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An S Corporation, also known as an S Corp, is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S Corporation.

An S Corp is a corporation with the Subchapter S designation from the IRS. To be considered an S Corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S Corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which the owner, or “shareholder”, is responsible. Liability protection is limited. S Corporations do not necessarily protect you from all litigation such as an employee’s tort actions as a result of a workplace incident.

The S Corporation is different from a traditional corporation (C corp) in that profits and losses can “pass through” to your personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself “reasonable compensation.” Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages.”

Forming an S Corporation

Before you form an S Corporation, determine if your business will qualify under the IRS stipulations. To file as an S Corporation, you must first file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corporation. Once your business is registered, you must obtain the necessary business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a listing of federal, state and local permits, licenses, and registrations you’ll need to run a business.

Combining the Benefits of an LLC with an S Corporation

There is always the possibility of requesting S Corp status for your LLC. Your attorney can advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S corp using Form 2553. You must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. The LLC remains a limited liability company from a legal standpoint, but for tax purposes it’s treated as an S corp. Be sure to contact your state’s income tax agency where you will file the election form to learn about tax requirements.

S Corporation Taxes

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit. All states do not tax S corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states such as Massachusetts, tax S corps on profits above a specified limit. Other states don’t recognize the S corp election and treat the business as a C corp with all of the tax ramifications. Some states, such as New York and New Jersey, tax both the S corps profits and the shareholder’s proportional shares of the profits. Your corporation must file the Form 2553 to elect “S” status 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.

Advantages of an S Corporation

• Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.

• Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns two percent or more shares, then benefits like health and life insurance are deemed taxable income.

• Independent Life. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.

Disadvantages of an S Corporation

• Stricter Operational Processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.

• Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.

A partnership is one business in which two or more people share ownership. Each partner contributes to all aspects of the business, including money, property, labor or skill. Each partner, in return, shares the profits and losses of the business. Because more than one person is involved in the decision-making, a wide variety of issues must be discussed prior to developing a legal partnership agreement. The agreement should include how future business decisions will be made, such as how profits will be divided, disputes resolved, ownership changes if or when new partners are brought in or current partners bought out, and how to dissolve the partnership. Although not legally required, partnership agreements are strongly recommended and it is considered extremely risky to operate without one in place.

Types of Partnerships

There are three general types of partnership agreements:

• General Partnerships assume that profits, liability and management duties are divided equally among partners. If you opt for an unequal distribution, the percentages assigned to each partner must be documented in the partnership agreement.

• Limited Partnerships (or a partnership with limited liability) are more complex than general partnerships. Limited partnerships allow partners to have limited liability as well as limited input with management decisions. These limits depend on the extent of each partner’s investment percentage. Limited partnerships are attractive to investors of short-term projects.

• Joint Ventures act as general partnership, but for only a limited period of time or for a single project. Partners in a joint venture can be recognized as an ongoing partnership if they continue the venture, but they must file as such.

Forming a Partnership

To form a partnership, you must register your business with your state through your Secretary of State’s office.

You’ll also need to establish your business name. For partnerships, your legal name is the name given in your partnership agreement or the last names of the partners. If you choose to operate under a name different than the officially registered name, you will most likely have to file a fictitious name such as an assumed name, trade name, or DBA name (“doing business as”).

Once your business is registered, you must obtain the necessary business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits tool on the Small Business Administration website to find a listing of federal, state and local permits, licenses and registrations you’ll need to run a business.

Partnership Taxes

Most businesses will need to register with the IRS, with state and local revenue agencies, and obtain a tax ID number or permit. A partnership must file an “annual information return” to report the income, deductions, gains and losses from the business’s operations, but the business itself does not pay income tax. Instead, the business “passes through” any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns.

Partnership taxes generally include:

• Annual Return of Income
• Employment Taxes
• Excise Taxes

Partners in the partnership are responsible for several additional taxes, including:

• Income Tax
• Self-Employment Tax
• Estimated Tax

Filing information for Partnerships

• Partnerships must furnish copies of their Schedule K-1 (Form 1065) to all partners by the date Form 1065 is required to be filed, including extensions.

• Partners are not employees and should not be issued a Form W-2.

