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Corporations come in all shapes and sizes: there are massive companies like Apple and Nike but also single-person corporations or those with only a handful of employees.

A corporation, for tax purposes, doesn’t have limits on its size. If you are a small business owner, you may want to consider establishing yourself as a corporation. In the eyes of the IRS, you can either become a C corporation or an S corporation. Understanding the difference between these 2 concepts can help you file for the correct status—and file your taxes more easily. 

Learn about the differences between C-corp and S-corp business designations to decide which type of business is best for you.

S-Corps Use Pass-Through Taxation

One of the biggest differences between S corporations and C corporations is that S-corps utilize pass-through taxation. Essentially, the business itself doesn’t actually pay taxes, which means the tax burden passes through to its owners. 

Pass-through taxation is often used for small business owners, partners, and sole proprietors. For example, a freelance web designer might establish an LLC to protect their personal finances. Even though their clients pay the LLC, all profits go to the individual who owns it. The LLC doesn’t have any profits to report, which means it can’t pay taxes. Even if the company reported profits, the business owner would have to pay taxes twice (once as a business entity and once as an individual). 

With a pass-through entity like an S-corp, all of the company profits are credited to the shareholders. This is the taxable income, not the revenue from the business. The shareholders and owners will report the earnings on their personal income tax forms and pay the IRS in this manner. 

With a C-corp, the corporation is taxed, which means the owners pay taxes twice. First, the company pays corporate income tax, and then the shareholders pay personal income tax. There is also a greater risk of double taxation when corporate profits are paid to shareholders as dividends. The IRS has guides for both S-corps and C-corps to fill out the proper tax forms and report their income rates each year.  

While setting up pass-through taxation might seem like a strategic move for your business, there are benefits to creating a C-corp instead of an S-corp. Whether you will reap these benefits depends on the future growth plans and structure of your organization.

S-Corps Have Limited Shareholders

Startup founders who want to bring in several stakeholders and eventually become a publicly-traded company often prefer C-corps. You aren’t limited by the number or types of shareholders you can have with a C-corp. 

With an S-corp, however, the number of shareholders you can have is limited. No S-corp can have more than 100 shareholders, and they must all be US citizens. Additionally, you can only have 1 class of stock for your shareholders. While different shareholders can hold different percentages of the company, they each have the same type of stock.

For example, Google has 3 different classes of stock. Each class is meant to provide different benefits to shareholders and powers to the founders:

• Class A: This is the standard option, where 1 share means 1 vote. If you invest in Google today, then you will most likely be a Class A shareholder. 
• Class B: This stock is primarily held by the founders who want to maintain control of the company even when people keep buying it. With this option, each share grants the holder 10 votes.
• Class C: This stock is mostly held by employees. This class has no voting rights.

This structure gives the most voting rights to the founders. Similar structures at other companies deny voting rights to some classes of shareholders. If you plan for your business to go public or if you want to open your company to new shareholders, you may need to create different share classes. 

C-corps are better able to raise venture capital because of their share structures. It may be harder to lure investors to your business if you choose to open an S-corp—important if you don’t plan to bring your business public but want to grow your working capital through private investment in the future. 

However, this is a non-issue if you only have a few key owners. Many S-corps are run by sole proprietors who are their only owners. They own 100% of the shares and take home 100% of the dividends. If you only plan to bring on a few investors, you might not need to consider the complexity of a C-corp. 

In the case of both S-corps and C-corps, you will need to report all of your shareholders in your tax documents. The S-corp application allows owners to add additional pages if there are more than 10 shareholders when the business is established. This proves that all of the shareholders approve of the formation of an S-corp and the tax burdens that come with it. 

C-Corp Is the Default Formation Option

When you decide to form a corporation, C corporation is the default option. It is possible to register with your state or file articles of incorporation today as a C corporation. However, if you want to become an S corporation, you will need to take steps to apply for this status through the IRS. 

Companies that want to reach S-corp status need to complete IRS Form 2553. With this form, you’ll need to explain when your fiscal year starts and ends (if different from December 31), and this date will determine your deadline to file.

