I regularly speak to business owners about entity types and their potential impact from a tax perspective. A while back, I created a webinar for accountants (and other professional services providers that work with businesses) on the topic of business structures and taxes. It is focused on the possible tax advantages and disadvantages of C Corporations, S Corporations, and Limited Liability Companies (LLCs). In this article, I’ll break down the important considerations that I discussed in that presentation.

  • Benefits of Business Incorporation
  • Overview of the C Corporation, S Corporation, and LLC
  • Tax Advantages and Disadvantages
  • Tax Cuts and Jobs Act
  • Helping Clients Select An Entity
  • Steps to Get Started
  • Entity Conversions
  • Helpful Resources

Benefits of Incorporating

If you’re operating your business as a sole proprietorship or partnership, you may be wondering, “Is it time to create a formal business structure.” And if you’re an accounting professional who works with business clients, you may have customers who are pondering that question.

Some of the features that attract small business owners to incorporating or forming a limited liability company (LLC) include:

  • Liability protection of personal assets
  • Credibility
  • Perpetual existence (i.e., the business can continue without the original owner)
  • Tax flexibility
  • More business tax deductions

Overview of Business Structures

Before I get into the tax advantages and disadvantages of each entity type, let’s take a minute to discuss the basics of each business structure.

C Corporation Business Structure

The C Corporation (C Corp) is the most common form of corporate entity. Owners are called “shareholders,” who must elect a board of directors to create and direct the business’s high-level policies and decision-making.

A C Corp is a separate legal entity from its owners, so shareholders (under most circumstances) are shielded from personal liability for the business’s debts. Note that forming a C Corporation is more complicated than establishing a business under other structures, so it’s generally not ideal for small businesses unless they intend to go public or seek venture capital funding.

C Corp Initial filing requirements include:

  • Articles of Incorporation
  • Initial Report (some states)
  • Publication Fees (some states)

C Corp annual compliance requirements include:

  • Annual Reports (most states)
  • Annual Meetings
  • Meeting Minutes
  • Retaining a registered agent to accept service of process on behalf of the business

S Corporation Business Structure

An S Corporation is different from a C Corporation in two significant ways:

  1. An S Corporation is a C Corporation that makes an election with the IRS to be taxed as a “pass-through entity,” and
  2. An S Corporation has limitations on ownership.

To qualify for S Corp status, a C Corp must meet strict requirements with the IRS. An S Corp must continue to meet the underlying C Corporation’s compliance responsibilities, such as holding annual shareholders’ meetings and directors’ meetings and documenting key shareholder decisions. They must also file a separate corporate income tax return for informational purposes even though the business’s income passes through to the individual shareholders’ personal tax returns.

S Corporation initial filing requirements include:

  • Articles of Incorporation
  • Initial Report (some states)
  • Publication Fees (some states)
  • Filing of IRS Form 2553

S Corp annual compliance requirements include:

  • Annual Reports (most states)
  • Annual Meetings
  • Meeting Minutes
  • Retaining a registered agent to accept service of process on behalf of the business

Note that eligible LLCs may also request S Corp election. I’ll explain that below.

Limited Liability Company Business Structure

A Limited Liability Company is a popular business structure because it combines the liability protection offered by incorporation while retaining some of the administrative simplicity (including pass-through tax treatment) of a Partnership or Sole Proprietorship.

An LLC shields its owners (called “members”) from personal liability because it is its own legal entity, separate from its owners. The LLC entity type is less complex to form and manage than the C Corp and S Corp.

LLC initial filing requirements include:

  • Articles of Organization
  • Initial Report (some states)
  • Publication Fees (some states)

LLC annual compliance requirements include:

  • Annual reports (most states)
  • Annual meetings (if required by the LLC’s operating agreement)
  • Meeting minutes (if required by the LLC’s operating agreement)
  • Retaining a registered agent to accept service of process on behalf of the business

Tax Advantages and Disadvantages

Let’s now take a look at the potential tax benefits and drawbacks of each entity type.

Tax Advantages of the C Corp Structure

  • Corporate Income Tax Rate Maybe Favorable – A C Corp’s profits get taxed at the corporate income tax rate. In some circumstances, that might work in the business owners’ favor. Depending on the location and shareholders’ personal tax situation, they might find the corporate tax rate will cost them less than if they were set up as a pass-through entity (LLC, partnership, or sole proprietorship).
  • Possibly More Tax Deduction Opportunities – As a C Corp, the business may be eligible for more tax deductions than if it were an LLC, partnership, or sole proprietorship.
  • S Corporation Options for Qualifying C Corporations – Eligible C Corps may be taxed as an S Corporation, enabling them to avoid the sting of “double taxation.”

