If you’re about to go out on your own and create a business, congratulations. Becoming an entrepreneur, especially an online entrepreneur is a good idea in this environment. When the government can’t shut you down due to a pandemic or whatever reason, having an online business becomes more valuable.
Before you start on your entrepreneurial journey, it’s important to understand the difference between three types of corporations.
Once you cross over to the side 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 be an entrepreneur, 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
A Business’ Legal Entity Is Important
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. You might have learned the terms “sole proprietorship” and “corporation” back in high school. They probably meant nothing to you then.
But now it’s important to understand what they mean. Every entrepreneur should know the pros and cons of the three types of corporations specific to your situation.
Avoid The Sole Proprietorship Default Route
Unless you specify otherwise, your new business will operate as what’s called a “sole proprietorship.” This means there’s no practical distinction between you and the business itself.
The “advantage” to a sole proprietorship is that it costs nothing to start. That is, 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.
I don’t recommend running a business as a sole proprietor, unless it’s a casual side hustle. Maybe 150 years ago you might, if you made horseshoes and paid your apprentice under the table.
However, 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’ll want to spend a little money before opening and incorporate. Why? You may hesitate at incurring upfront out-of-pocket expenses. However, 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. With the three types of corporations you become a corporate shareholder with all the rights that affords.
Incorporate Your Business
To incorporate, you have to spend money filing with a state. Not “your” state”, but “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? 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. That wouldn’t be efficient.
Advantages Of Incorporating In Delaware
Delaware protects shareholders (you’re a shareholder, remember?) more than other states do. Some states require the three types of corporations to have multiple officers and directors.
However, Delaware lets you get by with just one. You don’t even have to be a citizen. Actually, you don’t even have to live in the U.S. In addition, you don’t even have to publicly disclose your name.
Other Popular States For Incorporation
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 also popular states for incorporating, too.
The Worst States To Incorporate
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 laws 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 it 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 types of corporations.
- C corporation (C corp)
- S corporation (S corp)
- Limited liability company (LLC)
LLCs are technically not corporations, but consider them close enough for our discussion. C and S corporations are named after the particular subchapter of Chapter 1 of the Internal Revenue Code.
Main Difference Between C Corp And S Corp
Most major corporations are C corps, most smaller firms are S corps. The big difference between the two is that C corporation shareholders are subject to double taxation.
That means the government taxes the C company’s income at corporate rates, and taxes the dividends after the corporation distributes them to the shareholders. Ouch.
Dividends For Corporate Shareholders
What are dividends you may ask? That’s what you call the money that 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.
Related: The Right Ratio Between Salary And Distributions
Difference Between LLCs And S Corps
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.”
Let’s say 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. Be sure to read my post on What’s The Right Ratio Between Salary And Distribution To Save On Taxes And Avoid An Audit?
This isn’t so with an LLC. However, 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 there’s one big tradeoff. Your LLC has to issue you a K-1 statement. The K-1 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.
S Corps Are Great For Small Businesses
For a typical one-person S corporation, the paperwork consists of little more than this:
- Every month, return a form to the state department of taxation. Takes about 30 seconds, costs the price of a stamp.
- Each quarter, pay estimated taxes. It’s a lot easier when you save receipts as a matter of course. If you want, hire an accountant.
- Elect a board of directors, have an annual board meeting and keep minutes for your records.
And I also want to mention, if you have an S-corp or another type of pass-through entity structure like an LLC, be sure to check out the PTE tax election. It’s not available in every state, but it can be a great way to save on taxes. You can discuss the options and benefits with your accountant.
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 are 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. Here’s a helpful list of business expenses to reference.
Start An Online Business
Out of the three types of corporations, I decided to start an S-Corp for my online business. It’s been around six years since I started Financial Samurai and I’m actually earning a good passive and active income stream online now.
I never thought I’d be able to quit my job in 2012 just three years after starting Financial Samurai. But by starting one financial crisis day in 2009, Financial Samurai actually makes more than my entire passive income total that took 15 years to build.
If you enjoy writing, creating, connecting with people online, and enjoying more freedom, see how you can set up a WordPress blog in 15 minutes with Bluehost. You never know where the journey will take you!
Not a day goes by where I’m not happy I started this website in 2009. Financial Samurai has given me something to do in “retirement.” It’s been a joy to run this site and learn from all of you as well.
Related posts on the three types of corporations:
Why I Regret Selling My Online Business For Millions
Buying And Selling Blogs For A Living
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Patricia Weinert says
Do you have any advice as the what tax forms a small 2 person S corp would need to file when they first start? Look forward to your reply.
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?
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!
Financial Samurai says
Greg, can you incorporate in Delaware when you live in California?
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.
Financial Samurai says
Eeesh…. that sucks. Guess California and NYC are out! I will seriously focus on Nevada or Delaware. Hmmmm… perhaps I need an address there though? Will talk with the lawyer.
Balanced Dividends Mike says
Hi Sam –
I discovered your site about 2 months ago, and I’ve spent the last few weekends reviewing numerous articles.
I’m in the works of creating my blog site (following your in-depth article), utilizing BlueHost, WordPress and Genesis (theme). It’s not published yet, but I’m adding content that I’ve been writing for a few years. Your site really gave me that final “just do it already!” motivation.
That said, I came across this particular thread on corporations (which I’m familiar with already), but I wanted to ask as I couldn’t find the answer: what state did you end-up utilizing to incorporate and form your S-corp?
Thanks, BD Mike
This is a great post. So many options it can get so overwhelming so it really helps to know the basics.
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.
Kef = Led … typing in the dark.
Financial Samurai says
Sounds good. S-Corp sounds like the way to go, although an LLC and S-Corp seem to be blending in.
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.
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.
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.
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.
Financial Samurai says
Good people are seriously the key to so much. To have a great lawyer, accountant, and trusted advisor is priceless!!
Everyday Tips says
Glad you posted this again Sam, because one of my goals for January is to incorporate myself and I was going to come dig up this post on your site!
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.
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.
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 ;-)
Consumer Contracts Financing says
Great article. Even people in business for a long time needs a refresher course. I wish I knew the benefits of incorporating in other states back when our company started.
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.
Greg McFarlane says
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?)
Financial Samurai says
A regressive tax for biz owners! I like! But surely u ALSO have to pay Federal Income tax and state tax as well? Or is this in lieu of Federal?
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.
Financial Samurai says
S Corp it is! Greg, what exactly is self-employment tax? Is it an Additional tax on top of federal and state? How much is that sucker??
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…
This is a great post. I’d love to see one from the Canadian perspective as well, should I decide to incorporate someday.
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 ;)
Ken @Spruce Up Your Finances says
Excellent post and very informative.
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.
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.
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!
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.
Wonderfully condensed advice!
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!
Financial Samurai says
Whatcha think? Have you decided to make the move this year? I’m gonna hopefully start the process this weekend!