I often assist clients with forming a new legal entity. Part of that decision is whether to form an LLC or a Corporation. It's a decision that's based on both legal and tax considerations. Often, tax considerations take the front seat on this decision.
Besides at the time of starting a business, as the business grows or the owner's personal situation changes (or when tax laws change), it is wise to reevaluate and see if it is still the most tax-efficient structure.
This following post is written by guest author Steven Gu, CPA and Tax Attorney. The information here is too valuable not to share. This is re-published with Steven's permission.
There are huge misunderstandings among business owners around this topic that are costing them a ton of cash.
They were told remaining as an LLC for eternity is the right path (they were also told that you have such a high tax bill so you should be "grateful").
They were told to become a C Corp because of its 21% flat tax rate (but they didn't even consider what their end goal with the business is....and end up OVER paying).
They were told to be an S Corp because it was the best move, even though they are losing money.
They were told to set up a Partnership....but had no strategy in doing so and now the bank account is low due to self-employment taxes.
Different entity structures are taxed differently - both at the entity level and the owner's level. So you should evaluate the decision by looking at tax attributes on both levels too. You will also include other considerations such as an exit strategy or transitioning the business ownership to the next generation.
When is an LLC the best Structure?
It depends. Here are a few pros and cons:
The biggest legal advantage is that LLCs can offer similar legal protection as Corporations to their members (owners) against liability.
The biggest tax advantage is that it is SIMPLE. But because it’s simple, sometimes it can’t provide all the solutions to your needs.
An LLC also gives you the option of electing to treat the company as a partnership, C or S corporation for federal income tax purposes. But this could cause unintended consequences. Don’t make an election without consulting with your tax advisor.
Here are the most important things that you need to know about LLCs. LLCs Offer Legal Protection Using an LLC to conduct a business or investment activity generally protects your personal assets from LLC-related liabilities—similar to the legal protection offered by a corporation. As you know, liabilities can arise from simple things—like a delivery guy slipping on something you left on your front steps—or in seemingly endless and complicated ways if you have employees.
Tax Basics - Single-Member LLC
Single-member LLC businesses owned by individuals are treated as sole proprietorships for federal income tax purposes unless the member elects to be treated as a corporation. In other words, the default federal income tax treatment for a single-member LLC is sole proprietorship status. Under the default treatment, you simply report all of the LLC’s income and expenses on Schedule C of your Form 1040.
Net self-employment income is reported on Schedule SE of your Form 1040.
Rental income and expenses are reported on Schedule E of your Form 1040.
Farming or ranching income and expenses are reported on Schedule F.
Simple. You don’t need to file a separate federal income tax return for the single-member LLC. And other things being equal, simple is good. That's the biggest tax advantage of operating as a single-member LLC.
Tax Basics - Multi-Member LLC
Multi-Member LLCs are treated as partnerships for federal income tax purposes unless you elect to treat the LLC as a corporation. In other words, the default federal income tax treatment for a Multi-Member LLC is partnership status. Under the default treatment, you must file an annual partnership federal income tax return on Form 1065.
From the Form 1065 partnership return, the LLC issues an annual Schedule K-1 to each member to report that member’s share of the LLC’s income and expenses. The member then takes those taxable and deductible amounts into account on the member’s own return (Form 1040 for a member who is an individual).
The LLC itself does not pay federal income tax. This arrangement is called pass-through taxation, because the income and expenses from the LLC’s operations are passed through to the members, who then take them into account on their own returns. (The same pass-through taxation concept applies to entities set up as "regular" partnerships under applicable state law.)
Electing to Treat the LLC as a "C" or "S" Corporation for Tax Purposes
You have the option of electing to treat a Single-Member LLC or Multi-Member LLC as a corporation for federal income tax purposes. If you desire to have your LLC treated as an S corporation, it can elect S corporation status directly using IRS Form 2553, or it can elect C corporation treatment on IRS Form 8832.
Tax reasons generally dictate against taking that step. Electing corporate status from the LLC could have unintended tax consequences.
For example, a special federal income tax break allows you to annually deduct up to $50,000 of losses from selling eligible small business stock, or $100,000 if you’re a married joint filer, and treat the loss as a tax-favored ordinary loss instead of a tax-disfavored capital loss. Can an LLC membership interest count as eligible stock for this purpose? Apparently not. It’s not stock. Avoid the problem—set up as a corporation in the first place.
Here’s another example: it is common for start-up founders and key employees to receive a standard "Restricted Stock Purchase Agreement" with a vesting schedule. An IRC Section 83(b) election provides taxpayer an opportunity to elect to be taxed at the time of the receipt of the property (e.g., grant date) instead of the vesting date, so that the taxpayer will get tax-favored treatment. Again, an LLC membership interest won’t count as eligible stock for this purpose because it is not stock.
You can avoid these problems by setting up as a corporation in the first place. If you conclude that there are tax advantages to electing corporate status, why not just actually incorporate your company in the first place? That’s simpler. Keeping your tax matters simple is generally good policy.
When is an S Corporation the best Structure?
When you first see that 21% tax rate for the C corporation, you have to think that this could be the choice of entity for your business operation. Further, when you find yourself in the out-of-favor group (physicians, lawyers, etc.) for the 20% deduction (known as Section 199A Qualified Business Income Deduction), you naturally gravitate to thinking about the C corporation, perhaps as a means of getting even.
Is C corporation really better than an S Corporation from the tax perspective?
Should you switch from an S Corporation to a C Corporation? or vice versa?
The short answer: it depends.
It depends on what tax bracket you are at.
It depends on whether you need to take money out of your business
It depends on how much money you want to take out of your business
It depends on how do you plan to use your business profits (ROI)
It depends on your business model - for example, retail vs wholesale And many more...
The table below gives you a good look at how you would pay taxes on your profits, depending on your tax bracket. In the S corporation column, we listed the tax rates by the brackets that apply to individuals.
To see exactly how this works, let’s say that you are in the 34 percent tax bracket, and let’s say further that you have $100,000 in profits.
If you operate as an S corporation:
The profits come to you on a K-1 and you pay your Form 1040 taxes at the 34 percent rate, for a total tax of $34,000 on your S corporation profits.
If you operate as a C corporation:
The profits are first taxed at the C corporation level at a rate of 21 percent, for a tax of $21,000. This leaves you with $79,000 of the $100,000 in profits available for distribution as a dividend to you.
Your total taxes of $35,852 on the $100,000 of income consists of the following: C corporation taxes of $21,000, 1040 dividend taxes of $11,850 and 1040 NIIT of $3,002.
Based on the same $100,000 in profits, operating as an S corporation results in $34,000 to the government compared with the C corporation, which pays $35,853. The winner: the S corporation.
So based on the tax rates alone, you have no reason to switch to the C corporation because of tax reform. But does this mean an S Corporation is better for YOU? Not necessarily.
The above table just shows you an extremely simplified example with lots of assumptions. There are so many variables - maybe your tax bracket is different, or you are comfortable to keep money in the company, or your investment can generate more ROIs. Any of these variables will completely change the conclusion.
Whew! That was complicated. This goes to show that entity selection is not an easy decision, and no two situations are exactly alike. There is no "one size fits all" solution when it comes to entity selection and structure. Be sure to consult with your trusted tax advisor to make the initial decision of what entity to form. Also, continuously reevaluate from time to time as the company evolves and tax rates change.