The IRS guide to Partnerships provides all relevant tax forms and additional information regarding their purpose and use.

Advantages of a Partnership

• Easy and Inexpensive. Partnerships are generally an inexpensive and easily formed business structure. The majority of time spent starting a partnership often focuses on developing the partnership agreement.

• Shared Financial Commitment. In a partnership, each partner is equally invested in the success of the business. Partnerships have the advantage of pooling resources to obtain capital. This could be beneficial in terms of securing credit, or by simply doubling your seed money.

• Complementary Skills. A good partnership should reap the benefits of being able to utilize the strengths, resources and expertise of each partner.

• Partnership Incentives for Employees. Partnerships have an employment advantage over other entities if they offer employees the opportunity to become a partner. Partnership incentives often attract highly motivated and qualified employees.

Disadvantages of a Partnership

• Joint and Individual Liability. Like sole proprietorships, partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy the partnership’s debt.

• Disagreements Among Partners. With multiple partners, there are bound to be disagreements. Partners should consult each other on all decisions, make compromises, and resolve disputes as amicably as possible.

• Shared Profits. Because partnerships are jointly owned, each partner must share the successes and profits of their business with the other partners. An unequal contribution of time, effort, or resources can cause discord among partners.

A corporation, or a C corporation, is an independent legal entity owned by shareholders. This means the corporation itself and not its shareholders is held legally liable for the actions and debts the business incurs. Corporations are more complex than other business structures due to their costly administrative fees and complex tax and legal requirements. Corporations are usually suggested for established, larger companies with multiple employees. Corporations offer the ability to sell ownership shares in the business through stock offerings. “Going public” through an initial public offering, or IPO, is a major selling point in attracting capital investment and high quality employees.

Forming a Corporation

A corporation is formed under the laws of the state in which it is registered. To form a corporation, you will need to establish your business name and register your legal name with your state government. If you choose to operate under a different name other than the officially registered name, you will likely have to file a fictitious name or an assumed name, trade name or DBA name (“doing business as”). State laws vary, but typically corporations must include a corporation designation such as Corporation, Incorporated, or Limited at the end of the business name.

You will need to file certain documents, usually articles of corporation, with your state’s Secretary of State office in order to register your business as a corporation. Some states require corporations to establish directors and issue stock certificates to initial shareholders during the registration process. Contact your state business entity registration office for specific filing requirements.

Once registered, you must obtain the necessary business licenses and permits. Again, regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a listing of federal, state and local permits, licenses and registrations you will need to run a business.

Corporation Taxes

Corporations are required to pay federal, state and, in some cases, local taxes. Most businesses must register with the IRS and state and local revenue agencies and obtain a tax ID number or permit. A corporation is a separate tax-paying entity. Regular corporations are called “C corporations” because Subchapter C of Chapter 1 of the Internal Revenue Code is where you will find general tax rules pertaining to corporations and their shareholders. Corporations pay income tax on their profits, and in some cases, corporations are taxed twice – first when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns. Corporations use IRS Form 1120 or 1120-A, U.S. Corporation Income Tax Return to report revenue to the federal government.

Shareholders who are also employees of the corporation pay income tax on their wages. The corporation and the employee each pay half of the Social Security and Medicare taxes, but this is usually a deductible business expense.

Advantages of a Corporation

• Limited Liability. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.

• Ability to Generate Capital. Corporations have an advantage when it comes to raising capital for their business. They can raise funds through the sale of stock.

• Corporate Tax Treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.

• Attractive to Potential Employees. Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.

Disadvantages of a Corporation

• Time and Money. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating and tax costs that most other business structures do not.

• Double Taxing. In some cases, corporations are taxed twice – first, when the company makes a profit, and again when dividends are paid to shareholders.

• Additional Paperwork. Because corporations are highly regulated by federal, state, and in some cases local agencies, there are increased paperwork and recordkeeping burdens associated with this entity.

A cooperative is a business or organization that is owned and operated for the benefit of those using its services. Profits and earnings generated are distributed among the cooperative members, who are known as user-owners. An elected board of directors typically runs the cooperative while regular members have voting power to control the direction of the cooperative. Members can become part of the cooperative through purchasing shares, although the amount of shares members hold does not affect the weight of their individual votes. Cooperatives are commonly found in healthcare, retail, agriculture, art and restaurant industries.

