So you’ve decided to start your business, that’s awesome! You have a vision and a plan and you just know that it is going to sell. We’re all on board. Now you have to open actually open the business and you might be wondering, what kind? Which entity is the right fit for me and what are the pros and cons of each? Let’s dissect each one and do a comparison.
At origin, every corporation is born as a C-Corporation. This is a separate entity from you, the individual or the President, of the company. In a C-Corp, the officers of a company are treated as employees of the company from a tax standpoint. They receive a salary in the form of a W-2, and the corporation, on its end, can deduct those wages as work expenses. The officers then report that money on their personal tax return at whatever tax rate their bracket falls into. Of course, if you are single you can control that more. But if you are married and your spouse also earns an income, your spouse's wages will combine with yours and both of your incomes will be taxed at the new tax rate. The corporation itself also pays taxes. Meaning that if your company’s net income is $15K, the company will be responsible to pay the tax on that income.
Another point to keep in mind is that because a C-Corp is a separate entity from you, you are not personally responsible for debts or lawsuits that your company might face. What that means is your personal assets are safe from whatever your company goes through.
An S-Corporation was originally a C-Corp that has been elected to be treated like an S-Corp by the officer. By filling out the IRS form 2553 the company has converted itself into an S Corp. This could be done at any time. While both entities share some common benefits like personal asset security, there are some key differences in their tax treatments. S-Corps pay no federal tax. Whatever profit the company recognizes, it is distributed to the officers in the form of a K-1. Unlike a W2, there is no Social Security tax on this income. Under an S-Corp, an officer should take a salary in the form of a W2 but also can withdraw money from the business in the form of distributions via the K1. Therefore, part of your income is subject to full taxation, while part of it is only subject to federal taxation for a total of 7.65% tax savings on your, the Social Security rate.
By name, a Partnership is an entity that MUST contain at least 2 partners at all times. This becomes tricky if at any point one partner wants to sell their shares and there is no one to replace them in the Partnership, the remaining partner must close up shop and open a corporation on their own to continue the business. This is not the case for any other entity. Partners also do not have to take wages. They are paid through Guaranteed Payments which are also distributed in the form of a K1. However, unlike in an S-Corp, in a Partnership, the payments from the K1 are subject to both federal AND self-employed tax. So there is really no tax savings or benefit when compared to an S-Corp.