Tax implications of LLCs and corporations

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

In this article:

• Common state taxes
• LLCs and corporations provide their owners with limited personal liability regardless of how they are taxed
• How are corporations taxed under the IRC?
• How are C corporations taxed?
• How are S corporations taxed?
• What corporations can elect to be taxed as S corporations?
• Impact of timing of S corporation election
• State taxation of S corporations can vary
• Accumulating or retaining too much in earnings can increase tax liability
• How is an LLC taxed?
• Members can opt out of default LLC tax classifications
• Most states follow federal taxation rules for LLCs
• Consider self-employment tax when selecting entity type and tax classification
• Fringe benefit and retirement plan options vary depending on tax status

Common state taxes

Each state has different taxes imposed on businesses and different ways of calculating the tax due. Common state-level taxes include the following:

Income tax. Income tax can be classified as either corporate income tax or individual income tax.  For those business types that pass-through business income to the individual owners (such as LLCs and S corps), individual income tax is paid.

Franchise tax. A franchise tax can be imposed on corporations, limited liability companies (LLCs), and other business types formed by a state filing for the mere privilege of being incorporated in that state. (Franchise taxes also apply to companies that are registered to transact business, also called foreign qualified, in other states.)

Sales tax. There are different types of sales taxes and some are paid by the seller while others are paid by the buyer.

Use tax. While sales tax applies to retail sales that happen within that state, the use tax applies to storage or other use of tangible personal property or taxable services in a state.

Property tax. Most property taxes are used to fund local governments versus the state government, but should also be considered as a tax obligation your business will incur. Owning real estate is not a prerequisite for property tax. Many state and local governments charge personal property tax on furniture, equipment, and leasehold improvements.

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.

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 Internal Revenue Code (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.

Impact of timing of S corporation election

If you do not elect S corporation status when you form your corporation, you may have to deal with the built-in gains from when the corporation was taxed as a C corporation. If this is the case you should work with a tax adviser to ensure that all the potential tax issues are addressed.

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. In addition, even if they permit taxation as an "S corporation," they may require a separate state election before they will recognize the federal election.

Also, a few states impose a special tax on the income of every business, whatever the form of entity. You should find out if this is the case in the state in which the entity will be formed and the state in which it will be doing business, to get a complete picture of what your entity’s tax liability will be.

Accumulating or retaining too much in earnings can increase tax liability

In a C corporation, the owners are taxed only on the amount of earnings they receive as dividends — not the earnings the corporation retains. This is generally considered an advantage of C corporation taxation. (In a pass-through entity, the owners are taxed on their share of the entity’s earnings whether distributed or retained.)

However, if the C corporation retains earnings above the amount the IRS considers to be the reasonable needs of the business, the corporation may be assessed for the accumulated earnings tax.

The accumulated earnings tax is a penalty tax imposed on a corporation that is formed or used to help the shareholders avoid paying income tax by permitting its earnings and profits to accumulate, instead of being distributed.

The IRC also imposes an extra tax on certain corporations called “personal holding companies”. This is a closely held corporation that meets certain tests regarding its stock ownership and income. A personal holding company must pay an additional tax on the undistributed personal holding company income — which includes dividends, interest, and certain royalties.

The tax rules regarding the accumulated earnings tax and personal holding company tax are very complex. Small business owners who think this could be an issue should consult with their tax advisers.

How is an LLC taxed?

By default, an LLC with one member is what the IRS refers to as a “disregarded entity”. This means the IRS will treat the LLC as if it was a sole proprietorship. But, it’s still an LLC. It’s not a sole proprietorship. It’s only taxed like one.

An LLC with more than one member is taxed by default as if it was a partnership. But, it is still an LLC. It’s only taxed like it’s a partnership. (These tax rules are found in Subchapter K of the IRC for those who are interested in reading the partnership tax rules.)

Under these default classifications, the LLC is not a taxpaying entity. The owners make tax payments by reporting their share of profit and loss (whether or not it is actually distributed) on their personal income tax returns.

Most owners of a single-owner LLC must report income and business expenses using Form 1040 Schedule C Business Income and Expenses.

