Overview of Tax Implications of LLCs and Corporations
Selecting the right type of organizational form for your business requires that you carefully balance simplicity, asset protection, cost-effectiveness and tax ramifications. Generally, the LLC will be the most flexible and effective choice, but in some cases the corporation may make more sense.
When comparing the limited liability company (LLC) and the corporation, there are significant differences in the way each type is charged state fees, operated under state law and taxed by federal and state governments All these factors need to be considered when choosing the organizational form for your business.
When making your ultimate decision on entity form, you should consider the following specific tax issues:
- income tax liability--both federal and state;
- self-employment taxes;
- retirement plans; and
- fringe benefits.
Taxation Is Unrelated to Limited Liability
Many small business owners misunderstand the relationship between taxation and limited liability. Many owners mistakenly believe that, because their LLC is treated as a sole proprietorship or general partnership for tax purposes, somehow this means that liability in the LLC mirrors liability in these other business forms. The same misunderstanding arises when a corporation elects subchapter S tax status.
However, the two concepts are completely unrelated. Taxation has nothing to do with liability. All of the owners of the LLC and corporation enjoy limited liability. How the LLC or corporation is taxed is irrelevant to the question of liability.
Avoiding Double Taxation Is Seldom an Issue
The corporation is a separate taxpayer. It computes its taxable income before deducting or paying any dividends to shareholders. Therefore, the dividend is taxed at the corporate level. In addition, when the corporation pays a dividend (a distribution to the owners of current year earnings or accumulated earnings), the dividend is taxable to the owner upon receipt. Thus, in effect, the dividend has been taxed twice.
RJS Corporation has taxable income of $800,000 and will pay a $100,000 dividend out of these earnings. If the corporation's tax rate is a flat 40 percent, it will pay $320,000 in taxes ($800,000 x 40 percent).
Had the corporation been able to deduct the dividend, it would have paid only $280,000 in taxes ($700,000 x 40 percent). Its taxable income would have been lowered by $100,000, and its taxes lowered by $40,000 ($100,000 x 40 percent).
In addition, the shareholder will have to pay tax on the $100,000 received as a dividend. If the individual's tax rate is 35 percent, then the individual tax on the dividend income would be $35,000, making the full tax burden on the dividend payment $75,000.
Many commentators suggest that an LLC enjoys a tax benefit over a corporation because the "double taxation" of dividends can apply only with a corporation. The LLC is not a separate taxpayer, and it does not pay dividends. Thus, the double taxation concept does not apply to LLCs (unless, of course, an LLC elected to be treated as corporation for federal income tax purposes, which would be a rare occurrence.)
However, in practice the absence of "double taxation" of dividends in the LLC probably offers only minimal benefits to the small business owner. In a small corporation, the owners can avoid paying dividends and instead can withdraw cash from the business in deductible ways, as salary, lease and loan payments, etc. Very large salaries for small business owners have been upheld as deductible expenses. Most small corporations, in fact, do not pay any dividends, and yet distribute all of the disposable income to the owners in this tax-deductible way.
More importantly, most small corporations elect subchapter S status, which means that the corporation itself will pay no income taxes, and double taxation of dividends will not apply. Thus, for small corporations, the double tax on dividends is seldom a problem. In this respect, the only real benefit in the LLC is in not having to worry about avoiding double taxation in the first place.
Tax Elections Change How Entity Is Taxed
For tax purposes, an LLC is taxed as a sole proprietorship when there is one owner. It is taxed as a general partnership when there are two or more owners. Neither the sole proprietorship nor the general partnership is a taxpaying entity. They are termed "pass-through entities," or conduits. The owners report their share of profit and loss (whether or not it is actually distributed) on their personal income tax returns.
Reporting LLC Income, Losses and Expenses
Most owners of a one-owner LLC must fill out Form 1040 Schedule C. Business Income and Expenses. If the business is farming, then Form 1040 Schedule F, Farm Income, must be completed. If the business deals with real estate or rental properties, then Form 1040 Schedule E, Supplemental Income must be completed. The amounts from these forms are then transferred to the appropriate location on the owner's Form 1040.
