Business Entity Types in America and Their Taxation

Starting a company in America begins with selecting the right state. Making your state selection appropriate for your commercial business is very important as it will provide you with tax advantages. Each state has different taxation procedures and some states apply flexibility in taxation. At Simple Corporate Solutions, we establish companies in every state in America with the appropriate company type in the state that suits you. You can find business licenses, annual or periodic reporting, and subsequent legal processes after company formation in our other blog posts, and you can contact us with any questions. Now let's examine the company types.

LLC – Limited Liability Company

The company type we call Limited Liability Company is a very common company type in America, and under this heading, the details and tax procedures vary. A company can be established as an LLC in the state, which gives it LLC status. In terms of federal taxation, the company owner can convert their company to one of the C corporation or S corporation types. We will explain C corporation and S corporation companies in later parts of our article. If the company type remains as an LLC, in the federal structure (at the IRS), the company appears as an LLC if it has a single owner and is subject to income tax accordingly. If it has multiple owners, it is automatically taxed as a partnership. Let's briefly explain the SMLLC (single member LLC) and partnership company types.

Single Member LLC

The single member LLC company type, abbreviated as SMLLC, is a company established with a single company owner in the state. If no company type change has been made after the company formation, that is, if the company has not been converted to another company type such as C corporation or S corporation, the tax responsibility in the federal structure belongs to the company owner. In a sense, the company is disregarded in the federal structure, and tax transactions continue through the company owner's taxes. If the company owner is an individual, the company's tax is shown in the individual tax return. If the company owner is another company, this LLC is shown as a division or partnership of the parent company in the parent company's tax return.

Since tax transactions in America are subject to both state and federal laws, we summarize the transaction details here.

So, what are the benefits of an SMLLC to its owner? The SMLLC company owner is not personally responsible for the company's debts and obligations, which is the biggest advantage. Another major advantage is that it prevents double taxation; that is, since the company's profit is directly reflected in the company owner's tax, it is not taxed both in corporate tax and in the individual tax return of the company owner receiving dividends as in corporations. We can also mention the ease of management as another advantage. The company owner can manage their company themselves if they wish, or they can employ other people. Finally, since they are considered as companies, their credibility in the market is higher compared to some other business structures (such as sole proprietorship).

We listed the advantages, but are there no disadvantages? Of course there are. We just mentioned sole proprietorship. Rather than writing about this company type separately, let's make a brief explanation for you while examining SMLLCs. Sole proprietorships are actually companies opened by an individual without requiring legal process. Although being able to open without legal process is a great advantage, in summary its disadvantages are: It provides less financial protection compared to LLCs, meaning the company owner is responsible with their own assets for every debt and obligation of the business. Just as they are responsible for debts arising from the business's operations, lawsuits filed against them are also filed against the company owner. Another disadvantage is that partnerships cannot be formed and they are subject to high individual self-employment tax. As you can appreciate, their credibility in the market is almost non-existent compared to LLCs.

Returning to SMLLCs, one of its disadvantages is that it requires legal formation compared to sole proprietorship. Of course, considering the disadvantages we just mentioned about sole proprietorship, legal formation may make more sense. In SMLLCs, since the company owner is also in the position of company employee, they are subject to self-employment tax and are taxed as both employee and employer. Finally, we can count the resource creation problem of SMLLCs as a disadvantage. They do not have stock authority, which can create problems for investment.

Partnership

Partnership type companies are also established as an LLC in the state. In their formation, the company owner is this time multiple persons or institutions. The IRS recognizes these companies as partnerships in taxation and subjects them to tax. The most important point not to forget in taxation is that the structure in the state where the company was formed is subject to state tax, and in the IRS, that is, the federal tax administration, it is taxed according to the type it was converted to or according to its structure at formation. In other words, even if a company established as an LLC in the state goes through what we call an "election" company structure change, it will be taxed for the state in its form at formation. While the federal tax administration defines LLCs as a disregarded entity, it separates their taxation as SMLLC, partnership, or corporation.

We said that if an LLC has multiple partners when formed, it is considered a partnership at the IRS. There is one exception to this, which is when the company partners are husband and wife. In this case, the IRS leaves the decision of whether the company will be recognized as an LLC or partnership to the married couple who own the company. During the EIN, or federal tax number, application, the couple can choose their company's type.

