Nobody likes paying taxes, but it’s smart to consider the tax consequences of your business structure before you set up your business.
Limited liability companies and corporations are both popular types of businesses, but LLC taxes can be very different than corporation taxes. Here’s what you need to know.
For tax purposes, there are two types of corporations: C corporations and S corporations. All corporations start out as C corporations, but some can choose to be taxed as S corporations by filing a form with the Internal Revenue Service.
C Corporation Taxes
C corporations file a corporate tax return and pay corporate income tax on the company’s profit. If the corporation distributes some or all of that profit to shareholders, the shareholders pay personal income tax on those distributions. Because distributions are taxed at both the corporate and the shareholder level, C corporations and their shareholders often end up paying more in taxes than S corporations or LLCs.
S Corporation Taxes
S corporations don’t pay corporate income tax. Instead, the corporation’s profits pass through to the shareholder’s personal tax returns, and each shareholder pays personal income tax on his or her portion. For this reason, S corporations are known as “pass through entities.”
Corporations must meet certain requirements to be eligible for S corporation taxation:
- There must be 100 or fewer shareholders.
- Shareholders cannot be partnerships, corporations or non-resident aliens.
- There can only be one class of stock.
A corporate shareholder who works in the business is considered an employee. The corporation pays half the employee’s Social Security and Medicare taxes and withholds the other half from the shareholder-employee’s salary. A shareholder’s profit distributions are not subject to Social Security and Medicare taxes.
Shareholder-employees can sometimes minimize their taxes by taking a lower salary and a greater amount in distributions. However, the IRS requires that all shareholder-employees be paid a reasonable salary for the work they do, so if a shareholder-employee is being paid too little as a salary, they could be in trouble with the IRS.
LLCs are more flexible than corporations when it comes to taxation. Because an LLC is a relatively new type of business entity, it doesn’t have its own tax classification with the IRS. Instead, it can choose from one of three classifications:
- Disregarded entity taxation. When an LLC is taxed as a disregarded entity, it’s as if the LLC was a sole proprietorship or a partnership. The LLC’s income and expenses pass through to the owners’ personal tax returns. The LLC tax form is Schedule C of that return. An LLC will be taxed as a disregarded entity unless it chooses to be taxed as a corporation.
- C corporation taxation. By filing form 8832 with the IRS, an LLC can choose to be taxed as a C corporation.
- S corporation taxation. If an LLC meets the requirements for S corporation taxation, it can elect corporate taxation and then file form 2553 to be taxed as an S corporation.
If an LLC is taxed as a disregarded entity, its owners who work in the business are considered self-employed. The LLC does not pay any of their Medicare or Social Security taxes (also known as self-employment taxes). The owners must pay the full 15.3 percent self-employment tax for income up to $118,500, and 2.9 percent for additional income above that amount.
An LLC taxed as a corporation can treat its shareholders who work for the company as employees and enjoy the same employment tax benefits as corporations.
LLC Tax Advantages
To summarize, LLC tax benefits include:
- The ability to choose to be taxed as a disregarded entity. If your business doesn’t qualify to be an S corporation, this is the only way to receive pass through taxation.
- Simplified LLC tax filing. An LLC taxed as a disregarded entity does not have to file a corporate tax return, and a single member LLC need only file a personal return.
- Greater flexibility: your business can be taxed as a disregarded entity now but change to corporate tax status later.
Corporation Tax Advantages
The tax advantages of corporations include:
- The potential to minimize Medicare and Social Security taxes for shareholder-employees. However, you’ll also have the additional cost and hassle of managing payroll if you don’t have other employees.
- S corporations enjoy pass though taxation and aren’t taxed twice on corporate dividends.
- C corporation taxation can benefit companies that plan to leave money in the company bank account instead of distributing it to shareholders. That’s because profits that remain with the company are taxed at a lower corporate tax rate and aren’t taxed again as dividends.
- Some retirement plans, stock option and employee stock purchase plans are only available for C corporations.
- C corporation shareholders do not pay tax on certain employee benefits, including health benefits, life insurance benefits, and employer contributions to flexible spending accounts and health savings accounts. LLC members and S corporation shareholders who own more than 2% of the business must pay taxes on these benefits.
LLC vs. corporation? Take the time to evaluate your options before you make a final decision. And if you aren’t sure, get advice from a tax accountant who has experience with small business taxation.
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