Members of a multiple-owner LLC receive a Schedule K-1 from the LLC. The members must take the information that was supplied to them on Schedule K-1 and transfer it to Part II of Schedule E and to other forms as indicated on the Schedule K-1. These forms are then filed with the Form 1040.
A multiple-member LLC also must file a partnership information return, Form 1065, which shows how the money came in and was distributed to members, but no entity-level taxes are imposed. "Salary" to the owner of an LLC is really just a way of dividing profits, or an owner's withdrawal in a one-owner LLC.
Members Can Elect Out of Default LLC Classification
By default, an LLC is treated as a sole proprietorship when there is one owner and a general partnership when there are two or more owners, unless an election is made to treat the LLC as a corporation for tax purposes. This means that you don't need to take any action at all if you are happy with the default classification.
However, any LLC can elect to be taxed as a corporation. You can file Form 8832, Entity Classification Election to elect to be treated as a corporation for tax purposes (and only tax purposes.
Most States Follow Federal Taxation Rules for LLCs
Nearly all states follow the lead of the IRS with respect to LLCs in assessing state income taxes. Thus, the LLC automatically will be presumed to be a conduit for state tax purposes in these states, and no state corporate tax is imposed. However, if an entity classification election is made, it will be honored in most states. (California is a notable exception to this rule--it will not honor the federal classification and taxes LLCs at the entity level!)
Corporations Are Separate Taxpayers by Default
In contrast to the default classification of an LLC as a pass-through entity, by default, a corporation is considered to be a separate taxpaying entity. Therefore, a corporation must file a separate tax return, Form 1120, and pay its own taxes. Salary for the corporation's employees, including owner/employees, is reported on their own tax returns, as are any corporate dividends and distributions.
Corporations Can Elect Pass-through Taxation
By default, a corporation is a separate taxpaying entity. However, a corporation may be able to elect to reverse this taxation scheme and be taxed as a pass-through entity rather than as a separate taxpayer. This election, commonly referred to at the "subchapter S election" is made by filing Form 2553 with the IRS Once the election is in place, the S corporation still has to file a tax return (Form 1120S), but no taxes are imposed on the corporation itself. The profits, losses and other tax items would be passed through to the owners and reported on their own Schedules E and Forms 1040.
Be Aware of S Corporation Limitations
Not every corporation can elect to be taxed as an S corporation. A corporation must have 100 or fewer shareholders to be eligible to be an S corporation. However, all members of the same family are counted as a single shareholder, so that eases the impact of the 100-shareholder limit for family-owned businesses.
In addition, there can be only one class of stock in the corporation. While this seems limiting, the fact that you can have voting and non-voting shares eliminates many of the issues for a family owned business. Although you can not have one type of stock receive a dividend while another does not, you can give non-voting shares to family members.
Also, any trust holding stock must meet certain conditions--although these conditions will seldom limit what can be done in a small or mid-sized business.
Impact of Timing of S Corporation Election
If you do not immediately elect S corporation status, you (or more likely, your accountant!) will need to deal with the built-in gains from when the corporation was a regular corporation (C corporation.) If you have been operating your business as corporation and decide to make an S corporation election, you should work with an accountant to ensure that all the potential tax issues are addressed. Another major tax impact can occur if you decide to change the form of business operation. Converting from an S corporation to any other entity is a liquidation that may trigger recognition of built-up appreciation in the corporation's value and trigger recapture of accelerated depreciation. Nearly all of these adverse consequences can be avoid with thoughtful tax planning by a professional.
State Taxation of S Corporations Can Vary
If you form a corporation and then file an election to be taxed as an S corporation for federal purposes, don't automatically assume your state will recognize the federal election.
Most states will follow the election in assessing state taxes, but a few do not. Even if they permit an "S corporation," they may require a separate state election before they will recognize the federal election.
In addition, a few states impose a special tax on the income of every business, whatever its form. Always check with state taxing authorities in the state in which the entity will be formed and the state in which it will be doing business, before choosing a business form and a state of formation.
If a corporation is to be used, forming it as a statutory close corporation in Nevada completely eliminates the issue of state taxation, as Nevada has no income tax on corporations. Delaware has a corporate income tax, but it does not apply it to subchapter S corporations that are formed there but do no business there.
