WARNING: This is an extremely dry topic. Reading this post may result in drowsiness, restlessness and/or irritable behavior. Do not consume alcohol in excess and never operate motor vehicles or heavy machinery while reading this post.
Red Earth CPA makes no warranties of any kind, either express or implied, including but not limited to warranties of merchantability, vague interest by the reader, fitness for a particular purpose, of title, or of noninfringement of third party rights. Consumption of the article by a user is at the user’s risk. Talking to Red Earth CPA directly about this post will relieve boredom considerably.
One of the most popular ways to form a business in the past several years has been the Limited Liability Company (LLC). An LLC limits personal liability for the owners, protecting personal assets, similar to corporations, to limit the reach of plaintiffs in the event of lawsuits. Easier to form than corporations, this hybrid business form has been the go-to entity for many new ventures.
LLCs are issued at the state level. Each Secretary of State will register these businesses in their state just like they would a partnership, corporation or sole proprietor. However, unlike those other forms of entities, an LLC does not have a specific tax return for it.
The c-corporation, s-corporation, partnership and disregarded entity are the four options which the LLC may choose each with their own tax form.
But which one will save the most money on taxes?
Since the owner has the option to choose the tax return, the question is not which saves the most in taxes but which entity is the best choice for your LLC. Below is a discussion of the pros and cons of each of the four options available.
Commonly referred to as simply a corporation, the C-corporation is the entity chosen for most publicly traded companies. Stocks held in a brokerage and traded are almost always corporations. This is a well-established entity that can grow as large as needed.
Pros: The C corporation is not a “flow-through” entity and pays taxes at the corporate level. Since the passage of the Tax Cuts and Jobs Act in 2017, the income tax rate from 2018 forward is 21%, a very attractive rate. The tax return does not generate form K-1 for all the owners to incorporate into their personal returns, meaning your personal return will most likely be completed earlier than another form. Add to that, C corps have relatively straightforward rules governing how they can be used. With no limits on who can be a shareholder and an ideal structure to scale with venture capital and private equity, it’s easy to see why this is the choice for larger companies.
Cons: While technically an election, this is not a popular option for businesses looking for a quick and painless choice. To start, the C corporation is the selection for large publicly traded stocks, not smaller companies. There need to be employees of the corporation and, if one of the owners is an employee, those will be taxed again when the corporation issues a dividend. This is the dreaded double taxation; income is first taxed to the corporation and second to the owner when paid as a dividend. While the recent tax law cut the combined tax rate, the idea of double taxation for most smaller businesses is unpalatable.
Think of the “S” as standing for small. This entity was formed to simplify the C-corporation structure and does have some distinctions.
An S-corporation is a flow-through entity, meaning the corporation does not pay income taxes, rather it flows through to the owner. All profits and gains of the corporation are split out by activity, divided by the number of shareholders, and sent to the shareholder via the form K-1. The shareholders include the income in their personal tax return. The fact that the S-corporation does not pay taxes may make life easier for the shareholder as they can look at the activities of the corporation and their personal situation as one entity.
Pros: One of the major benefits to structuring an LLC as an S-corporation for tax purposes is the ability to limit self-employment taxes. (Self-employment taxes are the employer’s and the employee’s portion of Medicare and Social Security taxes. This can add an additional 15% in taxes to a small business owner.)
The IRS expects an S-corporation to hire someone (usually the owner) and maybe others as well.
Effectively, the corporate structure splits the role of owner and employees. Joe the owner of the corporation now needs to pay Joe the employee a wage. (Determining that amount is the topic of “reasonable compensation”.) This allows the owner of the corporation to choose how much payroll tax to pay. This is a very attractive option.
How often do you get the choice of how much tax to pay?
When the IRS accepts the S-corporation election, the acceptance letter includes some moderately threatening language that they can force the owner to pay payroll taxes if s/he distributes money without paying wages. This is boilerplate language essentially admitting that this is a structure that will limit payroll taxes, which is arguably the most attractive benefit of this structure.
Cons: Payroll must be set up with an S-corporation. That will involve a payroll provider, bookkeeping and an extra tax return with the accompanying K-1. Some limitations of the S-corporation is it can have no more than 100 shareholders, no corporation or partnership may be shareholders and the shareholder must be a US citizen or resident. The S-corporation is inherently more complex than a disregarded entity and issues such as basis and corporate tax codes are always in play, which will add to the accounting and legal fees.
The default tax filing option for more than one owner is to file as a partnership. While this seems as simple as two people going into business together and splitting the proceeds, it can quickly turn into the most complex business form.
Pros: Similar to an S-corporation, a partnership reports the financial activity on a tax return and then splits that activity by partner into a K-1. Unlike a corporation though, this can be split multiple ways. Profits can be allocated differently than capital, one partner can contribute sweat equity for a portion of the partnership and one partner can take money out when another partner does not. Partnerships are excellent for real estate and the flexibility of this option means there are many ways to negotiate a deal.
Cons: I’ve heard more CPA’s say they hate partnerships than any other business entity. The flexibility is great but it means the calculations, tax code and details are more complicated, leading to higher legal and accounting bills. Speaking of legal, tax attorneys camp out around this entity and are often needed in complex situations.
“Phantom” income, income recorded without receiving cash, can be produced from a reduction in debt in certain situations and can lead to partners owing taxes without taking money out of the partnership! This unwelcome surprise requires the owner to work closely with a tax advisor. In addition, the income to the partners can be subject to the self-employment tax, potentially adding an additional 15% in taxes to their income.
4. Disregarded Entity
This form is a fancy way of saying that there is no separate tax form to file. Disregarded entities keep the legal protection of the LLC while requiring no additional tax return for the owner. In the eyes of the IRS, they disregard the LLC for tax purposes.
Pros: LLCs report their income on the owner’s form 1040 just like they would without the LLC. The simplicity of this approach means the accounting is not as strict for reporting. The tax advisor fees are lower as there is no separate return to file.
Cons: An LLC filing as a disregarded entity has no tax advantages over a company filing on the same form. The income is still subject to the self-employment tax and this option is primarily to gain legal protection.
While the LLC continues to be a popular entity, forming one by itself does not save money on taxes. The decision still needs to be made how to file the LLC’s return. Tax savings can be realized in choosing the best tax reporting. Industry, income, length of business history and future plans must all be considered when choosing how your LLC should file taxes.