Companies that start their fiscal year on January 1 need to file Form 2553 by March 15 to qualify for the current tax year. If your fiscal year starts earlier or later, then the IRS sets different time deadlines. If you fail to complete Form 2553 by the deadline, then you might not qualify as an S-corp for another year. 

The IRS will let you know if your business qualifies to operate as an S-corp. The application process typically takes a few weeks—longer if Form 2553 is filled out incorrectly or if the IRS is experiencing backlogs in its mail. 

Regardless of whether your company gains approval to become an S-corp, you’ll still need to follow the same steps to form your business, submit an annual report to your state, and pay incorporation fees. You’ll also need to appoint a registered agent to act on your company’s behalf and create bylaws and guidelines for shareholders. Each year, if the number of shareholders or the percent each owner has under their name changes, you’ll need to report the adjusted ownership to the IRS.

It Is Harder to Transfer Stock With an S-Corp

With standard corporations and publicly-traded firms, the market determines the value of each share. This is why a shareholder can buy the stock at different prices—they might buy at 1 level and then increase their shares when the price drops in the future. However, with an S-corp, there is no public listing to determine a share price. There also aren’t easy ways for shareholders to sell their stock and buy from other companies. 

With an S-corp, an existing shareholder will need to work with the owner and other shareholders to sell their holdings. They’ll also need to agree on a market price for the buyout, typically based on the initial investment and changes to the company since then.

For example, if an initial shareholder invested $10,000 and the company has grown significantly in the past few years, they might sell their shares for $20,000 because of the increase in the company’s perceived value. If the owner wants to buy out a shareholder, they will make a compelling offer for the shares in order to entice them to sell.  

With IRS Form 2553, the owner needs to list each shareholder and their percent ownership. If a company has an ineligible shareholder—like someone outside of the United States or over the 100 person limit—then the S-corp status may be disqualified. While you can bring on new shareholders and buy out other shareholders as an S-corp operator, think about the challenges of transferring stock and how it could affect your business. 

Your Corporation Status Can Help or Hurt Your Taxes

While the main difference between S-corps and C-corps is how they are taxed, it’s also important to look at the rate at which corporations are taxed. For example, according to the 2017 Tax Cuts and Jobs Act, individual taxable income can range as high as 37%. However, C-corps are taxed at a flat 21%. This means that the taxes that business owners pay as a C-corp might be lower—even if they have to pay both corporate and personal taxes. 

However, according to the same act, owners of pass-through entities (like S-corps) may be able to deduct up to 20% of their business income from their tax returns. This provides a significant tax deduction if you are paying a high rate of personal income tax. 

While these 2 tax rate benefits are significant, it’s hard to determine which option is better. If you want to look at different scenarios based on your current financial situation, a tax specialist or accountant should be able to help you work out the numbers and find ways to help you save money. 

Consider Whether You Are Distributing or Reinvesting

While your shareholders can help to determine whether an S-corp or C-corp is better for your business, you also need to consider what you plan to do with your profits. 

If the majority of your profits will get distributed to your shareholders, you may be better off operating as an S-corp. This way, you won’t pay taxes on your profits as corporate income and then pay taxes on personal dividends. 

However, if you plan to reinvest the majority of your profits within the organization, your business may be better off as a C-corp. For example, as an owner or manager, you would pay taxes on the salary you get from the company and submit a standard W-2 form with your personal income taxes. You can then spend your company profits on additional investments—like paying down the mortgage on your office space or investing in additional fleet vehicles to grow your team. In this case, the profits become line items on your balance sheets as tangible assets. 

If you have strong plans for growth in the future, then a C-corp may be a better option. You will turn most of your liquid capital into assets instead of paying out cash to shareholders.    

Both S-Corps and C-Corps Provide Personal Protection

One of the main benefits of both S-corps and C-corps: they protect the income and assets of the individual owners and investors. This is why you see sole proprietors and partnerships become corporations—particularly limited liability corporations (LLCs). 

