When starting a business there are many questions from new small business owners is around how the business is taxed. Starting a sole proprietorship or partnership provides no options on how the business entity is taxed, however forming a Limited Liability Company or corporation provides additional options.
The ability to change how an LLC or corporation is taxed can be confusing, but as you read through this remember that the business structure and limited liability protection doesn’t fundamentally change, but how it can be taxed with the Internal Revenue Service does.
When starting an LLC or a corporation, the IRS automatically defaults the taxation of the business for federal tax purposes. A corporation’s default tax status is as a C corporation. An LLC defaults to either being taxed like a sole proprietorship if it has one member, or a general partnership if it has multiple members. Remember that even if your LLC is taxed like a sole proprietorship, you still have a separate legal entity and the liability protection the LLC provides. This just refers to how the IRS treats the business for taxes.
However, you can elect to have your LLC or corporation taxed differently from the default status if it suits your situation better. We will explore the differences between electing S corporation and C corporation status, under the Internal Revenue Code for your LLC or corporation.
S Corporation Overview
What are the benefits of electing S Corporation status?
There are two major benefits of electing S corp status. The first is that it’s considered a pass-through entity, which means the business income and losses flow through to the shareholders of the company to report on their personal income tax returns at their personal tax rates. This avoids the double-taxation of other types of corporations, which are taxed at the entity level and again on dividends a personal taxable income. [1] Even though there is no income tax paid at the corporate level, an informational federal return (Form 1120S) is still filed with the IRS.
Another benefit of S corporation status that applies especially to small businesses is that the owners don’t have to pay self-employment taxes on their income distributions. This saves them taxes of 15.3% on those distributions!
Last, owners of pass-through businesses can deduct up to 20% of their qualified business income (QBI) that can effectively lower their personal income tax rates to 29.6%
What are the drawbacks of electing S Corporation status?
There’s a list of requirements in order to be eligible for S corporation status. They are:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- Shareholders must be residents or citizens of the United States
- May not be partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock (common stock)
- Some types of businesses are not eligible to be a corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).[1]
Another disadvantage is that any S corporation owners who also do work for the company must take a reasonable salary, which is subject to the 15.3% payroll taxes (Medicare and Social Security taxes). The owners aren’t allowed to just take income distributions as their salary, or take a very low salary to try to lower their tax burden. An additional consideration is that S corporations must use the calendar year as its fiscal year unless they can prove to the IRS that they need to have a different fiscal year for business reasons.
How to become an S corporation
To become an S corporation, all owners must sign IRS Form 2553, Election by a Small Business Corporation. You can file this form with the IRS online, by fax, or by mail. [1]
C Corporation Overview
What are the benefits of electing C Corporation status?
A traditional C corporation is not a pass-through entity, so it is taxed completely separately from its owners. Earnings are taxed at the entity level, and shareholders are taxed on any corporate income (typically as dividends or capital gains) that is distributed at their personal tax rates. One benefit of electing C corporation status is the flexibility in choosing a fiscal calendar. This allows shareholders to decide what year they want to pay taxes when to take losses, or pay bonuses.
Lower corporate income tax rates are another benefit of C corps. The most recent tax law, Tax Cuts, and Jobs Act of 2017 makes the corporate level rate of 21% which is lower than the maximum personal tax rate of 37%. [2]
Another benefit is the ability to take additional tax deductions on potentially significant expenses, such as fringe benefits like health insurance for employees, disability insurance, charitable contributions, and salaries and bonuses. Lastly, the ability to carry forward losses is very helpful for new companies since it’s possible to have a loss for several years before seeing a profit. C corporations can carry a loss back three years and forward up to five years.
C Corporations don’t have restrictions when it comes to the number of owners. Anybody can be an owner, and there are no limits to the number of owners either. Owners of an S Corp must be U.S. citizens and are limited to 100 shareholders.
Last, a C corporation has greater flexibility to raise investment capital as they can have an unlimited number of shareholders and multiple classes of stock (common stock and preferred stock) which allows for different voting rights.
What are the drawbacks of electing a C Corporation status?
We’ve seen earlier that an advantage of S corporations is that they are not subject to double taxation since they are pass-through entities, so that is the major disadvantage of a C corporation. Small businesses and startups usually don’t have dividends so that keeps the tax liability down for shareholders.
In order to elect a C corporation status, the company needs to incorporate, which can be costly. There are four types of incorporation fees: filing the articles of incorporation with the Secretary of State, a first-year franchise tax prepayment, fees for government filings, and attorney fees.
How to Become a C Corporation
Your corporation or LLC can elect C corporation tax treatment by filing IRS Form 8832, Entity Classification Election. [3] As mentioned before, an LLC is automatically taxed like a sole proprietorship (single member) or partnership (multiple members) unless they file IRS Form 8832. Once the LLC is a corporation, normal corporate tax rules apply and it needs to file a corporate tax return, which is IRS Form 1120, U.S. Corporation Income Tax Return. There are no pass-through items on a 1040 return.
How to Decide between S Corporation or C Corporation?
If your business only has a handful of partners (or less than 100, to be exact) and you’re looking for more flexibility in running your business, electing S corporation status is usually the better choice. Incorporating your business bogs you down in requirements and also makes it more difficult for partners to transfer their interest since interest must be sold in a corporation. Remember: an S corporation needs to be a U.S. domestic business entity and all shareholders must be U.S. citizens.
It’s smart to elect C corporation status if you are hoping to list on the stock exchange someday or raise capital from investors. It also allows for more ownership options, because C corporations can have multiple classes of stock while you can only have one in S corporations. There is also the 21% corporate tax rate to consider.
In addition to electing a tax status, keep in mind that corporations have additional administrative requirements like having a board of directors (which can be one person), having an annual shareholder and board of director meeting (even if there is only one), taking minutes at meetings, filing annual reports, and paying annual fees. Also, bylaws will need to be adopted ad shares of stock will need to be issued to owners.
Conclusion
Both S Corps and C Corps benefit from limited liability protection, which means shareholders aren’t responsible for a company’s business debts or financial obligations unless the owners sign a personal guarantee which is common with a bank loan.
Starting a small business is a learning process, and taking the time to understand the key differences in tax classification is time well-spent. There are lots of possibilities for your LLC or corporation depending on the direction you want to take it and what your existing legal structure looks like. While you may be confident and ready to choose, this is an important decision and it often pays to talk with a tax advisor to make sure the optimal choice is being made for your specific situation.
Sources
[1] https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations