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.