If you operate as an individual owner without protection, your clients or employees can pursue your personal assets if they feel you have wronged them. For example, if you fail to complete a project for a client and they win a lawsuit against you, then the creditors claiming the damages may be able to go after your personal assets, like your house or savings accounts. If you can’t pay the damages in cash, these creditors might be able to claim your car as an asset. 

However, with a corporation, the creditors can only claim funds from the company, not the individual. If you have a company car under the business’s name, then the creditors can use that. However, they can’t touch any of your private assets. In the case of sole proprietors who form S-corps, most of the income passes through to the individual. This makes the business almost worthless except for any reported assets, equipment, or funds that haven’t been paid out. 

Even if you aren’t sure whether you want to form an S-corp or C-corp, take steps to become a corporation to protect yourself as your business grows.    

Management Still Operates the Business

Another similarity between S-corps and C-corps is that management still operates the business, even if there are multiple shareholders. For example, a startup founder might own 60% of the business and have 4 shareholders who each own 10%. If the founder is managing the day-to-day operations of the company, they’ll continue to run the business regardless of who the shareholders are. 

Corporations aren’t run by shareholders. Just because you buy stock in Apple doesn’t mean you work there. Most corporations still have a C-suite (CEO, CFO, etc.) and senior leadership levels that are responsible for managing the business. 

However, the owner and executive board of directors need to act in the best interest of the shareholders. This is called the “fiduciary duty of loyalty,” and it states that any executives must act in the best interest of the business or shareholders. This prevents owners from making decisions that they would directly profit from but could hurt shareholders and negatively impact employees.

This fiduciary duty is often why employees have different shareholder classes where they cannot vote on issues related to the company. They might know more about the operations than other voters—potentially leading to insider trading—or they could impact the company’s performance in order to profit personally.  

As you file to become a corporation, don’t get confused by what it means to be a shareholder or investor. If any confusion arises, create written guidelines in your bylaws about the rights of shareholders and the ethical responsibilities of owners. Ask a lawyer to review them and have your shareholders sign them before becoming cleared to buy into your firm. 

Evaluate Your Current and Future Business Goals

If you want to grow your shareholders and improve your working capital by working with investors, you may want to establish your business as a C-corp. If you plan to grow your business and keep your capital tied up in assets, you may benefit from working as a C-corp.

However, if you want to continue operating as a pass-through entity and expect to have a limited number of investors, an S-corp might be a better option. Review your choices and your plans for your future before you begin the S-corp application process. 

If you ever need to change your status with the IRS, you will need to fill out extra paperwork and navigate a waiting period. While it’s possible to change your status, you will have fewer headaches if you move forward with the right business structure on your first application. 

If you operate a small business or are self-employed, you may want to establish your business as a corporation. In the United States, you have the option of becoming an S corporation (S-corp) which allows for pass-through taxation and shareholder dividends.

If you’re considering turning your business into an S-corp, you’ll need to become familiar with Form 2553. Use this guide to learn more about this form and how to submit it. 

What Is Form 2553?

Form 2553 is a 5-page document that asks filers about their organization, fiscal year, and shareholders. However, if you have several shareholders, you may need additional pages. 

Once you’ve completed Form 2553 and any supplemental documents to form a corporation, the IRS will confirm whether your organization is approved to operate as an S-corp. If your organization doesn’t qualify, then you may need to recheck your paperwork or apply as another operating entity. 

How Do I Fill Out Form 2553?

Page 1: Mailing Address

Page 2: Basic Information

• Your name and Employer Identification Number (EIN)
• Your business street address (city, state, zip code)
• The date your business was incorporated and the state where it was incorporated
• The planned start date for your S-corp election 
• Your company’s tax year
• The name and title of your legal representative, along with their telephone number (By providing this, you authorize the IRS to call them for more information.) 

This page of Form 2553 also asks whether you have more than 100 shareholders (which can limit your eligibility) and if you are filing late. Form 2553 must be filed before the 16th day of the third month of your corporation’s tax year.

If your tax year starts on January 1, you have until March 15 to complete the form. However, you can also file ahead for the upcoming tax year if you have already missed this deadline.  

