Different Entity Types: C-Corps, S-Corps, LLCs & Partnerships
S corporations are a special type of corporation that is created by filing an election with the IRS. An S corporation is a corporation that elects to pass on its corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The shareholders of the S corporation report the flow-through income and losses from the business on their personal tax returns. The flow-through income and losses are then assessed tax at the shareholders’ individual income tax rates. This allows all S corporations to avoid double taxation on the corporate income. S corporations are responsible though, for tax on certain built-in gains and passive income at the entity level. S corporations file tax form 1120S and a schedule K-1 is passed on to the shareholder. S corporations are considered to be a unique and separate entity and as a result it limits the financial liability for which the shareholder is responsible.
In order to become an S corporation, the corporation files a Form 2553 Election by a Small Business Corporation signed by all of the shareholders. This form must be filed within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect. There are also other requirements to attain S corporation status. The corporation has to be a domestic corporation and it has to have only allowable shareholders. The IRS requires that the only shareholders the S corporation can have are individuals, certain trusts, and estates. The S corporation cannot have partnerships, corporations, or non-resident alien shareholders as shareholders. The S corporation also cannot have more than 100 shareholders. An S corporation also has to have only one class of stock. S corporations also cannot be an ineligible corporation, such as an insurance company. As an S corporation, it is also required that that any shareholder that works for the company must be payed a reasonable compensation.
A C corporation is a legal entity owned by shareholders. The corporation itself is held legally liable for the actions and debts of the corporation, not the shareholders. Corporations tend to have costly administrative fees and complex tax and legal requirements. Corporations offer the ability to sell ownership shares in the company through stock offerings. A corporation is formed under the laws of the state in which it has been registered in. In order to form a corporation, the business name needs to be registered with the state government. Generally, corporations must include a corporate designation, such as Corporation or Incorporated. In order to register a corporation, certain documents need to be filed with the Secretary of State.
Corporations are required to file federal, state, and maybe even local taxes. Most companies must register with the IRS, state, and local agencies. The corporation will receive a tax ID number or permit. A corporation is a single tax-paying entity. Corporations will pay income tax on their profits, unlike sole proprietors and partnerships. Corporations are taxed twice. The corporation is taxed first when it makes a profit, and the shareholders are taxed when they receive a dividend from the corporation. The C corporation tax return is the regular Form 1120.
LLC stands for Limited Liability Corporation. An LLC is a hybrid type of entity that combines the limited liability of a corporation and the tax efficiencies and operational flexibility of a partnership. The owners of an LLC are called members. The members can consist of a single owner, two or more owners, corporations, or other LLCs. LLCs are not taxed as a separate entity. All profits and losses flow through to the members of the LLC. LLC members will report their losses and profits on their individual tax returns, just like partnership owners would.
The LLC has to file as a corporation, partnership, or sole proprietorship tax return because LLCs are not recognized by the federal government. Some LLCs are automatically classified as a corporation by federal tax law and LLCs that are not automatically classified have the option on how to classify the entity. To elect the classification the entity has to file a Form 8832. This form is also used to change the classification status at a later time. Single member LLCs will file a Form 1040 Schedule C like a sole proprietor. An LLC that has partners will file a Form 1065 like a regular partnership. An LLC that is filing as a corporation will file Form 1120 or 1120S tax return.
A partnership is a single business where two or more people share ownership. In the partnership, each partner contributes to all of the aspects of the business. This includes money, property, labor, or skill. Each partner will then share all of the profits and losses of the business. A partnership should start with a legal partnership agreement to discuss issues of the partnership. Legal partnership agreements are not legally required, but they are strongly recommended.
Most partnerships will need to register with the IRS, state and local revenue agencies, and partnerships must obtain a tax ID number or permit. A partnership files an annual information return to report the income, deductions, gains and losses of the company’s operations, but the entity will not pay income tax itself. This return is the Form 1065. The profits and losses from the partnership get passed through to the partner’s K-1 and will be reported on the partner’s individual return. Partners will not receive a W-2 from the partnership.
When forming a new business, choosing a type of entity can be difficult. There are many factors to consider. It is always a good idea to consult with an attorney and a CPA prior to forming your business.