The Difference Between Three Types Of Corporations

If you’re about to go out on your own and create a business, congratulations. Once you’re here, on the side of the entrepreneurs and others who make the economic engine run, you’ll wonder why you didn’t start sooner. Salaried employment is great for some people, less so for others.

But if you’re going to do it, do it right. There’s more to creating a business than buying a license (you do know you have to buy a license, right?) and creating a website.

Most general contractors, plumbers, electricians, gardeners and graphic designers who set up shop don’t even think about what legal form their new business is going to take. (That’s legal “form” as in “organization or arrangement.” We’re not talking about a piece of paper you have to fill out, at least not directly.)

Making the wrong decision about legal form can cost you serious money even before the first sale. While you might have learned the terms “sole proprietorship” and “corporation” in high school, back when they meant nothing to you, now would be a good time to determine what they do mean and how organizing your business under one or the other can hurt or hinder you.

Don’t Go The Default Route

Unless you specify otherwise, your new business will operate as what’s called a “sole proprietorship” – meaning there’s no practical distinction between you and the business itself.  The “advantage” to a sole proprietorship is that it costs nothing to start, aside from the aforementioned business license and related fees. Kind of like how it’s an “advantage” to not have auto insurance, because of all that money you’ll save by not paying a premium.

You don’t want to do business as a sole proprietor. Maybe 150 years ago you did, if you made horseshoes and paid your apprentice under the table. Since there’s no legal difference between you and the business under a sole proprietorship, you’re on the hook for everything. Everything. If a customer sues an employee, whether it’s justified or not, you could be legally responsible for far more money than your company’s worth.

You want to spend a little money before opening and incorporate. Before you hesitate at incurring upfront out-of-pocket expenses, understand that it’s forward thinking like this that separates the successful from the merely busy. And once you incorporate, you’re not just a business owner, you’re a corporate shareholder with all the rights that affords.

Incorporate

To incorporate, you have to spend money filing with a state. Not “your” state”, “a” state.  Just because you’re headquartered in New Hampshire, that doesn’t mean you can’t incorporate in Montana.

Ever wonder why the catchphrase “a Delaware limited liability company” found its way into the vernacular? Not “some”, nor “many”, but most American publicly traded corporations are incorporated in The First State.

There’s a good reason for this. Under U.S. law, your corporation operates under the laws of the state in which you’re incorporated. This makes sense, otherwise you could be subject to 50 different sets of state laws, which isn’t exactly efficient. Delaware protects shareholders (you’re a shareholder, remember?) more than other states do. Some states require your corporation to have multiple officers and directors – Delaware lets you get by with just one. You don’t even have to be a citizen. You don’t even have to live in the U.S. You don’t even have to publicly disclose your name.

For a small corporation whose sole shareholder is also its manager, incorporating in Nevada might make more sense. Should a director of a Delaware corporation commit “gross negligence”, that can still lead to personal liability. Maybe that’s morally sound, pending a trial, but from a financial perspective it tilts the scales toward incorporating in Nevada if you want to avoid legal hassles that can derive from baseless accusations.

Wyoming and Alaska are popular states for incorporating, too.  On the other hand, incorporating in California or New York sucks on wheels. California’s laws are tilted disproportionately in favor of employees, customers, people who slip and fall on the sidewalk outside your retail location…basically anyone but you. New York’s aren’t much better. (The diaspora of businesses from each of those states is purely coincidental to this, by the way.)

But there’s so much paperwork.  Oh, stop it. Yes, paperwork sucks. It’s tiresome, and counterproductive, and exists largely to satisfy the government bureaucrats who make their living by creating byzantine regulations and getting people to adhere to them.

But if you’re sufficiently disposed, paperwork still beats the hell out of working for someone else.

Three Types Of Corporations

In the United States, there are three major types of corporation – the C corporation, the S corporation and the limited liability company (which is technically not a corporation, but close enough for our discussion.) C and S corporations are named after the particular subchapter of Chapter 1 of the Internal Revenue Code.

Most major corporations are C, most smaller firms S. The big difference between the two is that C corporation shareholders are subject to double taxation: the government taxes the company’s income at corporate rates, and taxes the dividends after the corporation distributes them to the shareholders.

Dividends?

Yeah, that’s what you call money when it filters through to the shareholders in a corporation. Dividends in this case serve the same purpose that wages and salaries do for ordinary employees in ordinary jobs.

But if you’re an S corporation, that’s not an issue. Also, you can pay yourself a salary and the government won’t subject it to self-employment tax. S corporations are designed for small companies, which yours will presumably start out as.

