just like many business decisions, consideration must be given to the tax consequences of choosing a particular business entity.  This article deals with the unique tax and non-tax advantages and disadvantages of choosing between a C corporation, an S corporation, a Partnership, and a Limited Liability Corporation (LLC).

C Corporation

Unlike partnerships, S corporations and most LLC’s, C corporations are taxpaying entities.  Some of the advantages and disadvantages of becoming a C corporation are as follows:

Advantages:

bulletShareholders are protected from claims against their personal assets by state corporate law.
bulletThe corporate form of business organization can provide a vehicle for raising large amounts of capital through widespread stock ownership.
bulletShares of stock in a corporation are freely transferable.
bulletShareholders may come and go, but a corporation can continue to exist.
bulletCorporations have centralized management.  All management responsibility is assigned to a board of directors, who appoint officers to carry out the corporation’s business.

Disadvantages:

bulletDouble taxation – the corporation computes tax on the taxable income reported on the corporate tax return using the rate schedule applicable to corporations.  When a corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns.  Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level.
bulletLosses of C corporations are not passed down and are not deductible to the individual shareholders. 

S Corporation

The S corporation rules were enacted to minimize the role of tax considerations in the entity choice that many small businesses face.  S corporation status provides a compromise for small businesses: they can avoid double taxation and loss limitations inherent in the regular corporate form while still enjoying many of the non-tax benefits extended to C corporations.  Thus, S status combines the legal environment of C corporations with taxation similar to that applying to partnerships.

Advantages:

bulletDividends paid by the corporation are distributed tax-free to shareholders to the extent that the distributed earnings were previously taxed to the shareholders.
bulletWhen the business is generating losses, deductions for allocable losses may be available to the shareholders.

Disadvantages

bulletTo achieve S corporation status, a corporation must first qualify as a small business corporation.  A small business corporation: 
bulletIs a domestic corporation (incorporated and organized in the United States)
bulletIs eligible to elect S corporation status
bulletIssues only one class of stock
bulletIs limited to a maximum of 100 shareholders
bulletHas only individuals, estates, and certain trusts as shareholders
bulletHas no nonresident alien shareholders

·         S corporations are subject to rigorous allocation and distribution requirements (generally, each allocation or distribution is proportionate to the ownership interest of the shareholder).

Partnership

A partnership is not a taxable entity.  Rather, the taxable income or loss of the partnership flows through to the partners at the end of the entity’s tax year.  A partnership must have at least two owners.  The owners can be an individuals, corporations, trusts, or partnerships. 

Advantages:

bulletWhen the business is generating losses, deductions for allocable losses may be available to the shareholders.
bulletAvoids double taxation of the C corporation structure.
bulletThere is far greater flexibility in allocating the enterprise’s profits, losses and credits (by means of special allocations) among partners or a partnership than among shareholders of an S corporation.
bulletThere are no limitations on who may be a partner, or on how many persons may be partners, unlike S corporations, which are subject to limitations on who may be a shareholder and on how many shareholders the corporation may have.

Disadvantages:

bulletUnlimited liability for the partners.
bulletA partner’s distributive share of ordinary partnership income and guaranteed payments for services are generally subject to the Federal self-employment tax.

Limited Liability Company

 The limited liability company (LLC) is a creation of state law.  LLC’s are owned by members, who aren’t personally liable for the LLC’s debts or obligations.  Under the “check the box” entity classification rules, if an LLC isn’t mandatorily classified as a corporation, it’s an “eligible entity” that may elect to be classified for tax purposes either as a partnership or as a corporation, except that a single member LLC that doesn’t elect to be a corporation is treated as not having any entity status, i.e., it’s treated as a sole proprietorship. 

 Advantages

bulletThe members are not personally liable for the debts and obligations of the entity.
bulletThere are no restrictions on the number and kind of owners like there are in S corporations.
bulletThere is far greater flexibility in allocating the enterprise’s profits, losses and credits (by means of special allocations) among members or an LLC than among shareholders of an S corporation.

 Disadvantages

bulletStatutes differ from state to state as to the type of business an LLC can conduct – primarily the extent to which a service providing firm can operate as an LLC.
bulletThere is no established body of case law interpreting the various state statutes, so the application of specific provisions is uncertain.
bulletA member who participates in the business will generally be subject to the federal self-employment tax on his or her distributive share of the entity’s ordinary income.

 While this provides a basic overview of the pros and cons of various entity classifications, we would encourage you to contact us with any questions regarding the various entities.