Most sellers begin their Amazon business as a sole-proprietorship, which is great when you first start up because it is easy and free when you’re first starting. However, as you grow, you’ll want to move into an official legal entity to protect your personal assets. This is because when you operate as a sole-proprietorship, you are personally responsible for all business losses to an unlimited level, which means if your company gets sued for any reason, they can go after your personal assets. This is why attorneys always recommend establishing a legal entity for your company as quickly as possible, because a primary purpose of the legal entity is to offer you limited liability. For most people, this means deciding between a limited liability company (LLC) or a corporation.
Fortunately, both a corporation and a limited liability company offer the owners limited liability. This article will explain the differences between an LLC and a corporation. If you would like specific help with determining which is best for your company, you’ll want to reach out to an attorney like SLS and your accountant.
The corporation is one of the oldest business entity types, and is likely the most common company type that comes to your mind when you think of a company. Many publicly traded companies are corporations, and you can tell based on the fact that they have “Inc.” or “Corporation” after their name. All publicly traded companies are a type of corporation known as the C-Corporation, which has to do with how it is taxed under the Federal Tax Code. In particular, C-Corporations are subject to double taxation, which means that the Corporation pays taxes on the profits it makes, and then the shareholders are taxed again when they receive dividends from the C-Corporation. Because of this double taxation, C-Corporations are not advised for small business owners. Additionally, C-Corporations have strict record keeping requirements that must be followed. In sum, C-Corporations are very popular for big businesses, but likely too much of a headache for most small businesses to consider this corporate form.
The S-Corporation is technically a corporation just like a C-Corporation, but becomes an S-Corporation after it makes an “S-election”. This “S-election” means that the business owner filed a form with the IRS making a “Subchapter S election”. Additionally, if you decide to form a S-corporation, most states allow you to insert a “closely held corporation” clause in your Articles of Incorporation which allows you to be exempt from some of the onerous requirements that C-Corporations are subject to. The S-Corporation is not subject to double-taxation, because the income “flows through” to each shareholder’s tax return. However, there are a couple key things to keep in mind about the S-Corporation:
- An S-Corporation does not have the “double taxation” that a C-Corporation faces, but it does require the owner to file a tax return for the S-Corporation each year.
- If you have multiple owners, S-Corporation rules require that profits be split according to ownership shares. This means if you have $100 in profit and own 90% of the company, you must be given $90 even if the 10% shareholder did 50% of the work.
- Maximum of 100 shareholders (but this will not affect most small businesses)
- The shareholders must make a timely S-corporation election on IRS Form 2553, no more than two months and 15 days after the beginning of the tax year the election is to take effect.
- Some states do not recognize the S-Corporation status and tax them as C-Corporations
- There are more regulations that S-Corporations face when compared to LLCs
- While dividends are taxed at lower rates in an S-Corporation than an LLC, the owner must be paid an appropriate salary to receive that tax break. The IRS can challenge an owner being “underpaid” salary and “overpaid” dividends.
- Documents required to form S-Corporation: Articles of Incorporation (include Closely Held clause) and Bylaws, IRS 2553 if you desire to make an S-election
The Limited Liability Company
The LLC is one of the most popular entity types for small businesses. LLCs are extremely flexible, and can be set up in many different ways by your attorney depending on what you select in your Operating Agreement. This entity is formed by filing Articles of Organization with your state, and then working with your attorney to draft an Operating Agreement. If you have only one shareholder, by default all profits flow through to your personal tax return and you do not have to file a separate tax return for the LLC. If you have multiple shareholders, by default the LLC is taxed as a partnership, and you will file a tax return for the LLC. However, LLCs are very flexible, so if your accountant advises you should make an “S-election”, an LLC can file the same Form 2553 that an S-Corporation files and will be treated as an S-Corporation from a tax perspective. Here are a few quick things to note about the LLC and why you may want to choose it for your company:
- The LLC is very flexible, and if you have only one owner (called a “member”) the Single Member LLC can be taxed either as a flow-through “disregarded entity” or an S-Corporation. (You would want to talk to your accountant before making this decision as there are important tax consequences they can advise you of based on your personal situation.)
- If you have more than one member, your “Multi-Member LLC” can either be taxed as a partnership or as an S-Corporation. (You would want to talk to your accountant before making this decision as there are important tax consequences they can advise you of based on your personal situation.)
- Unlike S-Corporations, multi-member LLCs that are taxed as a partnership have more flexibility when it comes to sharing profits. LLCs can decide to either split profits purely based on ownership percentage, or they can split profits however they want (as long as the members agree to the split and their operating agreement allows it).
- There is no double-taxation with an LLC.
- If the LLC does not make the S-election, they can choose to pay the owners however much they want in salary, and the IRS will not challenge it.
- Documents required to form an LLC: Articles of Organization and Operating Agreement