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S-corp, Partnership, or C-corp: Which is right for your small business growth?

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According to the Bureau of Economic Analysis, S corporations account for 76.8% of corporations with less than 500 employees and 37.3% of corporations with over 500 employees – making them by far the most popular business designation. Additionally, the IRS estimates that there are over 5 million S-corps in the US, nearly 3 times as many as C-corps. 

But is it the right fit for you and your business? The answer really lies in answering this question: What are your goals for your business and how will your operations run? How you answer those questions will help you decide if you want an S-corp, a C-corp, or a partnership. So what’s the difference? Here is the lowdown on each, and why you’ll want to give this some serious thought when deciding what type of business entity you’ll want to use. 

How is an S-corp different from an LLC?

Let’s get this out of the way. Your tax entity is not an LLC. At its most simple, you can think of an S-corp as a tax entity. An LLC is NOT a tax entity. It’s a legal structure – you’ll still have to select your tax entity. 

Why do most businesses and CPAs choose S-corps?

Most accountants or business owners will default to an S-corp because it offers a nice little savings for FICA, the Federal Insurance Contributions Act, best known as the amount that is deducted from paychecks every month. This is because you’re only taxed on profit with an S-corp, and you don’t pay FICA tax on that profit. It’s only a single layer of taxation. Whereas a C-corp has a double layer of taxation, and partnerships and sole membership LLCs DO pay FICA tax on the profits. Of course, as a shareholder-employee of an S-corp, you must pay yourself reasonable compensation as wages.

Most people default to an S-corp simply because it’s the easiest way to save on taxes. However, if you’re a growth minded business there are more factors to consider when structuring your org. In fact, an S-corp may be the wrong decision. 

The downside of choosing an S-corp

The biggest downside to choosing an S-corp is that when you pull assets out of your corporation, it’s a taxable event. That means appreciating assets like real estate can cause problems if they’re gaining a lot of value over the course of your business’s life. You typically do not want those types of assets inside of a S-corp in general.

An S-corp also limits you to 100 or less shareholders. Those shareholders MUST all be individuals (not businesses). The exception? Sometimes you can have an S-corp own an S-corp but it will have to be a qualified subsidiary – meaning that it’s not as simple as just allowing another company to buy you up. 

S-corps also limit their shareholders in other ways, such as limitations in HSA benefits or paying long term care premiums. Even figuring out insurance can end up being choppy waters to navigate. You’ll also only be able to allocate your profits based solely on ownership percentage, which can get tricky when you have a cash investor and an operator investor. 

All of these factors can end up hindering the growth of your business. Do other structures work better? Here’s what a partnership can do.

How a partnership is different from an S-corp

Partnerships are more sophisticated and flexible with their ownership structure and allow you to avoid some of the limitations you might have with an S-corp. This is because of membership agreements that are written into your LLC. With a membership agreement you can choose to specially allocate profits. Whether that means making an election annually or specially allocating profits based on whatever factors you want to draw up – a partnership agreement allows you to do that. This can be especially helpful when you have a passive investor and active partner. Your membership agreement can allow for the active partner to get the lion’s share of the profits, while the investor simply gets a return on their investment.

A partnership allows you flexibility in adding partners, which could be a strategic part of your acquisition strategy. It might allow you to merge companies instead of just buying them out and forcing a total exit. It’s also better if you need a cash infusion from another source. Say that you have a private equity-backed corporation that wants to be an owner of your partnership. They’ll be able to invest resources or money in exchange for ownership interest in a partnership. 

C-corps are for owners with a build and sell mentality

The third structure we’ll talk about today are C-corps, which allow you to pay taxes at a corporation level. This is typically the preferred structure of folks working with intellectual property or techies, who often have a get-in get-out mentality with their business. If your five-year plan involves selling your business, a C-corp may be the way you want to go to leverage significant tax benefits upon exiting the C-corp. 

The biggest downside? With a C corporation, the first layer of tax is paid within the corporation, and then if you want to take money out for yourself - not a wage, which would be a dividend (and taxable) - you’ll be able to, but the caveat is that doing so results in double-taxation. 

An S-corp or partnership works as a pass-through entity, meaning that income passes to your personal tax return as taxable income, where you can distribute those profits or withdraw remaining capital, tax free. So unlike with C-corps, you only pay tax once.

A lot of times we see folks who create C corporations tend to have one really good idea, want to develop it, and then spin it off before moving to something else. This isn’t the one to pick if you’re trying to build a business generationally or keep it in your family. But if you’re looking for the nontaxable exit? That’s definitely the one to choose.

Which is right for you? Talk to your CPA and find out.

Ultimately, the right choice boils down to your goals, which is why you should always talk these decisions out with a qualified CPA. One with the experience to know which is right for you. Do you have a small business but need to figure that out? We’d love to have a no-pressure chat with you to explore your options! 

 

For more on managing growth for your small business, read more in our Managing Growth series:

Part 1: Managing Your Business Growth Organically   

Part 2: Why a CPA Should Be the First Hire at Your Startup

Part 3: How to Grow Your Small Business Through Mergers & Acquisitions

 

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