Small business owners who are deciding whether to form a corporation versus a limited liability company (LLC) must take into account many factors. One of those factors is whether the choice will result in any significant income tax savings for the owners. That requires a basic understanding of how each business structure is taxed by the federal and state governments.
When making your ultimate decision — not only on whether to form an LLC or corporation — but how you want that LLC or corporation to be taxed (you’ll have options), you should consider, among others, the following tax issues:
- The income tax rate for corporations and individuals — both federal and state
- Self-employment taxes if any of the owners will also work for the company
- Retirement plans, if the owners want to establish them
- Fringe benefits for the owners and employees
LLCs and corporations provide their owners with limited personal liability regardless of how they are taxed
Most small business owners decide to form an LLC or corporation to own their business, rather than owning the business in their own names, to limit their personal liability.
LLCs and corporations are both legal entities that have an existence separate from their owners (called shareholders in the case of a corporation and members in the case of an LLC).
And all state corporation statutes and LLC statutes provide that corporations and LLCs are liable for their own debts and the shareholders and members are not personally liable based on their status as owners of the entity.
Therefore, the choice of an LLC or a corporation will not be based on which provides limited liability. They both do. And the choice of how that corporation or LLC is taxed for income tax purposes has no effect on that limitation of personal liability.
Note: Limited liability refers to a separation between business and personal assets.
Don’t confuse IRS tax classification with the type of entity you formed — an LLC is always an LLC, and a corporation is always a corporation
Some small business owners misunderstand the relationship between tax status and entity status. As we will discuss, the Internal Revenue Code (IRC) does not have one chapter dealing with corporations and one chapter dealing with LLCs. In fact, the IRC does not even mention LLCs.
Instead, as a default rule, an LLC with one member will be taxed in the same manner as a sole proprietorship, while an LLC with more than one member will be taxed in the same manner as a partnership.
In addition, an LLC can elect to be taxed as a corporation.
However, regardless of how the members decide to have the LLC taxed, it remains an LLC. An LLC’s tax classification has no effect on it being an LLC.
Similarly, even if the LLC members elect to have the LLC taxed in the same manner as a corporation, it’s still an LLC. It’s just an LLC that has opted out of its default income tax classification.
In addition, the IRC has two different corporation tax classifications — a corporation may be taxed as a C corporation or an S corporation (more on that later). But that is solely an income tax distinction. For the purposes of the state corporation law, and any purpose other than income tax, a corporation is just a corporation and it doesn’t matter if it is taxed as a C corporation or S corporation.
How are corporations taxed under the IRC?
By default, all corporations are taxed under Subchapter C of the Internal Revenue Code. These are referred to as C corporations. “By default” means that if the shareholders do nothing, this is how their corporation will be taxed.
“Default” also means that there are other options. And indeed there is another option. If all the shareholders so decide, and the corporation qualifies, it can be taxed under Subchapter S of the IRC. These are referred to as S corporations.
How are C corporations taxed?
A C corporation is a separate taxpaying entity. The corporation must file a separate corporate tax return, Form 1120, and pay its own taxes.
A C corporation 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 is taxed twice.
Double taxation is considered the main disadvantage of being taxed as a C corporation. Particularly where the owners want to distribute a large amount of the profits to themselves in the form of dividends, this can be costly to them.
How are S corporations taxed?
As noted, by default, a corporation is a separate taxpaying entity.
However, a corporation may be able to elect to be taxed as a pass-through entity rather than as a separate taxpayer. This election, commonly referred to as 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 are passed through to the owner or owners and reported on their own Schedules E and Forms 1040.
What corporations can elect to be taxed as S corporations?
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. (Note: members of the same family can be counted as a single shareholder.) Shareholders have to be individuals and have to be United States citizens or resident aliens.
In addition, there can be only one class of stock in the corporation. You can, however, have classes with different voting rights but you cannot have one class of stock receive a dividend (or any other financial advantage) while another does not.