Corporations May Have Additional, Specialized Taxes
In addition to paying regular income tax as a separate taxpayer, a corporation may also be subject to specialized taxes--designed to minimize tax evasion--that are not imposed on an LLC or an S corporation. As a result, all of these taxes can be avoided by making a subchapter S election, since S corporations are not subject to the tax. And, with an LLC you don't have to worry about dealing with this tax, or avoiding it.
Holding Too Much Money Triggers Accumulated Earnings Tax
The accumulated earnings tax is a penalty tax imposed on a corporation that is formed or used to help the shareholder's avoid paying income tax by permitting its earnings and profits to accumulate, instead of being distributed. All domestic corporations, other than personal holding companies and tax-exempt corporations, potentially are subject to the accumulated earnings tax.
Through 2013, the accumulated earnings tax is 15 percent on earnings that a corporation accumulates above $250,000. (The limit is $150,000 for certain "personal service corporations," which are corporations in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, where the owners provide the services). This tax does not apply to LLCs or to S corporations.
However, even with a regular C corporation, this tax is usually easy to avoid, by using some combination of these strategies:
- Reduce the earnings. Earnings can be reduced to zero, through the withdrawal of earnings in deductible ways such as higher salaries for the owners or by investing in business.
- Establish that the accumulation was "reasonable." The corporation can accumulate earnings beyond these limits, provided it can prove it has a business need to do so, such as payment of anticipated future operating expenses, a planned business expansion, etc.
Special Tax Rate Applies to Professional Service Corporations
A professional service corporation is a designation created by law. Professionals in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (where the owners provide the services) may elect this business form. The professional service corporation has to pay a flat tax of 35 percent on its earnings, rather than using the progressive rate structure that normally applies to corporations. The result will be higher taxes.
Personal Holding Corporations Have Strict Retained Earnings Rules
The personal holding company rules penalize closely held corporations for earnings that remain undistributed to shareholders. The rules are designed to prevent corporations from acting as incorporated pocketbooks of shareholders, collecting investment income or salaries on behalf of shareholders in order to avoid taxation at otherwise applicable individual income taxes.
A personal holding company is generally a corporation that meets the following tests:
- The corporation is a "regular" corporation—the tax does not apply to S corporations.
- Five or fewer individuals own more than 50 percent in value of the corporation's outstanding stock at any time during the last half of the tax year.
- 60 percent or more of the corporation's adjusted ordinary income is personal holding company income. .
Personal holding company income consists of dividends, interest and certain royalties. The personal holding company tax is imposed not on all personal holding company income, but on undistributed personal holding company income. Thus, if all of the corporation's dividend income is distributed to the shareholders, there will not be a risk of personal holding tax liability. And, remember, the tax never applies to an S corporation because the income is always passed through to the shareholders.
The tax is extremely complicated due to its many exceptions. In practice, the tax will not usually apply to small business owners. While the typical small business may be owned by five or fewer individuals, in most cases its income will not be passive, or will fall within some of the exceptions.
However, in an arrangement where a holding company and an operating company are used, the tax may very well apply to the holding company unless a consolidated tax return is filed. That consolidated return opens its own set of complications and complexities.
Consider Self-Employment Tax When Selecting Entity Type
Self-employment taxes are one aspect to consider when comparing an LLC to a corporation. Often, the tax implications of paying Social Security and Medicare taxes is not a significant difference between the two organizational choices.
The LLC is not a taxpaying entity and, accordingly, does not pay Social Security or any other employment taxes on the salary of the owner. The LLC owner is really self-employed, and the salary is only an owner's withdrawal from the business. However, the LLC owner must pay a self-employment tax on his or her personal income tax return (Form 1040.) This self-employment tax is, in reality, the Social Security tax and the Medicare tax that would ordinarily be paid by the employer and the employee.
In contrast, it is sometimes said that the owner of the corporation can avoid the payment of self-employment taxes by not taking money out of the business. This idea may not prove out in practice, because paying out all earnings as salary is the principal way that owners of corporations avoid double taxation of dividends.
However, it is true that the corporation can allow earnings to accumulate in the corporation (subject to the accumulated earnings tax limitations, in the case of a regular "C" corporation). To this extent, the corporation could provide an advantage over the LLC. Remember, an S corporation is a pass-through entity, so all income is taxed to the shareholders, regardless of whether it is actually distributed to them.
