What is the Best Legal Entity Type for an S-Corp?

Structuring a business comes with a lot of questions and few clear answers! Add the S-Corp election into the mix, and you may feel like you need both a lawyer and a CPA before you can even set up your business. You’re not wrong, but luckily we’ve consulted with lawyers and CPAs and we’re here to break it all down for you. Prefer to just let us handle it all for you? Give our CPA firm a call! We specialize in accounting for small businesses, bookkeeping, small business taxes and s-corp taxation, which is our serious mojo. Whether you need ongoing support or just want us to get you set up for success, we do entity formations and have bookkeeping and tax subscriptions to fit any small business. If you’re a DIY enthusiast, keep reading and we’ll get into these business structures.

The number one point of confusion we find with our clients is how the S-Corp election fits in, so before we jump into specific entity types, a quick refresher on the S-Corp election. Not sure what an S-Corp even is? Head over to What is an S-Corporation to get started.

Now to jog your memory, an S-Corp is a tax election, not a business structure. This means you can’t “register” a small business as an S-Corp. The business has to be already registered with a state government, which we talk more about in Who Can Make the S-Corp Election, and then you follow the steps in How to Make the S-Corp Election to obtain S-Corp status. So if an S-Corp isn’t technically a business structure, what are the main structures? The four big ones are Sole-Proprietorships, Partnerships, Limited Liability Companies (LLC’s), and C-Corporations (Corp.). Read on to find out more about each one and what the differences are.

Sole-Proprietorships

This business structure is the most simple. A sole-proprietorship is when an individual operates a small business basically as an extension of themselves. A sole-proprietorship is not legally incorporated or registered, which means there are no formal requirements to begin operating. Although there is no distinction between the individual and the business, sole proprietors can use a DBA (Doing Business As) in order to use a different name than their own for the business, but they can’t use the abbreviations Inc. or Corp. since they are not formally registered.

It is a “pass-through entity” for tax purposes and there is no legal distinction between the individual and the business. This means all of the profits and losses flow directly into the business owner’s income for tax purposes. However, it also means that liability flows directly through the business to the owner and there is no corporate protection. Additionally, a sole-proprietor is still responsible for paying both sides of employment taxes. Making the S-Corp election avoids this employment tax on business profits and is the biggest perk for small business owners to save money on taxes! Read more about it in What is an S-Corporation?

Can a sole-proprietorship make the S-Corp election? Not directly, because a sole-proprietorship is not legally incorporated, and as we talked about in Who Can Make the S-Corp Election?, formally registering your small business is a prerequisite to making the S-Corp election. So a sole-proprietorship must first file articles of incorporation as an LLC or C-Corp before converting to an S-Corp. Check out When to Make the S-Corp Election for more information about timing your small business registration with the S-Corp election, or give us a call to get started.

Partnerships

The most common form of partnership is a general partnership. This business structure is similar to a sole-proprietorship, but includes more than one owner. There are no legal requirements or formal incorporation needed to form a general partnership. However, it is strongly recommended to draw up a partnership agreement that addresses how to divide profits, resolve disputes, bring in new partners/buy out existing partners, dissolve the partnership and all other potential scenarios along with how the partnership will work for daily business operations.

Just like a sole-proprietorship, a general partnership uses a pass-through income structure and each partner includes their respective income or losses from the partnership on their personal tax returns. Additionally, all liability flows directly to the partners and is assumed to be divided equally along with profits or losses unless explicitly documented otherwise in the partnership agreement.

A second type of partnership is called a limited partnership or LP, and although it operates similar to a general partnership in terms of pass through income structure and the need to draft a partnership agreement, it differs in liability treatment. In an LP, at least one owner assumes unlimited personal liability for the business, but other partners may have limited liability that does not exceed their initial investment. An LP is advantageous for passive investors and is often used by small business owners to bring on investing partners who are not involved in the daily business operations.

Again, similar to sole-proprietorships, partnerships are still responsible for paying both sides of employment tax, which is why the S-Corp election is likely still a great move for partnerships to save money on their small business taxes! A partnership can not directly convert to an S-Corp since a partnership is technically not an incorporated entity the same way an LLC or C-Corp is. However, the transition isn’t too complicated, and our friendly team of S-Corp small business accountants can make it as smooth as possible. Check out How to Make the S-Corp Election or give us a call!

Limited Liability Companies (LLC’s)

An LLC is a common business structure that many sole proprietors convert to because it provides legal liability protection. The members of an LLC are personally protected from the legal or financial liability of the business. For small business tax purposes, an LLC also uses the pass-through structure. If it is a single member LLC, the IRS treats it the same as it would for a sole-proprietorship for taxes and it is considered a “disregarded entity” unless the taxpayer elects to be taxed otherwise. The IRS treats multiple member LLCs as partnerships by default. In both cases, the profits and losses of the business pass through to the individual member/s and are taxed at each member’s personal tax rate. Just like sole-proprietorships, LLCs are also responsible for paying the 15.3% employment tax, which again points us to making the S-Corp election to save this money on your small business taxes!

The steps and requirements to become an LLC vary by state, but it typically involves filing articles of organization and an operating agreement. Can an LLC make the S-Corp election? Yes! This is the most typical S-Corp conversion since an LLC is often a small business and it is already a legally registered business entity. Check out this article for the lowdown on eligibility requirements, or this one for next steps if you don’t want to just let us get the ball rolling for you.

C-Corporations (Corp.)

A C-Corporation is the big boy business structure. A C-Corporation is owned by stockholders and run by a director or board of directors who appoint officers to run the corporation’s operations. A C-Corporation has liability protection- stockholders, directors, and officers are not personally liable for legal or financial obligations of the corporation. Unlike an LLC or Sole-Proprietorship, C-Corps do not have a pass-through structure. Instead, C-Corps pay corporate taxes at the entity level. C-Corps file a corporate tax return in the same way S-Corps and LLC’s do, but the key difference is the taxation at the entity level, which LLC’s and S-Corps are not subject to.

Forming a C-Corporation can vary by state, but it generally includes filing articles of incorporation and may include issuing stock and registering with the federal Securities and Exchange Commission.

A C-Corporation can also make the S-Corp election assuming it meets the eligibility requirements outlined here, but for most small business owners, we recommend registering as an LLC with their state if they only do business in one state, or Delaware otherwise, as the first step. Once registered, we recommend making the S-Corp election right away.

Key Differences Between Entity Types

Now that you have an understanding of these three business structures and how they relate to converting to an S-Corp, let’s look at the key differences between them. Have questions about how to structure your small business or the S-Corp election? Our CPA Firm is here to help with entity formation, accounting services for small businesses, and saving you money on your small business taxes.

	Sole Proprietorship	LLC	Partnership	C-Corp	S-Corp
Legally Registered
Limited Liability
Pass-through Taxation
Reduced Employment Taxes
Avoids Double Taxation
Formation	No Action	State	State	State	State & IRS