If you are filing for your S-corp past the approved deadline, you’ll need to write an explanation as to why—and the steps you took to correct your actions. If you file Form 2553 too late, the IRS may deny the application, and you’ll need to reapply next year. 

Page 3: Shareholder Consent

For example, if 2 people form a partnership and decide to become an S-corp, 1 person would file Form 2553. However, they would both be listed on this page. Whoever owns more of the company—typically in the form of money invested—would have a higher percentage of shares. 

Deciding who owns your shares is important before you file to become an S-corp. This will determine how your dividends are paid each year. 

Form 2553 currently has spaces for 7 shareholders. However, if you have more, you’ll need to add all of them to ensure that your full company is represented. 

Page 4: Fiscal Tax Year

The IRS sets a standard tax year of January–December (with certain exceptions for various departments). In order to avoid penalties for missing different filing dates or creating confusion, you need to tell the IRS if your tax year differs from this one. 

If you already operate on a tax year that ends on December 31 and plan to continue with it, this page is pretty straightforward. It may look complicated, but it won’t be a problem if you have a standard tax year. 

Page 5: Trust and Late Classification

The final part is only relevant if you are seeking late corporate classification election representation. You will need to complete additional forms to qualify for these special exceptions. 

Take your time filling out Form 2553. By making sure each form is correct, you can avoid refiling with corrections and prevent delays on your S-corp approval.  

Can You File Form 2553 Online?

Do not mail Form 2553 to your closest location. IRS locations are not based geographically: just because you live closer to Utah doesn’t mean your form goes to the Ogden location. Failing to send your form to the correct address could cause delays in approval—or it could cause the IRS to ignore your application completely.  

How Do I Know If My Form 2553 Was Approved?

If your S-corp application is approved, the IRS will send you a letter confirming this status. Save this copy for your records. The IRS should also send you a letter if your status has been denied.  

How Long Does It Take to Process Form 2553?

However, 2020 and 2021 have not been standard years. Due to the COVID-19 pandemic and partial government shutdowns, the IRS experienced a massive backlog of unopened mail last June.

IRS Deputy Commissioner Sunita Lough estimated that more than 11 million unopened pieces of IRS mail needed to be reviewed and processed. Even before the pandemic, the IRS estimated that it could take up to 16 weeks to process written tax returns and other forms.

The IRS continues to experience a backlog of mail and has extended the 2021 tax season. If you submitted Form 2553 at the start of the year (before the March 15 deadline for businesses on a calendar year) but still haven’t heard back, the issue likely isn’t on your end. You can call the IRS to check on your S-corp status and see if they’ve processed your application yet.   

Learn More About Becoming an S-Corp

Many small businesses, including every American business with employees, need to be uniquely identified by the Internal Revenue Service according to the tax code. To get this number, you first have to fill out Form SS-4 for the IRS. Not only is this form important for your taxes, but potential lenders and investors often request it.

What Is Form SS-4 Used for?

Form SS-4 is used to obtain an Employer Identification Number (or EIN). Form SS-4 is 1 page and requires pretty simple information to put together.

Form W-9, which requests the taxpayer identification number of a taxpayer, is different from Form SS-4. While W-9 can seek certification of an EIN, Form SS-4 is used to actually apply for an EIN.  

What Is an Employer Identification Number?

An EIN is a unique number that identifies your business with the IRS. It is similar to an individual’s Social Security number, except that you aren’t issued a card like your Social Security card. The IRS created the EIN system in 1974.

Does My Small Business Need an EIN?

The IRS has a simple checklist for if your small business will need an EIN. Most small businesses that aren’t sole proprietorships will likely need an EIN.

If any of the following questions apply to your small business, you will need an EIN:

• Do you have employees?
• Is your business structured as a corporation or partnership?
• Do you file tax returns for Employment, Excise, or Alcohol, Tobacco, and Firearms?
• Do you withhold taxes on non-wage income paid to a non-resident alien?
• Do you have a Keogh plan (an uncommon retirement plan)?
• Is your business involved in any of the following types of organizations: trusts, IRAs, Exempt Organization Business Income Tax Returns, Estates, Real estate mortgage investment conduits, nonprofit organizations, farmers’ cooperatives, or plan administrators?

