To LLC or not to LLC - Understanding Limited Liability Companies (LLCs), C-Corporations and S-Corporations
As an entrepreneur poised to launch a new venture as a business owner, one of the most crucial decisions is selecting the appropriate business structure. This choice will significantly impact tax obligations, personal liability exposure, legal, and operational flexibility. This is why it may be beneficial to understand certain nuances when choosing between Limited Liability Companies (LLCs), C-Corporations, and S-Corporations.
Limited Liability Company (LLC)
For many small business owners and sole proprietors, the LLC structure offers an appealing blend of simplicity, flexibility, and protection.
One of the primary attractions of an LLC is its ability to shield personal assets of members from business liabilities. This protection extends to lawsuits and debt collection efforts, providing peace of mind for entrepreneurs and business owners concerned about personal exposure.
From a tax perspective, LLCs are treated as a sole proprietorship (single member LLC) or a partnership (multiple members).
LLCs themselves do not pay federal income taxes. The business profits and losses pass through to the members, who report them on their personal tax returns.
For their respective portion of the profits, LLC members are subject to both self-employment taxes, which currently (at the time of writing this article) stand at 15.3%, and personal income tax rates ranging from 10% to 37% depending on the individual's tax bracket. Consider a scenario where an LLC generates $145,000 in gross revenue with $20,000 in business expenses. The resulting $125,000 in profits would pass through to the members proportionately, and will be subject to both self-employment taxes and personal income tax.
It's worth noting that LLCs offer considerable flexibility in terms of management structure and membership. Unlike corporations, LLCs are not required to maintain a board of directors, and are either managed by the members themselves or a manager appointed by the members. This can be particularly advantageous for businesses seeking a less rigid governance model.
LLCs limit personal liability of members and offer a flexible governance model. Profits pass through to the members and are subject to both self-employment tax and personal income tax (unless the LLC elects to be treated as an S-Corporation - more on this below).
C-Corporation
For entrepreneurs with visions of scalability, investments or public offerings, the C-Corporation structure may be an interesting option.
Named after Subchapter C of the Internal Revenue Code, C-Corporations are distinct legal entities owned by shareholders and possess unlimited growth potential.
One of the defining characteristics of C-Corporations is their ability to issue multiple classes of stock, including both common and preferred shares, with differential rights (voting, liquidity, etc.) and obligations. This feature, coupled with the capacity for unlimited stock sales (up to the authorized limit which can be changed subject to certain restrictions), makes C-Corporations particularly attractive to investors and ideal for businesses contemplating an initial public offering (IPO) in the future.
The C-Corporation structure is not without its drawbacks. Perhaps the most significant is the specter of double taxation. C-Corporations are subject to a federal corporate tax rate of 21% on company profits. Subsequently, any dividends distributed to shareholders are taxed again as personal income at the individual’s tax rate, potentially resulting in a higher overall tax burden.
C-Corporations are governed by a Board of Directors and need to maintain detailed records of company bylaws, corporate resolutions, voting, and stock ledger.
C-Corporations are attractive to investors and may have multiple classes of stock with differential rights (voting, liquidity, etc.) and obligations. C-Corporations may be subject to double taxation - the company profits are subject to the federal corporate tax rate of 21% , and dividends distributed to shareholders are taxed again as personal income.
S-Corporation
For those seeking a middle ground between the simplicity of an LLC and the structure of a C-Corporation, the S-Corporation presents an intriguing alternative. Named after Subchapter S of the Internal Revenue Code, S-Corporations offer pass-through taxation while retaining many of the benefits associated with the corporate form.
An S-Corporation itself does not pay federal income taxes; instead, the shareholders of S-Corporations report the pass through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S-Corporations to avoid double taxation on the corporate income.
For instance, consider an S-Corporation that generates $500,000 in net income for the year. If the corporation had three equal shareholders, each would report $166,667 of income on their personal tax returns. This income would be taxed at the individual's personal income tax rate, which could range from 10% to 37%, depending on their overall income and filing status.
The potential for reduced self-employment taxes presents another significant advantage. In a typical scenario, an S-Corporation shareholder who actively participates in the business might receive both a salary and distributions. Let's say a sole shareholder of an S-Corporation with $300,000 in net income takes a salary of $150,000 and the remaining $150,000 as a distribution. The $150,000 salary would be subject to both income tax and the 15.3% self-employment tax. However, the $150,000 distribution would only be subject to income tax, not self-employment tax, potentially saving the shareholder up to $22,950 in self-employment taxes (15.3% of $150,000). However, there may be issues in the classification of salary and distributions.
The Tax Cuts and Jobs Act of 2017 introduced an additional benefit for S-Corporation shareholders in the form of the Qualified Business Income (QBI) deduction. This provision allows eligible shareholders to deduct up to 20% of their qualified business income from their taxable income, potentially reducing their individual tax burden.
However, S-Corporations are subject to more stringent restrictions than LLCs or C-Corporations. To qualify for S-Corporation status, the corporation must meet the following requirements:
Be a domestic corporation.
Have only allowable shareholders; may be individuals, certain trusts, and estates, and may not be 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).
Company profits pass through to the shareholders of the S-Corporation who report the company income and losses on their personal tax returns, thereby avoiding double taxation on the corporate income. Eligible shareholders may be able to deduct up to 20% of their Qualified Business Income from their taxable income. However, S-Corporations can have only class of stock, have no more than 100 stockholders, and stockholders cannot be partnerships, corporations or non-resident aliens.
LLC election as an S-Corporation
LLCs may elect to be taxed as an S-Corporation. This may be advantageous for LLC owners who want to enjoy the operational flexibility of an LLC, while potentially reducing their self-employment tax burden.
By electing S-Corporation status, LLC members may take a reasonable salary from the business profits and the salary component will be subject to both self-employment tax and the individual income tax rate. However, any remaining LLC profits beyond the salary component will not subject to the 15.3% self-employment tax. These passed-through profits are only taxed at the individual's personal income tax rate which may potentially result in tax savings, as compared to the self-employment taxes and income tax an LLC owner would typically pay on all of the business's net profits. However, there may be issues in the classification of salary and business profits.
The process of converting an LLC to an S-Corporation involves filing IRS Form 2553, Election by a Small Business Corporation. This election may provide tax savings for eligible LLCs, though it also comes with the same restrictions applicable to S-Corporations, as mentioned above. Each situation would merit a thorough analysis based on its particular circumstances.
LLCs may choose to be taxed as an S-Corporation by filing Form 2553 with the IRS. Doing so may potentially result in tax savings in the form of reduced self-employment taxes.
Conclusion
In conclusion, the choice between an LLC, C-Corporation, S-Corporation, or LLC election as an S-Corporation, depends on a multitude of factors, including the business's growth trajectory, capital needs, and desired management structure. By carefully weighing the tax implications, liability protections, and operational considerations of each entity type, one can make an informed decision that aligns with their entrepreneurial vision and long-term objectives.
THE AUTHOR IS NEITHER A U.S. ATTORNEY NOR A SUBJECT MATTER EXPERT. THE INFORMATION PROVIDED IN THIS ARTICLE DOES NOT, AND IS NOT INTENDED TO, CONSTITUTE LEGAL ADVICE; AND IT IS NOT PROVIDED WITH ANY GUARANTEE, WARRANTY, OR REPRESENTATION; INSTEAD, ALL INFORMATION AND CONTENT IN THIS ARTICLE ARE FOR GENERAL INFORMATIONAL PURPOSES ONLY.
