A regular question we hear is, “Should I have an LLC or a Corporation for my business?” That depends on your organizational goals, tax strategy and how you plan to protect yourself from potential liabilities. The following information is incomplete and general, and should not be relied upon for making any decisions. I am touching on just a few matters relating to taxation. If you wish to create a business entity you need to have a meeting with your CPA as a first step.
A corporation is a legal entity that is separate and distinct from its owners. The states that allow for their charter also consider them to be an individual person, with the same rights to enter into contracts, own assets, have bank accounts and loans, sue and be sued separately from its owners, and have a work force. Ownership percentage is determined by the number of shares authorized and issued.
A limited liability company (LLC) is a form of partnership that combines the limited liability of a corporation with the pass-through tax rates of a partnership. Partnerships are pass-through entities because the profits are not taxed on the partnership tax return, but are passed through to the partners’ individual tax returns where the profits are subject to individual tax rates, as well as Social Security and Medicare taxes.
If you form an LLC by yourself and have no partner, the partnership is considered by the IRS to be disregarded for tax purposes, hence the term “Disregarded entity.” By disregarding the partnership entity, you are not required to file a partnership tax return. You do however retain the legal entity and its protection of the owner from the company’s liabilities. You would report your business income and expenses on the Schedule C of your personal income tax return. Schedule C profits are subject to Social Security and Medicare taxes; called self-employment taxes.
Unlike a Sole Proprietor who also reports on Schedule C, the disregarded entity LLC is legally separate from its owner. If the LLC is sued, the owner is generally not liable unless personally negligent. Contrast that with a sole proprietor who has all of her assets, personal and business, at risk. Of course our sole proprietor can, and should, buy liability insurance.
Once a corporation or LLC are formed at the state level, it is up to the owners to make an election with the IRS as to how those entities will be taxed in future years. If you form a corporation and fail to make an election with the IRS, you will have a C corporation on your hands.
A C corporation is a clearly separate legal entity that requires a unique understanding to properly manage. The owners are subject to double-taxation because corporate income taxes are paid before any profit is distributed. If the owners receive a dividend, those are taxed again on the personal tax returns of the recipients. That is double taxation. Smaller C corporation owners usually take a salary to extract value from their corporations, but if they fail to take a bonus at the end of the year and leave profits in the corporation, the entity will pay corporate income tax. You need to know what you are doing, or have help from your accountant, to effectively manage a C corporation, or Professional Service Corporation.
If you elect to classify your corporation under subchapter S, your profits will flow onto your personal tax return and will only be subject to income taxes. This is very different from distributions from a partnership where distributions are subject to self-employment taxes in addition to income taxes.
An LLC with multiple owners can be taxed as a partnership. However today we see most small LLC’s electing to be taxed as a corporation, and making the subchapter S election to retain the pass-through nature of the profits that also avoids the self-employment taxes.
Wages are subject to Income tax, Social Security tax and Medicare tax. S profits, which come after payroll expenses, are extracted as a distribution, and are subject to income tax only. Social Security and Medicare taxes (called FICA) are 15.3%; with the business paying half and the employee paying the other half. When the owner is also the employee, that one person ultimately pays the entire 15.3%. Consider that on a $100,000 salary, the FICA will be $15,300. If your business lasts 20 years and you always take the same salary, the FICA adds up to a substantial $306,000.
Any owner of an S entity is automatically considered, by law, to be an employee of that business. They are further required to take a reasonable wage or salary for their position. What is reasonable? The simplest answer is whatever you would have to pay somebody else to do your job. To save money, some S owners only take a token salary and allow most of the fruits of their labors to flow onto their tax returns as distributions, escaping a portion of the SS and MED taxes. The explosive growth of the subchapter S entity over the last 20 years is no accident. The IRS is very aware of this behavior and does have the power to step in and convert distributions of profits into wages when they catch somebody, and the penalties and interest can be substantial.
If you own a business or are thinking about starting one, the requirements and pitfalls are so numerous that to rely on anyone but a CPA or Attorney to help with your organizational decisions will result in mistakes that will cost a lot more than the professional fees; which by the way are deductible to the business. The penalties for your mistakes are never deductible.