If you answered “yes” to any of these questions, you should fill out SS-4 and submit it to the IRS.

Using Form SS-4 To Obtain an EIN

Applying for an EIN with the IRS is always free. Beware of any services or websites that claim you must pay to receive an EIN. You can apply for an EIN online, which is similar to filling out Form SS-4 but without the physical paper.

To apply for an EIN through fax or mail, though, you will have to fill out Form SS-4.

You can do this before opening the doors to your business if you know your company will need one.

“If you are thinking about setting up a business, IRS Form SS-4 is a critical step to take because it’s your business’ unique identifier to the IRS. This number is linked to bank accounts and many other aspects of your business,” explains tax preparer H&R Block.

Whether applying online or with Form SS-4, the application must list the name and taxpayer identification number (that is, the Social Security number, EIN, or Individual Taxpayer Identification Number) of the true principal officer, general partner, grantor, owner, or trustor. The IRS calls this person the “responsible party,” and the person “controls, manages, or directs the applicant entity and the disposition of its funds and assets,” the IRS says.

The IRS requires you to keep the information up-to-date on your Form SS-4 in regards to your company and the responsible party. Changes can be submitted using IRS Form 8822-B.

“Keep the Form SS-4 information current,” the IRS continues. “Use Form 8822-B to report changes to your responsible party, address, or location. Changes in responsible parties must be reported to the IRS within 60 days.”

Once accepted by the IRS, you will receive a notice from the agency.

How to Fill Out Form SS-4

Filling out Form SS-4 is straightforward, and the information required for the 1-page form should be easily available. While the specifics of how you fill out the form will depend on your business, structure, and industry, you generally are providing identifying information for your company and the responsible party filling out the form.

Expect to provide information like:

• The business’s name and address
• The responsible party’s name and taxpayer identification number
• Structure of business
• The date your business was created
• Your reason for applying to the IRS for an EIN
• The number of employees that work at your business
• Your business’s main activities
• The main types of products and/or services your business offers

How Lenders Use Your Form SS-4

Beyond registering with the IRS, you will likely also need to have your Form SS-4 handy when applying for business loans.

Form SS-4 shows that your business is officially verified with the IRS and, therefore, the United States government. Your SS-4 notice and EIN are both important to have in hand when you go about applying for commercial loans. 

Lenders look at your EIN and Form SS-4 much in the same way your Social Security card is used to verify your identity in the US. It also shows that your business is based in the U.S. 

Remember, unlike your Social Security number, no card is issued when you receive an EIN. Your Form SS-4 notice serves the same purpose as a Social Security card, which is why lenders will want to see a copy of it. 

If you need a copy of your Form SS-4, contact the IRS Business and Specialty Tax Line.

Knowing the market value of your business is important for many reasons, even if you aren’t thinking about selling anytime soon. By determining your business’s market value, you get a sense of what your company is worth beyond just income statements and balance sheets.

How Do You Determine the Value of a Small Business?

Book value basically takes your balance sheet and values your company based on your assets minus your liabilities. Unless you are planning to liquidate, this isn’t a good way to calculate business value. In fact, you shouldn’t really consider assets when calculating a market value. A buyer won’t be interested in purchasing your company just to sell off your vehicles, property, and equipment—they will be interested in producing revenue from your company year over year.

Present value calculates your business’s value based on past and present data, like annual revenue. Most rule of thumbs methods of valuing a business calculate a version of present value. This can give you a good basic understanding of how much your business is worth.

Market value, in the end, is the most important number if you want to sell your business—this is the value that a buyer will pay for your business. While calculating the present value of your business can give you a baseline, the market value will ultimately be decided by—as the term suggests—the market.

What Is the Rule of Thumb for Valuing a Business?

Both methods require looking up either the SDE multiple or the percentage of revenue averages for your specific line of business. These multiples can be impacted by the size of your business and your location.

