6 types of corporations: Which is right for your startup?
Nearly every United States corporation started as a small business. So, it only makes sense that nearly every small business has to eventually think about what kind of entity they want to be and how they want to organize their company. This is why understanding the different types of corporations is important.
To help you make the right decision for your company, let's take a look at the various types of corporations and business structures. But first, let's explore how your business structure impacts your operations, from the bottom to the top.
How does your type of corporation or entity affect your business?
As far as the law is concerned, your business is a legal entity. Being such, there are a number of legal implications that come with each type of corporation and business structure. These legal implications range from personal liability protections to tax-exempt statuses to higher levels of federal income tax.
For example, an LLC ensures your personal assets are safe in the event of a business lawsuit or debt. But, an LLC doesn’t allow you to take advantage of the same kind of tax savings as, say, an S corporation.
As a startup, your company likely exists as a sole proprietorship or general partnership. But, as your company grows and your structural and financial needs shift, you'll likely need to change the type of business entity you're classified as. So, what types of corporations and entities are out there?
The different types of corporations and business structures
When it comes to types of corporations, there are typically four that are brought up: S corps, C corps, non-profit corporations, and LLCs. But, there are additional business structures as well, some of which could be the right fit for your company.
Before diving into this list, it’s worth noting the first four items listed are types of corporations. The following two are business entities that are not considered corporations.
An S corporation is a business entity that passes almost all finances through to its shareholders. These finances include income and losses, as well as tax deductions and credits. By passing all of these finances through to shareholders, S corporations are able to be taxed like a partnership but gain corporate perks.
More specifically, this means that shareholders are responsible for income and loss. The S corp pays specific corporate taxes pertaining only to passive income and gains outside what the shareholders keep. This allows S corps to avoid the double taxation that often comes with C corps.
For example, let’s say you have a C corp with several shareholders who have all invested the same amount. Before those shareholders see their profit, your company first has to pay corporate taxes on the income generated. Then, the already-taxed money is paid out to the shareholders as profit, who report it on their personal tax returns and pay tax again.
With an S corp, the profits are passed directly to the S corp shareholders, meaning shareholders are responsible for the taxes. This allows the S corporation to avoid corporate tax, as the profits are being taxed at a personal level when the shareholders report it on their income tax returns.
But, there's a catch: any shareholders of an S corp can't be corporations, nor can they be partners with the company. This means shareholders are generally part of a trust or estate, or are individuals and non-profits. This limits who can be a shareholder, but again, allows you to take advantage of lower corporate taxes in many cases. You’re also limited to no more than 100 shareholders, which can limit future growth.
S corporations can be general partnerships, LLCs, or corporations, making them rather flexible. While there are certain tax benefits, it's worth noting the IRS tends to pay extra attention to S corporations. This is because the structure provides loopholes through which shareholders may try to evade taxes. For example, an S corp could claim employee pay is actually a distribution and avoid taxes.
A C corporation is similar to an S corporation, in that it can be a partnership, corporation, or LLC. A C corp is also privy to certain tax benefits, chief of which is that the profits of the company are taxed independently of the profits of the owners.
Unlike S corps, a C corp can have any number of shareholders from any background. This means C corp shareholders can also be employees of the corporation itself. But, a C corp must have a board of directors. The board of directors acts as the decision-makers for the company, while the shareholders are more like the financial backing.
C corporations can be hit with double taxation, however, which happens when the profits of the company are taxed at the corporate level and then again on individuals' income tax returns. This is often avoided by spreading profits out to employees as benefits, which allows the corporation to be taxed at a lower rate on a personal tax return. But, this complicated corporate structure often necessitates an account or financial advisor, which is an added cost.
If your plan is to grow your business and eventually sell it, a C corporation can be a great way to keep your personal assets as a separate legal entity from your professional corporation. The ability to have a number of shareholders, even those from other corporations, gives C corps great growth potential, too. Just remember: you will likely incur financial costs in the form of paying advisors, especially come tax time.
A non-profit corporation is similar to a traditional corporation in structure: There's generally a board of directors, as well as donors or financial backers. But, a non-profit generates no profits, as the name implies. A non-profit must also be created in support of a specific cause, generally one that's public, specifically for members of the non-profit, or groups of people.
Non-profit corporations are tax exempt, paying no corporate taxes or federal tax. They're also permitted to receive funding from a wide variety of sources: grants, public donors, private donors, and corporations. Further separating non-profits from for-profit corporations, donations to non-profits are typically tax-deductible for donors as well.
If you're passionate about helping others and your focus is to maximize the good you do, not the profits you make, a non-profit is the best way to see your mission through.
Limited liability companies (LLCs)
A limited liability company (LLC), also known as a limited liability corporation, is a business entity that prioritizes the separation of the people in the business and their personal liability. Similar to other corporation types on this list, an LLC protects members from being financially responsible for damages. More specifically, an LLC protects the personal assets of the owners in the event of a lawsuit or any kind of financial damages.
Forming an LLC requires articles of incorporation, in which the structure of the business is laid out. Unlike a C corp, no board of directors is required for an LLC. In fact, an LLC can choose almost any structure desired, meaning it can imitate an equal partnership, have a board of directors, or fall somewhere in between.
LLCs offer additional perks, including simpler financial structures than corporations, taxation at a personal level (not a corporate level), and the ability to own multiple pieces of real estate under different LLCs to limit taxation.
If you plan on keeping your business close to the vest and don't intend on going public, an LLC can be a great way to improve your professional appearance and gain certain legal and tax benefits.
A sole proprietorship is a one-person show. In a sole proprietorship, the business and the person are the same, with no legal separations between the two. This means the person is personally and financially responsible for any debts or damages.
While solo in name, sole proprietors are able to hire employees or contractors. But, the work done by any employees hired through a sole proprietorship is still legally bound to the sole proprietor. Again, this keeps the responsibility all on the founder of the sole proprietorship.
Unlike a freelancer, a sole proprietor has a registered business name, can hire employees, purchase business insurance, and even obtain higher forms of business licenses.
Sole proprietorships are easy to start, making them a great way to give your solo operation a more professional appearance. If you're currently freelancing or plan on starting a small operation that requires only your efforts, a sole proprietorship could be the right choice.
A general partnership is similar to an LLC, in that the members can structure the business as they see fit. But, in a general partnership, all profits, legal obligations, assets, and losses are shared. All members of a general partnership are responsible for any financial and legal damages, with their personal assets at risk in the event of forfeiture.
The primary perk of a general partnership is that it's easy to set up. There's far less paperwork involved than with setting up a corporation or LLC, and it's a great way to make your appearance even more professional. But, keep in mind all members of a partnership are equally responsible for damages incurred. So, it's a good idea to only go into a partnership with those you trust.
The right type of corporation for you
Your company is exactly that: yours. Only you know where you want it to be, both in the near future and the far off. Think about your goals to decide which type of corporation or business entity feels right for your company.
Your needs will likely change over time, so rest assured your choice of business entity isn't set in stone. If you realize you may have made the wrong choice, you can always begin the process of restructuring your company.
Take your time, do your research, and you'll land on the right business entity for your startup. From there, you can work on your small business continuity plan, and be prepared for anything life throws your way, be it taxes, an unexpected financial crisis, or a new business partner.