Forming a Cooperative

Forming a cooperative is different from forming any other business entity. To start, a group of potential members must agree on a common need and a strategy on how to meet that need. An organizing committee then conducts exploratory meetings, surveys, and cost and feasibility analyses before every member agrees with the business plan. Not all cooperatives are incorporated, although many choose to do so. If you decide to incorporate your cooperative, you must complete the following steps:

• File Articles of Incorporation. The articles of incorporation legitimizes your cooperative and includes information such as the name of the cooperative, the business location, purpose, duration of existence, and names of the incorporators, and capital structure. Once the charter members (or the incorporators) file with your state business entity registration office and the articles are approved, you should create bylaws for your cooperative.

• Create Bylaws. While the law does not require bylaws, they do need to comply with state law and are essential to the success of your cooperative. Bylaws list membership requirements, duties, responsibilities and other operational procedures that allow the cooperative to run smoothly. According to most state laws, the majority of your members must adopt articles of incorporation and bylaws. Consult an attorney to verify that your bylaws comply with state laws.

• Create a Membership Application. To recruit members and legally verify that they are part of the cooperative, you must create and issue a membership application. Membership applications include names, signatures from the board of directors, and member rights and benefits.

• Conduct a Charter Member Meeting and Elect Directors. During this meeting, charter members discuss and amend the proposed bylaws. By the end, all of the charter members should vote to adopt the bylaws. If the board of directors were not named in the articles of incorporation, you must designate them during the charter meeting.

• Obtain Licenses and Permits. You must obtain relevant business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a list of federal, state and local permits, licenses and registrations you’ll need to run a business.

Cooperative Taxes

A cooperative operates as a corporation and receives a “pass-through” designation from the IRS. More specifically, coops do not pay federal income taxes as a business entity. Rather, the coop members pay federal taxes when they file their personal income tax, paying federal and state incomes tax on the margins earned by the cooperative, with the amount of taxation varying slightly by state. Coops must follow the rules and regulations of the IRS’s Subchapter T Cooperatives tax code to receive this type of tax treatment.

Some coops such as credit unions and rural utility cooperatives are exempt from federal and state taxes due to the nature of their operations.

Advantages of a Cooperative

• Less Taxation. Similar to an LLC, cooperatives that are incorporated normally are not taxed on surplus earnings (or patronage dividends) refunded to members. Members of a coop are only taxed once on their income from the cooperative and not on both the individual and the cooperative level.

• Funding Opportunities. Depending on the type of cooperative you own or participate in, there are a variety of government-sponsored grant programs to help you start.

• Reduce Costs and Improve Products and Services. By leveraging their size, cooperatives can more easily obtain discounts on supplies and other materials and services. Suppliers are more likely to give better products and services because they are working with a customer of more substantial size. Consequently, the members of the cooperative can focus on improving products and services.

• Perpetual Existence. A cooperative structure brings less disruption and more continuity to the business. Unlike other business structures, members in a cooperative can routinely join or leave the business without causing dissolution.

• Democratic Organization. Democracy is a defining element of cooperatives. The democratic structure of a cooperative ensures that it serves its members’ needs. The amount of a member’s monetary investment in the cooperative does not affect the weight of each vote, so no member-owner can dominate the decision-making process. The “one member-one vote” philosophy particularly appeals to smaller investors because they have as much say in the organization as does a larger investor.

Disadvantages of a Cooperative

• Obtaining Capital through Investors. Cooperatives may suffer from slower cash flow since a member’s incentive to contribute depends on how much they use the cooperative’s services and products. While the “one member-one vote” philosophy is appealing to small investors, larger investors may choose to invest their money elsewhere because a larger share investment in the cooperative does not translate to greater decision-making power.

• Lack of Membership and Participation. If members do not fully participate and perform their duties, whether it be voting or carrying out daily operations, then the business cannot operate at full capacity. If a lack of participation becomes an ongoing issue for a cooperative, it could risk losing members.

