If you're reading this, you very well may be considering launching your own business. If so, congratulations for taking this next step toward becoming an entrepreneur. If not, cheers to you for wanting to become that much more financially savvy. Of course, to have your business plans officially in action, you're going to have to figure out the best legal structure under which to incorporate your new company. Two of the more common business organizations are corporations and limited liability companies (LLCs). Both arrangements present pros and cons. As an owner of a small- to medium-sized enterprise, your potential tax burden will come to the forefront of well, your burdens. In terms of sorting out the legal structure of your business, you need to look at your accounting to sort out what corporate tax structure will suit you.
What Is A Corporation?
Essentially, a corporation is a legal entity that has "limited liability" separate from that of the individuals who own it. Both LLCs and corporations fall under this definition. Practically speaking, the difference lies in the taxation formula and the amount of paperwork the company is willing to handle. A C-corporation is subject to the standard corporate taxation structure after said enterprise goes through filing the necessary paperwork with the state. A sort of middle path between C-corporations and LLCs are S-corporations, which do not pay any federal income tax. Instead, S-corporation shareholders get apportioned the corporation's income and losses and accordingly make the declarations and deductions on their individual income tax returns.
What Are The Pros And Cons Of Filing As A Corporation?
In terms of accounting, the biggest advantage to incorporating as a C-corporation is being able to shift business income to take advantage of taxation under different tax brackets. Generally the higher the tax bracket, the higher the tax rate. As of the time of writing, the maximum statutory corporate income tax rate in the United States is 35 percent. Effectively, this rate is often much lower, thanks to deft use of tax breaks. Some major US companies such as General Electric Company(NYSE:GE) often pay a negative effective amount in federal income tax via loopholes. A commonly used one is moving corporate profits into other expenses such as salaries. For example, a C-corporation pulling in $100,000 would be taxed at 25 percent. An easy way to lower this rate would be to declare half of that amount as salary, leaving the corporation's earnings in the 15 percent tax bracket. Shareholders of a C-corporation are also taxed on dividends from the company.
Another factor to consider when deciding on what business structure works better is paperwork versus company benefits. By law, corporations have to hold board of directors' and shareholders' meetings and keep official files of corporate proceedings. LLCs don't need to do this. On the other hand, corporations can offer employees investment plans such as stock options, stock purchase plans and associated retirement plans. Given that LLCs are not publicly owned corporations, obviously they cannot offer stock options in their company.
But with a clearer taxation outline comes less daily freedom. Corporations have more rules as to governance of the company. The board of directors are responsible for the overall management of the company; the officers for the day-to-day. An LLC allows the management to be decided upon by the partners in the group; however they often do not have personal liability of the company. In a corporation, shareholders do not have liability, meaning the buck—both literal and figurative—stops with the management.
What Is An LLC?
An LLC is a loose form of corporate structure that's relatively new to the United States—the IRS didn't even have a position on the structure until 1980. Today, the IRS website defines limited liability corporations as "a business structure allowed by state statute," then goes on to say "the federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file a corporation, partnership or sole proprietorship tax return."
An LLC, by default, is not taxed as a corporation, but more like a sole proprietorship. Accountants and tax lawyers call this a "pass-through" entity. Partners' individual portions of the LLC's earnings are used to calculate their own tax liability, in terms of income, credits and deductions.
What Are The Pros And Cons Of Filing As An LLC?
LLCs do offer more flexibility. Payouts from the LLC are not taxed like dividends from a corporation. An LLC can indeed file for tax as a corporation using IRS form 8832, however. In this case, dividends would be liable to tax. A tax break to which S-corporations and LLCs are privy is their partners' eligibility to deduct losses from their regular income. C-corporation shareholders do not have this privilege, making LLCs more attractive on this end. LLCs can deduct their company's profits and losses from their personal tax returns, given the near-self-employment status accorded by this corporate structure. S-corporations also offer this accounting option.
And also, as mentioned above, there's less paperwork involved in terms of reporting corporate proceedings—no board meetings necessary, beyond perhaps a leisurely coffee or an online chat. But without some sort of incorporation, an LLC does not have the accounting option to shift around income to benefit from lower tax brackets. If an LLC does not opt to file taxes as a corporation, its salaries and profits are subject to self-employment taxes, which add up to a combined 13.3 percent.
Be sure to take into consideration state-level tax laws. In some states, tax laws effectively make LLCs' default tax liability privy to double taxation. Filing as an S-corporation is an easy way to avert some of these taxes. If a company incorporates, its profits are not liable to payroll taxes such as Social Security and Medicare. Given the relative novelty of LLCs, it may be difficult for them to secure credit. Ask around to gauge a sense of where LLCs stand in your target markets. Plus, in terms of securing funding, LLCs cannot issue stock to potential investors like corporations do.
Keep in mind that some common employee benefits, such as health insurance and term-life insurance, have taxes associated with them for LLC participants, sole proprietors and shareholder-employees of S-corporations owning 2 percent or more of the company. Essentially, the difference between an LLC and a corporation is like that between freelancers and permanent employees: where one offers freedom, the other offers straightforward accounting.