Partnership companies file income tax returns in federal taxation but do not pay the debt; instead, the tax debt is transferred to the individual tax returns of the company partners and the tax is paid through individual returns. Just as the tax debt arising from the tax return is transferred to the individual, the same situation applies if there is a tax credit. That is, partners are responsible with their personal assets for the company's debts and obligations, which is a disadvantage. If creditor persons or institutions cannot receive payment from the company for company debts, they will collect from the company owners, and all company owners are 100% responsible with their personal assets for the company's debts and obligations.

The advantages of partnership companies are: The company being easy to open and close structurally, risk sharing, work sharing, and the knowledge and skills that partners will offer being more than individual. On the other hand, disadvantages include partners' responsibility with their personal assets, possible disagreements between partners, profit sharing, and possible disruptions in decision making.

Corporation

As we mentioned when explaining the LLC company structure, when starting company formation in the state, a company is either established as an LLC or as a corporation. Here, corporation refers to C corporation. C type companies can be converted to S corporation after formation, and the same applies to LLC companies; they can also submit their requests to be taxed as C corporation to the IRS. In this part of our article, we will separate corporations into C corporation and S corporation.

C Corporation

A company is either directly established as a corporation in the state and taxed as a C corporation at the IRS, or it can be converted to a C corporation after being established as an LLC through a company type change application to the IRS (C corporation election). Whether a company is an LLC, partnership, C corporation, or S corporation is its tax structure at the federal treasury, that is, the IRS.

A C corporation is a legal entity. That is, it acts as a separate entity from its partners or owner. It can have an owner or partners and employees. Company owners (shareholders) are not personally responsible for the company's debts and obligations. However, this responsibility is limited to the percentage of shares they own in the company. For example, if a shareholder has a 10% share in the company, in case of non-payment of company debts, they are only responsible with the capital they put into the company. That is, even if the company goes bankrupt, the shareholder's personal assets (house, car, bank accounts, etc.) are not used to pay these debts. Only the capital they invested in the company or share value may be lost. This system allows investors to invest in companies by limiting their personal financial risks.

A C corporation files a tax return separately from its owners. Company owners are called shareholders, and a C corporation can have an unlimited number of shareholders. When filing a tax return, since the company will pay tax before paying dividends to its shareholders, the company profit is taxed again in the shareholders' individual taxes. This is what we call double taxation, meaning the profit is subject to tax twice. Although this situation appears to be a disadvantage, company profitability increases with the low C corporation corporate tax rate.

As we mentioned above, C corporation type companies can sell an unlimited number of shares. An advantage here is that these shares can be freely transferred. C corporations, which are one of the company types that a non-American citizen must establish to do business in America, differ from the other company type, LLCs, with this stock option. If the person or partners want to establish a large business, C corporation type companies are ideal. If a large investment will not be made, LLC (or partnerships established with partnership) will be more advantageous. C corporation companies must register with the SEC after a certain growth. The SEC is the United States Securities and Exchange Commission. That is, the SEC oversees securities and exchanges in America.

One of the most important points not to forget when examining company types and their taxation when establishing a business in America is the investment advantage situation of the state where the company will be formed. While some states require additional reporting, states with less reporting should be preferred according to the business you will do. If the state where you will do business is different from the state where you will establish the company, there are additional documents to be obtained; such as out of state or foreign corporation applications. To be able to make this application, many documents and/or applications may be required, such as an application for a document showing that your company is in good standing in the state where the company was formed.

S Corporation

The company type we call S Corporation is a quite common and preferred company type in America. Like in the partnership companies we mentioned in LLCs, profit and loss are transferred to the individual tax returns of the company owner/owners, meaning no tax debt arises as a company. So there is no double taxation situation. In addition, as we mentioned in C corporation companies, the company owner or partners are not responsible for company debts with their personal assets, they are protected with their limited liability.

The most important feature that distinguishes S corporation and C corporation company types is the shareholder limit. While there is no limit in C corporations, the maximum shareholder limit in S corporations is 100. Another difference is that shareholders must consist only of US citizens or persons with permanent residence permits, and legal entities can only be partners, not other types of companies. In summary, S corporation type companies are suitable for small businesses, while C corporation type companies are suitable for companies with larger commercial goals.

In S corporations, company owners can be company employees and can include themselves in the payroll. That is, like other employees, company owners will also pay their taxes (such as medicare and social security tax) on the salary they set for themselves. Of course, if there is company profit, this profit will be shown as company profit in the company owners' individual tax returns and will be subject to individual tax on this income.

In light of this information, in summary, persons or companies who want to do business in America should first look at which state is more advantageous for the commercial business they will do. While which state to do business in and which state to establish the company in is of great importance, the company type must also be chosen correctly. If you also want to establish a company in America, you can contact us to get opinions from our expert team.