Finally, there are LLCs. The most important difference between them and S corporations is how the IRS treats excess profits, or in IRS jargon, “distributions”. If you own and operate an S Corporation and pay yourself a “reasonable” salary out of the profits, the remaining profit is “distributed” to you at the end of the year and isn’t subject to self-employment tax. Not so with an LLC. (But you can tell the IRS you want your LLC to be treated like an S Corporation for tax purposes. Just file Form 2553 before “the 16th day of the 3rd month of the tax year.”)

LLCs require less paperwork than S corporations, but with one big tradeoff: your LLC has to issue you a K-1 statement, which lists your share of the LLC’s income and expenses, to be transferred to your 1040. It’s not that different than paying regular old income taxes.

For a typical one-person S corporation, the paperwork consists of little more than this:

-every month, returning a letter to the state department of taxation. Takes about 30 seconds, costs the price of a stamp.

-every quarter, paying taxes. A lot easier when you save receipts as a matter of course. If you want, hire an accountant.

You’ll almost sound grown up when you run an S corporation: you get to elect a board of directors and everything.

A board of directors? My head is spinning.

You know who your directors and officers are? You, and whomever you want to appoint, assuming you want to appoint someone. In Delaware, remember (and in Nevada), you don’t even have to do that. You do have to hold an annual meeting, though. You can do this in your bedroom, and maybe one day, in your pool. (One point in favor of LLCs is that they don’t have directors’ meetings, or even directors.)

And we haven’t even gotten to the best part: tax writeoffs, which deserve a post of their own. As wonderful as they are, they’re yet another indication of how our tax code, flawed and labyrinthine as it is, exists to punish employees at the expense of business owners. While you might not like the system, the opportunity is there to take advantage of it.

Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Everyday Tips says

    This is an incredibly informative post. I have considered ‘incorporating myself’, and this article is very helpful.

    I just may turn into ‘Everyday Tips and Thoughts, S Corp’.

    I am going to bookmark it!

  2. Money Funk says

    That is a lot of information to take in, but I appreciate you explaining it all. Especially since I am considering filing all this paperwork. I was not aware that you could incoporate in ‘a’ state other than your own. It seems beneficial to review the guidelines for the state you chose to incorporate in.

  3. Simon Zhen says

    Wow, nice intro to what many bloggers aspire to accomplish. Bloggers who start to taking monetization seriously (essentially becoming entrepreneurs) will find this information quite educational.

  4. Money Reasons says

    I knew a lot of this already, but I didnt’ know why Delaware had some many businesses formed over there. Yeah, I knew there was advantages… I just didn’t know what they were!

  5. Kevin @ Thousand-aire.com says

    Fantastic information. I have very little background knowledge on any of the content here, and now I feel like I understand it pretty well.

  6. Charlie says

    Nice post. I’ve always wondered about the Delaware popularity. That’s good to know that you can pick any state without needing an office there. If only they’d let us choose which state to pay (or not to pay) taxes to ;)

  7. EveryPesoCounts says

    Here in the Philippines, we’re a country of one nation… I would guess that the law is virtually the same regardless of which part of the country you want to put a business on. A mentor told me never to consider sole proprietorship but he never told me why… In sole proprietorship here, you use the same Taxes Identification Number for your business and the one you have at work(or your personal TIN). A lot of small business here just seem to do fine with their small foodcarts. As for corporations, I think there’s a required capital before you can call your business as such…

  8. Steve Jobs says

    I totally agree with Everypesocounts. Sole proprietorship is really a good one in the Philippines. Small businesses are really doing fine there even if it is in a food cart only. Your post is really an informative one.

  9. Greg McFarlane says

    @Financial Samurai

    First, thanks to everyone for the kind words. I hope my post helps out the American readers (not sure what good it does the Canadian and Filipino readers, alas.)

    As for self-employment tax? Oh, it’s a peach. If you worked for yourself in the past year, or formed half a partnership, you need to fill out IRS Schedule SE. (I’ll leave it to you to figure out what the “SE” stands for.) There’s a special exemption for bankruptcies, which is hopefully an academic point for everyone reading a blog about slicing through money’s mysteries.

    Self-employment tax is great example of how the tax code is written to benefit business owners at the expense of people who work for salaries and wages. The self-employment tax rate is 15.3%, until you get to $106,800. After that, it sinks to 2.9%. Yes, a regressive tax. Your elected officials can talk about “tax breaks for the middle class” all they want, but don’t let anyone kid you into thinking that the IRS code is written to benefit anyone but business owners.

