Choosing your business structure — LLC, S-Corp, C-Corp — may seem like a daunting task if you don’t know the advantages and disadvantages of each. By understanding the differences between entity structure, you could significantly minimize your tax liability.
LLC (Limited Liability Company)
Its vitally important to understand how an LLC is structured according to tax law. LLC’s differ from corporations because they are not taxed as a separate entity. Rather, the profits and losses pass-through the business to each member or “owner” of the LLC. Each member will then report the profits and losses from the business on their personal federal tax return. Therefore, LLC’s don’t calculate taxable income by a corporate rate, instead the tax liability will be calculated based upon each member’s or owner’s tax rate. The business itself will not pay federal income taxes, however some states may apply an annual tax charge to LLC’s.
One of the major benefits of forming a LLC is it gives the members protection for their personal assets. Owners or members are not personally responsible for the business debts and liabilities of the LLC. Therefore, creditors are unable to pursue personal assets, such as house, car, savings accounts, etc. to pay business debts.
Your LLC will be treated by the IRS like a sole proprietorship or partnership based on the number of members in your business. Although, keep in mind that certain LLC’s are automatically treated and taxed as corporations by federal tax law. If the LLC is not automatically classified as a corporation they can choose their business entity classification. This will require filing Form 8832.
Single- or multi-member
Your LLC will be either a single member or multi-member. A single member LLC will be treated by the IRS as a sole proprietorship unless you elect to be a corporation. Therefore, again, the LLC will not pay taxes. Rather, profits and losses will need to be reported on the single member’s personal tax return in section Schedule C. A multi-member LLC will automatically be treated as a partnership unless you elect to be taxed as a corporation. Still the business is not taxed but each member will report their profit or loss based on the percentage of ownership on their personal tax return. Typically, multi-member LLC’s will have a formal agreement prepared defining the terms and conditions for the business, which includes how profits and losses are allocated to members.
As a member of an LLC you are considered self-employed and therefore aren’t subject to tax withholding. Each member or “owner” is required to pay estimated taxes and self-employment taxes which includes Medicare and Social Security. These payments must be made quarterly to the IRS and the state office.
When operating an LLC state taxes typically are paid in a similar fashion to paying the IRS. Some states will charge a LLC tax on top of the members income tax paid. Other states will charge an annual fee sometimes referred to a franchise tax, registration fee, or renewal fee. Check the tax and business law in your specific state before forming an LLC.
A S-Corporation, sometime referred to as an S-Corp., is very similar to a LLC because the “pass-through” effect works the same way. The profit or loss is not reported by the business entity rather, it will be reported on the owners/investors personal tax return based on their ownership stake in the business.
When a business elects S-Corporation status it eliminates the disadvantage of “double taxation” of corporate income and shareholder dividends related to C-Corporation tax status. A simple example can illustrate how double taxation happens. For example, let’s say a corporation makes $400,000 in given year and there are four shareholders. If it’s a S-Corporation, the entity or business will not be taxed for that amount. Rather, if each of the four shareholders have equal share of the company stock, then they will each pay taxes on $100,000 on their personal tax return.
Now, if we use the same example, instead it’s classified as a C-Corporation then the company will pay taxes at the current federal tax rate of about 21% (recently changed from 35% to 21% in 2018). If the remaining profit of $316,000 is distributed to the 4 shareholders as dividends, each member will pay taxes on $79,000 in dividend income at the federal rate of about 15% (this rate depends on income and filing status). Therefore, the members will be taxed at the business or entity level and at the personal level.
In short S-Corporation status offers several advantages including: limited liability, pass-through taxation, double taxation elimination, investment opportunities and perpetual existence.
A C-Corporation is the most common formation for small business owners. A normal C-Corp is owned by individual shareholders who own shares of the company. The business is a separate legal entity. C-Corps are like S-Corps in that the owners are not responsible for business liability or debts.
One of the major benefits of a C-Corporation is it can offer many fringe benefits that are taxed less than they would be under sole proprietorships, partnerships, LLCs, and S-Corporations. Benefits like health insurance are not subject to either ordinary income taxes or employment taxes, while fringes benefits under other types of entities are subject to employment taxes.
Corporations are subjected to a progressive income tax rates, just like individuals. Typically, the more you make the higher the rate. Under the new tax package known as Tax Cuts and Jobs Act, the top corporate tax rate is reduced from 35% to 21% making it more favorable to form a C-Corporation.
A major disadvantage of a C-Corp is it does do not offer favorable long-term capital gains tax rate. All capital gains, no matter if they are long-term or short-term, are subject to the corporation’s tax rate. Another disadvantage is capital losses can only be netted against capital gains, not from income.
Again, keep in mind that C-Corporations are subject to “double taxation” meaning that the company will pay taxes at the federal rate and the shareholders will pay taxes again when profit is distributed.
What Structure is Right for You?
Each business structure has its pros and cons. Remember that the “pass-through” feature for LLCs & S-Corps could benefit you if your personal tax rate is lower than the corporate tax rate. Also, there could be potential tax savings from forming a LLC because you’re considered self-employed and aren’t subject to tax withholding. Be aware that forming a C-Corp could have disadvantages depending upon your situation because you could face “double taxation” on the profits of the business at a federal corporate rate and on the dividends distributed.
This article is intended to be an overview guide before speaking with your accountant or attorney. Do not use this article as the one source for your business needs.