Tax Disadvantages of the C Corp Structure

A Double Tax Hit – A C Corporation’s profits are taxed at the corporate level when they are earned. Then, any profits paid as a dividend income to shareholders are taxed again on the shareholder’s individual tax returns.

Tax Advantages of the LLC Structure

  • Pass-through taxation – Single-member LLCs are taxed as sole proprietorships, and multi-member LLCs are taxed as partnerships by default. Therefore, they provide simplicity (and possible cost-advantages, depending on individual income tax rates) of pass-through taxation.
  • Tax flexibility – LLCs that meet the IRS’s eligibility requirements may elect to be treated as an S Corporation for income tax purposes. This may reduce the LLC members’ Medicare and Social Security tax obligations because only the owners’ salaries and wages are subject to those taxes (profit distributions are not).
  • Flexibility when distributing profits – LLC members choose how the LLC will divide company profits and losses among its owners. This enables them to consider not only money invested but also time and work invested when distributing profits.

Tax Disadvantages of the LLC Structure

  • Self-Employment tax 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 their distributive share of the LLC’s profits, even if invested back into the business.
  • Owners may not be employees – Members of an LLC cannot be on the company’s payroll (unless the LLC is granted S Corp status). Therefore, owners must bear the full burden of self-employment taxes.

Tax Advantages of the S Corp Structure

  • Lessens the Self-employment Tax Burden on LLC Members – As I mentioned earlier, eligible LLCs may elect to be taxed as an S Corp. What’s the advantage of that? Only income paid to LLC members on the payroll is subject to self-employment taxes. Profits paid as distributions are not subject to Social Security and Medicare taxes, so LLC members may find that the S Corporation election lowers owners’ personal tax burden.
  • Enables C Corporations to Avoid Double Taxation – As an S Corporation, a corporation’s profits and losses flow through to shareholders’ personal tax returns and are taxed at the individual tax rates. The corporate entity does not pay income tax. Shareholders that are employees of the C Corporation only pay self-employment tax on the wages or salaries that the corporation pays them. Dividend income paid to shareholders is not subject to self-employment tax; those monies are taxed as either ordinary income or qualified dividends.

Tax Disadvantages of the S Corp Structure

  • May limit growth potential – An S Corp cannot have more than 100 shareholders, limiting the number of owners who can invest in the business.
  • Reasonable compensation concerns – An LLC that elects for S Corp tax treatment must be careful that it pays fair compensation to its owners for the work they perform. If they get paid too low of a salary, it may raise red flags with the IRS.
  • Lack of uniformity at the state level – S Corporation income taxes are not treated the same in every state. Some states automatically honor the federal S Corp election and provide pass-through taxation, while others might not. It depends on a state’s tax code.

Tax Cuts and Jobs Act Effects on Entities

The Tax Cuts and Jobs Act (TCJA), which was signed into law in December of 2017, made tax law changes that affected every business. TCJA has had the most impact on corporations and pass-through business entities.

TCJA Changes for Corporations

C Corporations, for the most part, have experienced positive changes. Highlights of how TCJA has affected them include:

  • C Corporations are now taxed at a flat rate of 21 (including personal service companies). (Pre-TCJA, the corporate tax rate was 35 percent.)
  • Corporations are no longer required to calculate alternative minimum tax rates. However, they may be able to use AMT credit carryovers until 2021.
  • They may still partially deduct dividends, but not as much as before the TCJA.

TCJA Changes for Pass-Through Businesses

Before the Act, taxable income from sole proprietorships, partnerships, S Corporations, and LLCs were passed through to owners and taxed at those individuals’ standard rates. Under TCJA, pass-through businesses are still taxed at individual rates, minus a deduction of 20 percent.

The deduction helps to create a lower tax rate for non-corporation businesses. There are some limitations and restrictions, though.

  • The deduction must be equal to 20 percent of the QBI earned from the business.
  • Much of the business’s income is excluded from QBI, thus giving a smaller deduction. (QBI does not include interest, dividends, or capital gains from property sales.)
  • The deduction is restricted to the lesser of 20 percent of the QBI or 50 percent of the total W-2 wages paid by the business.
  • The 20 percent deduction may not apply for businesses where “the principal asset is the reputation or skill of one or more of its employees or owners.” That includes services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, and trading.