Percentage of Sales Method

To calculate your business value according to the percentage of sales method, start with your total revenue for a year. Then you must look up the average percentage of sales values for companies in your peer group. You can calculate your market value by using the percentage of your sales.

If the average market value of bars in your area is 30% of annual revenue and your bar brought in $1 million in sales last year, the market value of your bar is $300,000 according to this method.

SDE Multiples Method

Your SDE doesn’t show your value in itself—that is where the multiple comes in. The SDE multiple is an industry standard that is between 0 and 4. Based on your industry, it estimates what your company is worth by multiplying your SDE by the multiple number.

If your SDE was $100,000 last year and your company’s SDE multiple is 2.5, the value of your business according to this method is $250,000.   

How Much Is the Average Small Business Worth?

This multiple, though, is probably inaccurate for most small businesses because industry, location, customer base, and intellectual property are much more important than the average value of all small businesses in the country.

A trendy startup could be worth $1 billion on the market, while a mom-and-pop dry cleaner will be worth much less. This is why the average value of small businesses doesn’t mean much.

How Much Revenue Should a Small Business Have?

According to the US Census, the average American small business without employees, i.e. 1-person operations, earned about $47,000 in annual revenue. Businesses with 5 to 9 employees average just over $1 million in annual sales. The average revenue increases along with the number of people employed.

Remember, though, that revenue is not the only factor when determining your business’s value. Your intellectual property, market share, and other factors can significantly bolster your business valuation.  

When you file your taxes as a small business owner, you can deduct depreciation from your gross income through Section 179. As your business assets’ value lessens over time through use, so too can your company’s value, meaning you’d recoup less if you were to liquidate or sell your business. The IRS compensates business owners for depreciation through tax deductions at a rate set through MACRS. 

The Modified Accelerated Cost Recovery System (MACRS) is a depreciation calculation adopted in 1986 that is primarily used for tax purposes. Through this system, business owners have a set amount they can deduct, unifying the process across all companies and industries. 

Through the MACRS system, an item has higher levels of depreciation during the first few years and lower levels of depreciation as its ages. This process allows business owners to recoup the cost of their assets faster by front-loading tax deductions from depreciation.

How to Calculate MACRS Depreciation

• Start with the original value of the asset—or what you paid for it if you bought it new.
• Determine the item’s class based on its useful life. You can only deduct the item for the number of years during the expected recovery period set out by the IRS. (There will be more on finding your class and the IRS MACRS guidelines later on.)
• Choose your depreciation method. You can use the straight-line depreciation method or declining balance method with different rates depending on your asset and MACRS guidelines. 
• Note your MACRS depreciation convention—or the period when you started to use the asset. This can fall into mid-month, mid-quarter, and half-year conventions for IRS calculations.
• Determine what percentage you can deduct using the graphs listed in the IRS MACRS tables.   

To calculate MACRS depreciation, you can use an online calculator to determine how much you can deduct. The right calculator can guide you to make sure your information is accurate by asking specific questions related to your assets. 

What Can You Learn From the IRS MACRS Guidelines? 

The IRS also explains what can and cannot be depreciated and how to handle repairs or improvements to the asset. The entire guide is more than 100 pages long, including a glossary of terms and an index of specific topics.  

One of the most useful sections of the MACRS guidelines is Table B-1 toward the end, which breaks down the various types of equipment that can be deducted on your taxes, its expected class life, and the recovery period in years. 

For example, buses have an expected class life of 9 years and a recovery period for MACRS in 5 years. Meanwhile, sheep and goats for breeding have a class life of 5 years and take 5 years to recover.  

Depending on the nature of your business, you can focus on a few key charts set out by the IRS to determine your depreciation amount and guide your MACRS calculations.  

Why Should You Use MACRS Depreciation?

First, it is easier to prove to the IRS how you reached that deduction amount. You can use their charts and formulas to prove your request is fair and accurate—which will protect you in the event of an audit. 

Furthermore, the IRS wants you to recoup the cost of your investment faster. They favor deductions during the first few years so you can get your money back. This can help your company if you invest in expensive equipment that otherwise limits your profits or buying power. 