But one reason that there's no real advantage in either the LLC or corporation when it comes to self-employment taxes is that the owner ultimately bears the cost of the tax in any event, whether it is paid through the business, or directly by the owner, and this cost will be the same in both cases.
In 2014, the corporation pays Social Security tax of 6.2 percent on the first $117,000 of salary paid to the owner, and the owner has to make a matching contribution (through a payroll deduction) of 6.2 percent.
On the other hand, the LLC owner is self-employed. The LLC owner must pay a "self-employment tax" at the rate of 12.4 percent of the first $117,000 in 2014 of self-employment income. This tax is, in reality, a combination of the Social Security tax that would be paid by the employer (6.2 percent) and the employee (6.2 percent.).
Similarly, the corporation pays a Medicare tax on your salary at the rate of 1.45 percent, with no limit on the earnings to which the rate applies, while you must pay a matching 1.45 percent contribution through a payroll deduction. In the LLC, you would pay 2.9 percent on your self-employment income (equal to the contribution made by the corporation and the employee-owner combined).
In each case, you effectively pay the same total rate of 15.3 percent in 2014 on the same base of earnings. (In the corporation, 6.2 percent + 6.2 percent + 1.45 percent + 1.45 percent = 15.3 percent; in the LLC, 12.4 percent + 2.9 percent = 15.3 percent).
Accumulating Earnings May Reduce Self-Employment Tax
When comparing these two entity forms and their tax implications, a corporation might provide an advantage over the limited liability company (LLC), in terms of self-employment taxes, particularly if you intend to retain earnings within the business for some special purpose.
In a corporation (whether an S corporation or a regular C corporation), owners pay no self-employment taxes. If they receive income from the corporation as an salary, then normal payroll taxes must be paid (i.e., FICA, FUTA and income tax withholding.) If they receive dividends from the corporation, normal income tax rates apply, but self-employment does not apply.
Moreover, if the corporation retains its earnings, the shareholders do not pay any tax until those earnings are distributed. (Of course, the corporate does pay tax on the income.) In contrast, in an LLC, all of the owners must pay self-employment taxes on their share of the business's earnings (whether or not distributed.)
Thus, there may be a distinct disadvantage to running your business as a corporation if you want to let earnings accumulate in the entity, free of self-employment taxes. For example, a corporation may accumulate earnings in anticipation of an owner retiring. The owner's shares can be redeemed with the accumulated earnings. If done properly, the redemption qualifies for capital gains treatment, and thus lowers taxes for the owner. The LLC owner can do the same thing, except that he or she must pay self-employment taxes on the earnings as they are generated.
This also may be a disadvantage in the manager-managed LLC because in many cases the non-manager owners may not be paid any salary or distributions. Yet, unless careful steps were taken, all of the owners would have to pay the self-employment tax anyway, on their share of the entity's earnings, even though they receive no distributions. The way to avoid this problem is to be sure that the LLC operating agreement provides that income is shared on some basis other than the ratio of capital accounts, so that the non-manager owners will be allocated little or no income, and, thus, pay little or no self-employment taxes. This can be accomplished by having the LLC pay the manager-owner salary, lease and loan payments, etc.
Of course, this only shifts the payment of the self-employment taxes to the owner-manager. It does not solve the problem of the owner who wants to accumulate income in the holding LLC, free of these taxes.
Self-Employment Tax Options for LLC Members
If you are an LLC owner, you can deduct half of the self-employment taxes you pay on your personal income tax return, Form 1040. This can be done even if you don't itemize deductions. This fact may lower the effective cost of the taxes and, thus, shift the advantage to the LLC. While the corporation can deduct its half of these taxes on its own tax return, this does not yield a direct benefit to the owner because the corporation files a separate tax return and pays its own taxes.
Furthermore, in the LLC, federal and state unemployment taxes are avoided on the owner's income, including guaranteed payments received for salary. In contrast, the corporation must pay both federal and state unemployment tax. The federal unemployment tax (FUTA) rate is 6.0 percent. The tax applies to only the first $7,000 you pay to each employee as wages during the year. The $7,000 is the federal wage base, but your state wage base may be different.
