As a business owner, you probably know that there are potential tax-related upsides and downsides for every type of business entity. But the question is, what exactly are those tax advantages and how do they apply to you?
Deciding which legal business structure to form for your business is SO important! So let’s take a moment to lay out the tax pros and cons in a way that will hopefully make this decision easier to make.
LLC (limited liability company)
As a “disregarded entity” for tax purposes, an LLC’s profits and losses flow through to its owners’ personal tax returns. From a tax perspective, there is no difference in how a sole proprietor is taxed versus an LLC. Note that from a legal standpoint, an LLC is considered a separate entity from its members, so it provides some liability protection to its owners. Generally, LLC members’ personal assets are not at risk if the company gets sued or cannot pay its debts.
Tax advantages of the LLC structure:
- Owners choose how to distribute profits. LLC members may choose how their business will divide the company’s profits and losses among its owners. This allows for members to consider not only money invested, but also time and work invested when distributing profits. No payroll is necessary – you can just transfer funds from the business to the owner.
- Less expensive formation and reporting. Typically the costs to form an LLC, as well as your annual state reporting requirements and tax filing fees are far less than corporation fees.
- S corporation election option for qualifying LLCs. LLC members may elect to have their LLC treated as an S corporation for tax purposes down the line. More on that later!
Tax disadvantages of the LLC structure:
- Bigger self-employment taxes burden. All of an LLC’s business profits are subject to Social Security and Medicare taxes. This may create an unfavorable financial situation for LLC owners as they must pay self-employment taxes on the LLC’s profits, even if they don’t take a distribution.
A C corporation is a separate legal and tax-paying entity. Its profits, losses and liabilities are tied to the business, not its owners (shareholders). It comes with more complex compliance formalities than the LLC structure, but it also offers the highest level of liability protection for owners of the business.
Tax advantages of the C corporation:
- Corporate income tax rate may be favorable. A C corp’s profits get taxed at the corporate income tax rate, which is currently 21% (federally). In some circumstances, that might work in the business owners’ favor. Depending on where the business is incorporated and shareholders’ personal tax situation, they might find the corporate income tax rate will cost them less than if they were set up as an LLC and had to pay the individual income tax rate (and self-employment tax) on their company’s profits.
- S corporation option for qualifying C corporations. Eligible C corps may be taxed as an S corporation. I’ll explain more about that below. The primary advantage of the S corp election for C corps is that it can enable them to avoid the sting of “double taxation.” This leads me to the potential tax disadvantages of the C corporation…
Tax disadvantages of the C corporation:
- A double tax hit. A C corporation’s profits are taxed when they are earned. Then, any of the profits paid as dividend income to shareholders is taxed again on the shareholder’s individual tax returns. Ouch.
And now we get to my favorite structure… the S corp! The S corporation isn’t a legal entity in itself but rather an option for a qualifying LLC or corporation.
Tax advantages of the S corporation:
- Lessens the self-employment tax burden on LLC members. The primary advantage is that only income paid to LLC members on payroll is subject to self-employment taxes. Profits paid as distributions are not subject to Social Security and Medicare taxes. Therefore, an LLC’s members may find that the S corp election will lower their personal tax burden.
Tax disadvantages of the S corporation:
- May limit a corporation’s growth potential. S corps may not have more than 100 shareholders, so corporations that want to maximize their growth potential may find the S corp option limiting.
- Reasonable compensation is key for LLC members working as employees. An LLC must pay its owners fair compensation for the work they perform. If it pays its members unreasonably low wages and doles out the majority of money as distributions, it could raise red flags with the IRS and other tax authorities. It might appear that the LLC members are playing the system to avoid paying their fair share of self-employment taxes.
Every business and situation differs, however I typically recommend clients to start with creating a single-member LLC and then electing to file as an S corp down the line once the tax savings of the S corp outweigh the associated fees.
If you are considering an S corporation for your business structure, but sure to check out my S corporation 101 guide and tax saving calculator!
And remember, it is always important to speak with an attorney and CPA prior to making these decisions for your business!
Candace is the founder of NewWay Accounting and is a CPA who specializes in working with fellow entrepreneurs. She strives to take the fear and anxiety out of taxes and help empower small business owners to feel more confident and in control of their finances.