A limited liability company (LLC) is a hybrid legal structure providing the limited liability features of a corporation with the tax efficiencies and operational flexibility of a partnership. The “owners” of an LLC are called “members.” Depending on the state, the members can be a single individual (one owner), two or more individuals, corporations or other LLCs. Unlike shareholders in a corporation, LLCs are not taxed as separate business entities, rather all profits and losses are “passed through” the business to each member of the LLC. The LLC members then must report the profits/losses on their personal federal tax returns in the same manner owners of a partnership would do.

Forming an LLC

Each state has slight variations as to how to form an LLC; however, they all follow the same basic principles:

• Choose a Business Name. You must follow three rules when naming your LLC: (1) it must different from an existing LLC in your state; (2) it must indicate that it’s an LLC (for example “LLC” or “Limited Company”); and (3) it must not include words restricted by your state (for example, “bank” and “insurance”). Your business name is automatically registered with your state when you register your LLC so there’s not a separate registration process.

• File the Articles of Organization. The “articles of organization” is a basic document that legitimizes your LLC and includes information such as your business name, address and the names of its members. In most states, you file the Articles with the Secretary of State. Some states require you file with a different office, such as the State Corporation of Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations and Commercial Code. There may also be an associated filing fee.

• Create an Operating Agreement. Most states don’t require an operating agreement; however, having an operating agreement is highly recommended for multi-member LLCs because it structures the LLC’s finances and organization, and provides rules and regulations for optimal operation. The Operating Agreement typically includes percentage of interests, allocation of profits and losses, members’ rights and responsibilities, and other provisions.

• Obtain Licenses and Permits. Once your business is registered, you must obtain the required business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a listing of federal, state and local permits, licenses and registrations required for your business.

• Announcing Your Business. Some states, such as Arizona and New York, require the extra step of publishing a notice in your local newspaper about your LLC. Check with your state’s business filing office for requirements.

LLC Taxes

According to the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Rather, all federal income taxes are passed on the LLC’s members and are thus paid through their personal income tax. While the federal government doesn’t tax income on an LLC, some states do. Check with your state’s income tax agency.

Since the federal government doesn’t recognize an LLC as a business entity for tax purposes, all LLCs must file a corporation, partnership or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law. Visit IRS.gov for guidelines on how to classify your LLC.

An LLC that is not automatically classified as a corporation can choose their business classification. To choose a classification, an LLC must file Form 8832. This form is also used if an LLC wants to change its classification status. Read more about filing as a corporation or partnership and filing as a single member LLC at IRS.gov.

Depending on your LLC’s classification, you should file the following tax forms:

• Single Member LLC: Form 1040 Schedule C like a sole proprietor.
• Partners in an LLC: Form 1065 partnership tax return like owners in a traditional partnership.
• Filing as a Corporation: Form 1120, the corporation income tax return.

Combining the Benefits of an LLC with an S-Corp

You can always request S-Corp status for your LLC. You’ll have to make a special election with the IRS to have your LLC taxed as an S-Corp using Form 2553. You must file prior to the first two months and 15 days of the beginning of the tax year in which the election is to take effect. An attorney can advise you on the advantages and disadvantages of changing to an S-Corp status.

The LLC would remain a limited liability company legally, but for tax purposes it would be treated as an S-Corp. Contact your state’s income tax agency about the tax requirements and if they recognize elections of other entities such as the S-Corp.

Advantages of a Sole Proprietorship

• Limited liability: Members of an LLC are protected from personal liability for business decisions or actions of the LLC. If the LLC incurs debt or is sued, the members’ personal assets are usually exempt. Remember that limited liability means “limited” liability in that members are not necessarily protected from wrongful acts, including those of their employees.

• Less recordkeeping: The operational ease of an LLC is one of its biggest advantages. There is less registration paperwork and smaller start-up costs compared to an S-Corporation.

• Sharing of profits: Members distribute the profits as they see fit so there are fewer restrictions on profit sharing.

It’s up to the members to decide who has earned what percentage of the profits or losses.

Disadvantages of a Proprietorship

• Limited life: In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations in order to close business. However, you can include provisions in your operating agreement to prolong the life of your LLC should a member choose to leave the business.

• Self-employment taxes: Members of an LLC are considered to be self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.