In addition, the LLC owner can avoid the self-employment tax if payments are made by the LLC to the owner as lease payments and loan repayments.
The Internal Revenue Code imposes the self-employment tax on profits derived from ownership of the business, plus any guaranteed payments for salary. The owner will not be "in the business" of leasing real estate (or equipment, furniture, etc) or making loans. Thus, the tax will not apply to these receipts. (In addition, the Code also specifically exempts lease payments received from anyone except a real estate dealer).
Lease payments and loan repayments are paid to the LLC owner for a reason other than his or her capacity as an owner. Accordingly, they are deducted by the LLC in computing its distributable income. Because the LLC does not pay taxes itself, this really represents a way to allocate income to a particular owner, but avoid the self-employment tax.
"Guaranteed payments" made to an LLC owner, for services rendered (i.e., salary) are also deductible by the LLC. However, these payments are subject to the self-employment tax with respect to the partner who receives the payments. They are added to his or her distributable share of the LLC profits, and he or she pays the self-employment tax on the total.
Division of profits in the LLC is covered by the LLC's operating agreement. Different schemes exist that can involve payments made to owners for leases of assets, loan repayments, and salary. Whether or not salary is deemed a "guaranteed payment" can affect how much net income is left to be divided among the LLC owners. In addition, some allocation schemes can have adverse income tax consequences.
See our discussion of withdrawing funds from the business and tax aspects of funding decisions before you undertake to create an allocation scheme in your operating agreement.
Fringe Benefit Options Vary Based on Entity Type
It may be possible to combine the LLC and the statutory close corporation to achieve both the asset protections afforded by the LLC and the possible self-employment tax savings attributable to the corporation. You can do this by forming two entities: a holding company and an operating entity.
As you recall, assets in a corporation will be subject to less protection than those in an LLC, with respect to claims of your personal creditors. This risk can be mitigated by making the holding entity an LLC and the operating entity a statutory close corporation. The holding LLC would be the owner of the operating corporation. Thus, the owner's personal creditors would have to make claims against the LLC, to reach the operating entity's assets.
One problem that may arise is that allowing income to accumulate in the operating corporation will make these assets vulnerable to the claims of the business creditors. This problem can be mitigated by encumbering the operating corporation's assets with liens that run to the holding entity.
However, the accumulation of earnings may not be an issue, or even a possibility, for the small business owner. The chief reason corporate earnings are accumulated is to redeem (i.e., buy back) a retiring owner's stock. The redemption, if done properly, will result in capital gains treatment, and thus lower taxes for the retiring owner.
As a practical matter, most small business owners will not be concerned immediately with retiring and cashing out of the business. Further, most small business owners are not likely to be in a position to accumulate earnings in the business.
The upshot then is that the small business owner seeking to avoid self-employment taxes probably will want to use two LLCs as the operating and holding companies, and withdraw funds through lease and loan payments.
Fringe Benefits Could Sway Your Entity Choice
On the surface the corporation enjoys a slight advantage over the LLC when it comes to providing certain tax-free fringe benefits to its owners, such as company-paid life insurance and dependent care assistance.
However, this advantage only exists with a regular C corporation. It does not apply to S corporations because any owner of a 2-percent-or-more interest in a subchapter S corporation is treated the same as an LLC owner. Thus, there is no advantage over an LLC with respect to most fringe benefits.
One of the most important fringe benefits of all, tax-deductible health insurance, is now deductible for LLC owners and S corporation owners, as well as sole proprietors and partners, under federal law.
Where providing fringe benefits to the owner and his or her family is an important issue, consideration should be given to forming the operating entity as a statutory close corporation in one of the states that offer the special statutory close corporation forms.
Another alternative would be to elect to have the LLC taxed as a corporation. Because the LLC can elect to be taxed as a corporation, it can, in this way, achieve the same benefits enjoyed by corporations. Most LLC owners almost never make this election because the benefits achieved would be small in comparison to the disadvantages of corporate tax status. However, for those small business owners interested in providing the extra tax-free fringe benefits, this election may be preferable to forming a corporation. After all, the LLC offers better protection for the business owner's interest against the claims of his personal creditors. This is a significant protection. It is not available even in the statutory close corporation, which, in other respects, resembles the LLC.
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