Learn More About Other Depreciation Methods

Get to know the resource section offered by Lendio to become better informed about bookkeeping and asset management

All businesses, from self-employed freelancers to Fortune 500 corporations, spend money. You might have to pay rent, buy inventory, pay employees, buy a desk lamp, or purchase heavy machinery—or even a new building. These expenses lower your company’s overall profit margin, so it’s critical to pay close attention to how you’re spending money.

Not all expenses are considered the same in the small business world. Some expenses, like rent and wages, are regular and recurring. Generally, these everyday purchases are considered operating expenses. Others, like the purchase of a vehicle or property, happen once and then last your business a long time. These are known as capital expenses.

The terminology can be misleading—if you drive it every day, isn’t a new car an operating expense? Probably not. Knowing the nuances of operating expenses and capital expenses is important for every small business owner.

Furthermore, differentiating between the 2 categories becomes paramount when preparing financial statements and filing your business taxes.

Operating Expenses

The list of operating expenses is vast and ever-expanding—office supplies, equipment leases, travel, some types of taxes, utilities, and insurance are all considered operating expenses because you spend the money in order to conduct regular business. Wages are operating expenses, although they might be calculated into your COGS depending on your business.

Capital Expenses

Property, equipment, and vehicles are common capital expenses. Expanding or adding value to an existing asset, like through a building expansion, could also be a CAPEX.

Instead of recording capital expenditure on your profit and loss statement, you list CAPEX as assets on your balance sheet.

Importantly, many capital expenses—like vehicles—depreciate in value over the usable lifespan of the asset. This depreciation over a fixed period of time, usually monthly, is recorded as an expense on your profit and loss statement. Overall depreciation is recorded on your balance sheet and subtracted from the value of the asset.

While many CAPEX are tangible entities, like buildings, some intangible purchases can be considered CAPEX, particularly patents.

Why Are OPEX and CAPEX Categorized Differently?

Sometimes you can choose how you want to categorize an expense. If you buy a car outright, for example, it’s a CAPEX, but a lease for a vehicle is an OPEX.

OPEX vs. CAPEX on Financial Statements

“While OPEX are line items in the expense category on a cash flow statement, CAPEX are typically found under the heading ‘Investment in property, plant, or equipment,’” e-commerce company Shopify explains. “CAPEX usually require a sizable financial investment and, for that reason, often need the approval of the company’s board of directors or shareholders.”

Categorizing your various expenses on the proper profit and loss statements and balance sheets is essential for understanding the overall financial health of your company—and will better position you to receive funding.

OPEX vs. CAPEX During Tax Time

“Through depreciation you recover the cost of the asset over its useful life,” says Manny Davis of AllBusiness. “The IRS has strict requirements as to how many years an asset must be depreciated over. Since these assets cannot be expensed 100% in the tax year they are purchased, it will lead to a higher taxable income amount for the company in the given year and therefore higher taxes.”

The IRS allows some CAPEX to be expensed in total and at once through Section 179. Because of specific situations like this, you should consult with a tax professional about your business taxes—even if you don’t regularly hire an accountant. Utilizing bookkeeping software like Lendio's software also helps.

When opening a business, you have a lot of choices to make—including the structure of your business or the business entity. One of the most common types of businesses is known as an LLC, or limited liability company. In addition to being one of the easiest entities to form and maintain, it also offers legal and financial protection to its owners. 

Keep reading to understand LLCs and why they are so popular. 

What Does an LLC Mean?

However, an LLC limits the liability to just the business assets. These assets include company profits, equipment, and inventory but do not extend to any personal assets outside the business.

An LLC is often used by business owners to protect themselves personally when they go into business. 

How Can You Start an LLC?

What Does an LLC Cost?

Along with a startup fee, you will need to pay an annual fee to maintain the designation. These fees also vary widely depending on where you live. In Missouri, there is no annual fee, though business owners still need to submit annual reports. In Maryland, business owners need to pay $300 annually.

Look up your filing fees before you decide to become an LLC so you can budget for the costs. 

What Is an Annual Report?

These annual reports are typically due around the anniversary date of formation. You can often find annual report templates online. 

