Business formation 101: LLC, C corp and S corp

Business formations offer tax benefits, but the new tax law may fuel the need to change one's business entity structure.

Incorporation of a business can offer two main benefits: liability protection and tax advantages. The right structure will depend on the business. Business owners can get a better idea of which structure is right for their professional endeavors by understanding the basics of these formations. Here are three of the more common business structures business owners take into consideration during the formation process:

  • Limited Liability Company (LLC). An LLC offers liability protection. Essentially, this business structure serves as a wall between an owner's personal and professional assets. Any claims for debts or liabilities connected to the business would impact only the business investments. This basically means a creditor can only go after the assets of the business, not the assets of the business owners. For taxation purposes, the Internal Revenue Service (IRS) generally considers an LLC as a "pass-through" structure. As such, business owners report business profits and losses on personal income tax returns.
  • C corporation (C corp). Both the C corp and the S corp have the same liability protections noted above for the LLC. The difference is in the taxation structure. Business owners may choose a C corp for larger companies as it can have unlimited shareholders and various voting privileges. Those who own shares must pay personal income taxes on earned dividends. C corps also have corporate tax obligations.
  • S corporation (S corp). The S corp is not a business structure, it is a designation used to distinguish an S corp from a C corp for tax purposes. The IRS does not require S corps to pay corporate taxes. Instead, the tax structure of an S corp is more comparable to an LLC with a similar "pass-through" status. This structure is best for small to medium sized companies as it can only contain up to 100 shareholders.

In some cases, business owners may choose one form of business structure and later change into another. This need to change can be fueled by a number of factors, including changes to tax law. As such, due to recent tax changes, business owners are wise to review their business structure strategy and consider potential revisions.

How could the new tax law impact an entrepreneur's business formation strategy?

The new tax law has led to a reduction the corporate tax rate. The rate, once set at a top rate of 35 percent, went down to 21 percent for the 2018 tax year.

It may seem like LLCs would benefit most from this change. However, the top individual tax rate has also been reduced from 39.6 percent to 37 percent. Qualifying business owners can also deduct up to an additional 20 percent of pass-through income from their business enterprise. This can mean an LLC could pay lower taxes as a C corp. This possibility has fueled the need for business owners to review their business entity designation strategy.

Business owners must take these new tax changes into consideration. However, business owners must also keep in mind that the tax law is scheduled to sunset and changing to a C corp is generally easier than changing back.