LLCs Compared to Corporations
LLCs are similar to corporations in that they allow you to start a business without worrying about unlimited liability. However, in creating the LLC, state laws provide some advantages over corporations.
Advantages of an LLC
- Fewer corporate formalities. An LLC requires less formality than a corporation. Corporations must hold regular meetings of the board of directors and shareholders, keep written corporate minutes and file annual reports with the state. On the other hand, the members and managers of an LLC need not hold regular meetings, which reduce complications and paperwork. In a corporation, improper procedures may allow a creditor to pierce the corporate veil and hold shareholders liable.
- Tax flexibility. By default, an LLC is treated as a "pass-through" entity for tax purposes, much like a sole proprietorship or partnership. This means that LLCs avoid double taxation. However, an LLC can also elect to be treated like a corporation for tax purposes, whether as a C corporation or an S corporation.
- Special profit allocations. An LLC can make special allocations of profits and losses among members, whereas S corporations cannot. S corporations must have one class of ownership in which profits and losses are allocated according to the percentage of ownership.
- Property contributions. Contributing property to set up an LLC is not taxable, even for minority interest owners; whereas for a corporation, the Internal Revenue Code (IRC) only allows it to be tax free for the contributors who have control of the business.
- No ownership restrictions. An LLC may have an unlimited number of members, whereas an S corporation is limited to one hundred. The owners of an LLC can be foreign persons, other corporations, or any kind of trust, but the owners of corporations cannot be.
- Ability to use the cash method of accounting. Most limited liability companies can use the cash method of accounting. This means income is not earned until it is received. On the other hand, C corporations often must use the accrual method of accounting.
- Ability to deduct losses. Members who are active participants in the LLC's business can deduct its operating losses against the member's regular income to the extent permitted by law. Shareholders of an S corporation are also able to deduct operating losses, but shareholders of a C corporation are not.
- Ability to place membership interests in a living trust. Members of an LLC are free to place their membership interests in a living trust. In the case of an S corporation, placing shares in a trust can raise issues with the S corporation status.
Disadvantages of an LLC
- Profits are subject to Social Security and Medicare taxes. For an LLC that is disregarded for tax purposes, there can be the disadvantage that all earned income is subject to the self-employment tax, unlike in an S corporation in which some money can be taken out as salary and some as dividends. However, the LLC can opt to be taxed as a corporation and then opt to be taxed as an S corporation.
For a large business in which the owners take out salaries of $117,000 or more plus profits (as of 2014), there would not be much difference since the Social Security tax does not apply above that level. But for a smaller business, in which an owner would take out say, $30,000 salary and $20,000 profit, the extra taxes on the $20,000 would be over $3,000. If this is an issue, then you can still have an LLC, but you can opt to be taxed as a corporation, and then file IRS Form 2553 to be treated as an S corporation.
- Owners must immediately recognize profits. Unless an LLC elects to be taxed as a corporation, profits are automatically included in a member's income. On the other hand, a C corporation does not have to immediately distribute profits to its shareholders as a dividend. This means that shareholders in a C corporation are not always taxed on the corporation's profits.
- Personal liability for payroll taxes. The owners of an LLC that is taxed as a disregarded entity (like a partnership or proprietorship) can be personally liable for payroll taxes that are not paid by the company. Shareholders of a corporation would not be liable for these taxes unless they were officers or directors.
- Unfavorable state tax rules and fees. In some states, an LLC must pay higher taxes and fees than would a corporation that generated the same revenues.
- Fewer fringe benefits. Employees of an LLC who receive fringe benefits, such as group insurance, medical reimbursement plans, medical insurance and parking, must treat these benefits as taxable income. However, C corporation employees who receive fringe benefits do not have to report these benefits as taxable income.