Every day, Kentucky entrepreneurs looking to start new businesses face one of the hardest challenges – determining what type of operational structure they should adopt. There is something of a continuum when it comes to business models.
On one end of the spectrum is the sole proprietorship, the easiest to establish and most basic to run. However, it offers no liability protection for personal assets held by the owner. On the other end of the spectrum is a corporation that does provide protection for personal liability, but with more complex creation and management needs. And, to add to the mix is the fact that there are two types of corporations – an
S corporation and a C corporation. Understanding how these models are similar and how they differ is important when deciding if either fits a particular company’s needs.
Taxation model differences
Forbes magazine explains that a C corporation is essentially taxed twice while an S corporation is only taxed once. The reason for this is that a C corporation files and pays income tax as a business entity. In addition, individual shareholders report distribution earnings on their personal tax returns and pay income tax accordingly.
In contrast, an S corporation pays no corporate income tax. Instead, all profits and losses are passed on to the shareholders for reporting on their personal tax returns solely. Fox Business notes that this method also means that any business losses may reduce the personal income and therefore the personal income tax liability of shareholders in an S corporation.
The double taxation for C corporations may also come into play for shareholders who withdraw money from the company. Such a distribution may be viewed as another dividend and therefore subject to corporate and individual tax. A shareholder in an S corporation who is paid a reasonable wage by the company may withdraw money from the business without such ramifications.
Differences extend beyond taxation
Beyond how a business is taxed, the operational structure chosen determines how decisions will be made and even who can be a shareholder of the business. In fact, some people recommend that choosing a model on this basis first is more appropriate than choosing a model based upon taxation.
C corporations provide the most flexibility in terms of who may purchase shares of the business. S corporations not only cap the number of shareholders but also limit such ownership to citizens of the U.S. only. Voting rights, liquidation and dividends are also handled very differently between the two structures.
It is recommended that Kentucky business founders discuss their needs with an experienced lawyer before making a final determination of what type of structure to settle on. This gives entrepreneurs the ability to understand the many nuances that may affect their companies going forward based upon their choice.