When Should You Form an LLC?

You don’t have to file your paperwork in January to form your LLC. Some states offer a “delayed effective date” up to 90 days out. This means you can work through your paperwork in October or November for an LLC launch date of January 1. 

One of the key traits of an LLC is the separation between professional and personal accounts. If you plan to start a company, make sure you have a foundation of good bookkeeping to easily report your income and expenses. Use an app like Lendio's software, which offers free tools for small business owners. This can make establishing a business easier.

There are several methods to calculating depreciation, and business owners often want to find what works best for them—accuracy, convenience, tax-friendly. While the straight-line method might be easy, it doesn’t take into consideration how cared-for an asset is and how much work it performs. An item that is used constantly and rarely cared for won’t last as long (and will have a lower value) than a well-cared-for item or rarely-used asset. 

The units of production depreciation method works to address this principle by tracking how much an item is used and using that to determine its value. Get to know this depreciation method better to see if it is right for you. 

What Is the Units of Production Depreciation Method? 

With the units of production depreciation method, an asset’s value is based on how much it is used—or the number of units it has produced. This method is often used for manufacturing equipment that wears down over time as it produces more products. 

This depreciation method is popular in production-oriented industries because it can fluctuate based on machine demand for that year. For example, if a company works overtime to fill orders 1 year but then has downtime during another year, the depreciation amount is different because the assets were used less and therefore retained more of its useful life—value.

How to Calculate the Units of Production Depreciation Method

The units of production depreciation method is fairly straightforward to calculate. However, you will need to change the calculation annually based on the units an asset produced. You will also have to track how many units an asset produced to make sure your calculation is accurate. 

Start by calculating the Units of Production Rate (UPR):

• UPR = (Cost of the Asset - Salvage Value)/ Total Units that Will Be Produced Over Its Life

Naturally, this calculation is an estimate. You can’t predict how long an asset will last (especially machinery) and the number of units it will produce—but you can make an educated guess based on the IRS value expectancy and the production rate of similar assets.   

Once you have the UPR, multiply it by the number of actual units produced for that current year. 

Let’s use the example of a baker who makes doughnuts with a specialized machine. This is what the formula might look like. 

• (Machine Cost - Salvage Value)/Estimated Doughnuts Made Over Its Life x Doughnuts Made This Year
• ($25,000 - $500)/100,000 x 10,000
• $24,500/100,000 x 10,000
• 0.245 x 10,000
• $2,450

The depreciation for that year is $2,450. Now, if the baker makes more doughnuts the next year, the depreciation will be higher because there is more wear on the machine. Let’s say the baker made 15,000 doughnuts the following year. In this case, the depreciation would be:

• 0.245 x 15,000
• $3,675

Once you have the base formula for calculating units of production depreciation, you can estimate how much you lost in assets each year with relative ease. 

Pros and Cons of this Method

The main drawback of the units of production method is that you can’t use it to calculate your tax deductions for the year. This means it can’t be your only depreciation method of choice. Some companies use the units of production method for their internal accounting (or to report to shareholders) and then opt for a different method for their taxes. 

The units of production method also can’t be used for every piece of equipment. Not all assets can be tracked by what they produce. (You wouldn’t base the value of a computer on the number of emails it has sent or the total PowerPoint presentations it has created.) This means you could end up using multiple depreciation formulas for various assets internally, as well.

Finally, the units of production method isn’t predictable. You can’t easily estimate how your assets will change until you close your books and look at the number of units you produced. Your depreciation rates could fluctuate over time. 

While all of these cons are significant, many manufacturers still prefer this method of accounting for depreciation because the value of an asset is directly tied to production. Teams can track an asset’s value over time to get a clearer idea of how long it should remain functional. This allows them to budget for replacements if an item is wearing out or schedule maintenance after a certain number of units is produced. 

Learn More About Depreciation and Bookkeeping 

As you set up your accounts for your small business, consider the various options at your disposal for calculating depreciation. Using the units of production method might be ideal if you work in manufacturing, but it likely isn’t the only model you should use.