Will small business and independent owners find more tax savings with a Corporation Or LLC? In a prior article (Click Here) , I discuss the similarities and differences between Corporations and Limited Liability Corporation (LLCs) relative to ownership matters, limited liability and management structures. This article looks at the different tax structures found in Corporations and in an LLC and provides information and direction that may help you make the entity tax selection that is best for you.
Tax Advantages And Savings With An LLC
The Limited Liability Company (LLC) offers a business owner more tax choices than a corporation. It automatically qualifies for a pass through single layer of taxation but can elect to be taxed as a C corporation or an S corporation. The owner (s) are responsible for all self-employment taxes that apply. They can itemize their business expenses on a Schedule C form and use the regular federal 1040 form.
By IRS standards in its natural form the LLC is treated as a sole proprietorship when it has one member and as a partnership proprietorship when multiple owners are involved. Partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership. The LLC’s income, gains, deductions, losses, etc. essentially “flow through” to LLC owner/members to be taxed on their individual tax returns.
The LLC only needs to file a business return if it has more than one member and it is not taxed at the business level. Filing fees and annual fees are by and large higher for LLC incorporation than for the C Corp and S corp.
Each state may have their own rules for incorporation so you are advised to first know your particular states rules and guidelines and then confer with an accountant and tax attorney to decide what entity tax wise is in your best interest.
Tax Advantages And Savings With Corporations
A general or C corporation by default is subject to double taxation, meaning that it is taxed once at the corporate level and then again when a distribution is made to the shareholders. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation. The appropriate Form 1120 is used to report taxes. The only way a C Corporation can qualify for pass through single layer taxation is to become an S corporation.
An S corporation is really only a tax designation. In order to form one, you incorporate as a regular C corporation in accordance with state laws, and then you make what is known as an “S election” with the Internal Revenue Service using Form 2553. This election, if approved, permits the S corporation to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes.
There is no taxation at the S Corporation level which can have huge implications seeing that you are cutting your taxes in half. The shareholders of the S corporation report the flow through of income and losses on their personal tax returns by making use of Form 1040, Schedule E along with a Schedule K-1 and the corporation completes one of the appropriate Form 1120 series. In addition the S corporation must meet the following requirements:
Be a domestic corporation
- Have only allowable shareholders including individuals, certain trusts, and estates and may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations). (Taken directly from the IRS statutes )
If you opt for an S corporation it is imperative that you constantly check to confirm that your business remains compliant with the S corporation tax rules. Failure to meet the S corp tax rules, even if by accident, can result in significant tax consequences and penalties. If you are an employee of the S corp it is important that your salary be reasonable and comparable to the national salary norms on which you will pay federal taxes, FICA’s Social Security and Medicare tax, but S Corp dividends are not subject to self-employment taxes.
Be very careful not to underestimate your salary and profit substantially from the untaxed dividends or you will likely receive negative tax reviews and consequences from the IRS. You are again advised to utilize the services of a CPA and Tax Attorney to decide if this is the best option for you and to maintain all the ever changing S Corp requirements.
There are some differences in tax treatment between the standard LLC and the S corporation as it pertains to self-employment taxes. S corp salaries and bonuses are taxable income but there is no self-employment tax on the dividends applicable to an S corp. Depending on the nature of your business, there is then a potential method to reduce this tax with the S corporation treatment that is not available to a standard Limited Liability Company.
You really need to investigate how your state looks at this entity seeing that some states treat them in the same manner as the federal government; some only recognize them as C corps and still others states simply tax the shareholders on their percentage of the profits. Given the complexity of this tax area, it is highly recommended that you use a tax attorney and confer with your accountant.
The LLC came into being in 1977 in the state of Wyoming. During the late 1980s and early 1990s The IRS and the states came to an understanding that a person (sole proprietorship) or persons (partnership proprietorship) who become incorporated as an LLC now can, by a separate decision, elect how they wish to be taxed. This election is huge because it allows an LLC to elect to be taxed as an S corp and thus receive relief from self-employment tax (15.3%) depending on accounting procedures and state guidelines.
If you are a small business or an independently owned business filing for an LLC and then electing to be taxed as an S Corp, a sizable tax benefit is possible. The only reason you would not opt for this duel is if you planned to take your business public or you needed venture capitalists and investors to help you establish your business. While the S corporations are the most common form of a business structure, the advent of the Limited Liability Corporation has given entrepreneurs a new popular option when forming their business. The LLC, taxed as an S Corp, has helped cause a 10 fold increase in utilizing this entity taking it from fewer than 120,000 in 1995 to more than a million today.
Corporation or LLC Conclusion
Throughout this article, I have shown the entity tax similarities and the differences between the Corporations and the Limited Liability Company. The entity you choose needs to factor in: your short and long term goals, the state you live and do business in, whether you meet the requirements of the entity, whether you wish to take your small business public and/or are in need of investors. Answer those questions in conjunction with the input of your CPA and a Tax Attorney will help you choose the entity that is best for you.
For me personally an LLC with the “S election” is the best option when tax and non tax factors are considered for my small business. With its ability to elect how it wishes to be taxed in conjunction with its simplistic and flexible management style it has become the easiest entity for me to initiate and operate. The final question is no different than the first, will you see more tax savings with a Corporation or LLC?