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 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.

Members can opt out of default LLC tax classifications

LLC owners (single-member LLCs or multi-member LLCs) don't have to take any action at all if they are happy with the default classification.

However, any LLC can elect to be taxed as a C corporation. You can file Form 8832, Entity Classification Election to elect to be treated as a C corporation for tax purposes (and only tax purposes).

In addition, if the LLC qualifies, it can then file an election to be taxed as an S corporation. But, even if the LLC is taxed like a C corporation or an S corporation, it is still an LLC.

How the LLC will be taxed should be addressed in the LLC operating agreement.

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 disregarded entity or pass-through entity for state income tax purposes in these states, and no state corporate tax is imposed.

In addition, if an entity classification election is made, it will be honored in most states.

Consider self-employment tax when selecting entity type and tax classification

Self-employment taxes are one tax issue to consider when deciding whether to choose an LLC or corporation and then in deciding how that LLC or corporation should be classified for tax purposes.

The members of an LLC who also actively work for the business are considered owners, not employees. They must pay self-employment taxes (for Social Security and Medicare) on the income they receive from the LLC — both income received as salary and as a share of the profits.

In a corporation, the employees who work for the corporation are considered employees, even if they are also shareholders. They only have to pay Social Security/Medicare taxes on their salary — not on any distributions of profit.

The owners of some LLCs will elect to be taxed as a corporation (usually an S corporation if the LLC qualifies) because the difference in self-employment taxation provides them with what they consider a significant tax saving.

Fringe benefit and retirement plan options vary depending on tax status

The deductibility of fringe benefits differs depending on tax classification. A fringe benefit is compensation paid to employees for performing services beyond that of the regular salary.

In a C corporation, the employees can exclude the value of the benefits from their personal income. This is true even if they are also owners.

However, there are special rules for S corporations and for LLCs taxed under the default rules. Certain fringe benefits paid to employees who also own 2% or more of the entity must be included in those employees’ personal income.

In addition, the rules regarding the tax-advantaged stock option and retirement plans that can be set up by employers differ depending upon whether the employer is taxed as a C corporation or a pass-through entity.

The rules regarding the taxation of fringe benefits and retirement plans are complex and you will want the assistance of a tax adviser before setting up these plans.

Conclusion

To summarize, if you choose to form a corporation, by default, the corporation will be a separate tax entity. It will pay a federal income tax, and in many states, a state income tax. Its shareholders will pay income tax on the dividends they receive.

Some of the advantages of this kind of taxation include greater deductibility of fringe benefits and retirement plans and the fact that shareholders do not pay taxes on the profits that are not distributed to them. A disadvantage is the double taxation of profits that are distributed to shareholders.

Some corporations can make an S corporation election and be a pass-through entity. The corporation will not pay income tax. Its income, losses, and other tax items pass through to the shareholders, who pay personal income taxes on their share of the corporation’s profits.

A principal advantage of S corporation taxation is that income distributed to shareholders is not taxed twice. Self-employment taxes for an S corporation can also be less than other pass-through entities. However, the rules regarding fringe benefits are less beneficial than those for C corporations.

An LLC can be taxed in one of four ways.

• A single-member LLC, by default, is taxed as a disregarded entity, meaning the business’ profits and losses are the owner’s profits and losses. This is the simplest of tax schemes since there is no tax filing other than the owner’s 1040.
• An LLC with more than one member is a pass-through entity. The LLC’s profits and losses pass through to the members, who pay personal income taxes on their share of the profits.
• The members of an LLC may also elect to have their LLC taxed under the rules applicable to C corporations.
• If the LLC qualifies, it can choose to be taxed according to the rules applicable to S corporations.

The advantages of being taxed as a disregarded or a pass-through entity include that they avoid double taxation and the owners may be eligible for a deduction of up to 20% of qualified business income.

Which taxing scheme is best for a small business owner depends on many factors. There is no one right way to go. All types of small businesses are different.

Furthermore, tax laws are very complex and the IRS constantly revises its regulations. Consulting with a tax professional is essential in making the right choice.