Choosing the Right Entity Type for Your Business

So, with all of that information to consider, what else should business owners think about when deciding on a business structure? Here are some questions that can help:

  • Does the business owner have personal assets?
  • Are they concerned about personal liability?
  • Do they need to live off of the business’ profits each year?
  • Do they want to keep paperwork and administration as simple as possible?
  • Do they want to keep the business forever?

Answering these can help shed light on which business entity will offer the best outcomes. Business owners should enlist the expertise of an attorney and accountant or tax advisor to learn how a business structure will affect them legally and financially.

Self-Employed Individuals and Self-Employment Tax

Currently, the self-employment (SE) tax rate is 15.3 percent, which includes a 12.4 percent Social Security tax and a 2.9 percent Medicare tax (higher if earnings reach certain thresholds). How might forming an LLC or S Corporation affect business owners’ SE taxes?

Limited Liability Considerations

  • All profits are claimed on LLC members’ individual tax returns. Members pay the full 15.3 percent SE tax on their income from the business (except for members who are not active in the ‘operation of the company).
  • LLC members who pay SE tax can deduct half of the total amount from their taxable income.

S Corporation Considerations

  • S Corp election allows owners to classify some earnings as salaries and some as distributions.
  • Owners who are employees of the S Corp are liable for the 15.3 percent SE taxes and income tax on salaries, but only regular tax (not SE tax) on distributions.

Steps to Get Started

Generally, it’s best for businesses to incorporate in the state where they are physically located. However, some business owners choose to incorporate in a different state if they believe it has a favorable tax and legal environment.

For example:

  • Nevada and Wyoming don’t levy a state corporate income tax or a state personal income tax.
  • Delaware doesn’t have a corporate income tax for businesses formed there and no personal income tax on non-residents.
  • Delaware has a separate court system for businesses and individuals.

No matter where a business will be registered, many of the legal steps are the same:

Steps to Form a C Corporation

  1. Conduct a business name search and choose a name.
  2. Name a registered agent to accept service of process on the corporation’s behalf.
  3. Draft Articles of Incorporation.
  4. File Articles of Incorporation with the state.
  5. Write up corporate bylaws.
  6. Apply for a Federal Tax ID Number.
  7. File an initial report (if required).
  8. Start a corporate records book.
  9. Hold your first board meeting.
  10. Complete additional federal, state, and local requirements.
  11. Comply with all licensing and zoning laws.
  12. Stay compliant annually by filing annual reports.

Have CorpNet incorporate your business –>

Steps to Form an LLC

  1. Conduct a business name search and choose a name.
  2. File Articles of Organization.
  3. Choose a registered agent.
  4. Decide on member vs. manager management.
  5. Create an LLC operating agreement.
  6. Apply and obtain a Federal Tax ID Number.
  7. File an initial report (if required).
  8. Complete additional federal, state, and local requirements.
  9. Comply with all licensing and zoning laws.
  10. Stay compliant annually by filing annual reports.

Have Corpnet form your LLC –>

Steps to Elect S Corporation Status

  1. Make sure the business is incorporated as a C Corporation or has filed as an LLC before filing for S Corporation election.
  2. A C Corporation must submit and file IRS form 2553 (signed by all shareholders).
  3. An LLC must submit and file IRS form 2553 (signed by all members).

Additional Resources

Whether you’re an accounting professional helping your clients better understand their options or a business owner who wants to learn as much possible about available business entity types, I encourage you to visit in CorpNet’s Learning Center for information. Also, tune into the recording of the webinar that this article is based on.

Note that those online sources are for educational purposes only and not to be mistaken for or used as tax, accounting, or legal advice. Every person’s and business’s situation is unique in some way. For tax, financial, and legal advice, individuals and businesses should consult licensed professionals for guidance when selecting an entity.

After business owners have made an informed choice, CorpNet welcomes the opportunity to assist them in preparing and submitting their:

  • State business registration forms
  • Initial reports and annual reports
  • Federal Tax ID Number (EIN) application
  • Business license and permit applications
  • S Corporation election

Also, CorpNet provides registered agent services in all 50 states. Contact us today for help with all of your business filings!

For all of you tax, legal, accounting, bookkeeping, and business consulting professionals out there, I extend the opportunity to join the CorpNet Partner Program. It enables you to expand your revenue stream by adding business formation and corporate compliance services to your offerings. You can partner with us as a white label Reseller, branding our services as your own, while receiving wholesale discount pricing that you can mark up. Or,  become a Referral partner who refers your clients to us in return for a referral fee. The CorpNet Partner Program is free, and there are no minimum sales volumes required. Learn more and join today!