    Schedule SE is also for people who had “church income” of “$108.28 or more.” Not $110, not even $108, but $108.28. Gotta love the hardworking bureaucrats who write these things, and can justify their existence by making exceptions that go literally to the penny.
    I merely touched on this in the post, and thanks again to Sam for letting me ramble. There’s way more about this in my book. (You saw the Amazon link above, right?)

  10. Car Insurance Comparison says

    Also, a cheaper and more flexible way to get the same tax treatment as an S Corp is to form what is unofficially called an “LLC Envelope” which is simply forming an LLC and then filling out two IRS forms that makes the election for your LLC to be taxed as an S corp. Super simple and less of a headache then forming a corporation.

  11. The Financial Blogger says

    I got my incorporation to make sure I separate my income from my corporation income. Plus, in Quebec, you pay 50% less taxes in a corpo vs an individual tax rate.

    There are tons of expense you can deduct which make the incorporation very interesting. You just have to know the accounting principles ;-)

  12. Mark says

    When I started my business a few years ago, I agonized over what type of entity to set up. I ended up settling on a LLC. It had all of the benefits that I was looking for and was a low cost option.

  13. Steve Jobs says

    Hmmnnn… that makes sole proprietorship totally useless. But I think there are still micro businesses which are running as a sole proprietorship especially for restaurant owners or deli owners.

  14. lovely leverage says

    When my hubby started his business (real estate/asset management) 2 years ago he registered as a partnership (in Canada), because it required less paper work. This year he finally realized that there are many benefits of incorporating a business. Even though it invovles more work but it will protect you and save you money in the long run. He had to reorganize his documents, which took a lot of his time and money. You are absoutely right it is very important to set up your business right the first time. Also make sure you find yourself a good accountant and a good lawyer. It really makes a difference. It took us 2 year to find a good accountant, and we are still trying to find a better lawyer.

  15. krantcents says

    Excellent explanation! You raised some interesting points regarding the different states’ effect on the corporation. My plan is to discuss this with my CPA when I start to earn money (>$600). So far, I preference would be a LLC.

  16. Jerret says

    I don’t necessarily agree that you should wait to start your business before incorporating.
    If you’re NOT starting a business because you haven’t incorporated, just start the dang business.My father-in-law operated as a sole proprietor for 10 years before becoming an LLC and he was in a highly litigious industry!

    And, remember, a corporation isn’t bulletproof. If you’re sued by a customer/supplier/employee for monetary damages, you can be found liable personally if a judge decides you were negligent.

    I personally think a corporation just adds more stress when you’re trying to get a fledgling business off the ground. But that’s just me :-)

    • Financial Samurai says

      This is a good debate. I think people should just got ahead and start the business and not let paperwork get inthe way. It’s slow to start off anyway. Give yourself a month or two, and if things gain momentum, by all means incorporate!

      I guess it depends on what you’re selling too.

      It sure seems like at most all one needs to spend is $2,000.

  17. SPENDaholic says

    This is a really great post. Breaks down the types of corporations as well as pros and cons for each. Looking forward to more insightful comments from experienced readers.

    I’ll probably be looking to start a business when I’m 30 and have more experience and capital to invest in 4 years.

  18. Flexo says

    After running my business as plain-old LLC for a few years, discussions with my accountant kef to the decision to elect S-Corp tax treatment. Some benefits of LLC, some benefits of S-Corp, and a much smaller tax bill.

  19. Sandy @ yesiamcheap says

    Speaking from experience NY is NOT business friendly at ALL unless you have a large business and employ thousands. The paperwork is crazy and if you inhale they fine you. Blood sucking bastards.

  20. Suba says

    I don’t know if Greg will still read this. If anyone knows, I have been reading about this and it sounds like even if I incorporate anywhere else, I STILL have to pay the $800 franchise tax to CA just because I live here? Is that right? If I have to pay taxes in 2 states what is the advantage of incorporating in DE?

    This is one the articles I read on forming an LLC in CA vs DE. It says I have to pay the tax in CA anyway? http://danashultz.com/blog/2009/04/29/why-not-incorporate-in-delaware/

    Anyone know if that is right (or wrong)?

    • Financial Samurai says

      Might be like buying a car out of state with no sales tax. If I buy in Oregon, and registered in CA since that’s where I live, I have to pay the 10%. Makes sense. States need money and will get you no matter what.

      Time to move Suba!

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