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Tax Considerations

We are going to examine the chief differences, advantages and benefits of important tax considerations of incorporating and comparing Corporations and Limited Liability Companies. These two entities share features and have broad differences that should be weighed carefully.

Not all tax advantages are created equal. Finding the right combination for you is essential.

We are going to have to branch out a bit from just discussing Corporations compared to LLC’s and include a Corporation with a different tax classification, the Sub Chapter S Corporation. A standard “C” Corporation is taxed on a corporate level. This means that the corporation files its own tax return and pays taxes itself. The shareholders of a C Corporation pay taxes on income and distributions from the business. This means that shareholders are subject to what is called “double taxation”. The IRS has a section of the tax code for Corporations, when you incorporate and complete an IRS form, that allow pass through taxation, that also has some limitations, which we will discuss briefly. Filing IRS Form 2553 and applying for the S Election redefines how the entity is taxed. The income is passed through the Corporation and the profit and losses are then reported on the shareholder’s personal tax returns. This is quite similar to sole proprietorships and partnerships. This is a great advantage for some businesses, incorporating the strength of a Corporation for protection, with favorable taxation. The limitations are the number of shareholders and who/what can be a shareholder. C Corporations can have unlimited amount of shareholders and another Corporation can be a shareholder as well as open the door for foreign investors, who can own stock. S Corporations have to be owned by domestic individuals and are limited to 75 shareholders total. In most cases for small business, this is hardly a limitation. The chances are that if you’re going to incorporate and have more than 75 shareholders, that you would have this process performed by a small army of attorneys.

Comparing Tax Scenarios When Incorporating

Right off the bat, the Limited Liability Company is the most flexible when it comes to taxation, there are many options. By default the LLC is taxed as a sole proprietorship, for single owner LLC’s, or a partnership, for multiple owner companies. Corporations are taxed as a separate entity, by default. The corporation pays income taxes on revenue as well as the shareholders on income. S Corporations are a special IRS classification that allows pass through taxation to the shareholders and this is the only taxation method.

When you incorporate, a primary feature of being incorporated are the tax benefits. Deducting necessary business expenses in categories provides some relief from the overall tax bite on your business revenue. Corporations and LLC’s vary with allowed deductions when it comes to employee benefit plans, contributions to retirement and healthcare. For example, corporate shareholders can deduct officer health plans, whereas LLC members pay income tax on that contribution as income. We’re not going to perform a side-by-side comparison with allowed IRS deductions between incorporated entity types and tax classifications here, however we will illustrate the landscape and keep the focus on making the right decision for you when you choose to incorporate your business.

Limited Liability Company Taxation

This scenario is about a good as it gets. By default all profit and losses are passed through the business to its owners, who report it on their personal tax return. This is the same as a sole proprietor or partnership. Very simple taxation. The LLC can file for several different tax classifications by preparing IRS Form 8832. The LLC can opt for being taxed as a Corporation. Furthermore, if the LLC has this election, it can then elect Sub Chapter S as well. Being taxed as an S Corporation.

Why would you choose corporate taxation on an LLC?
C Corporations are taxed on the profits remaining in the business at year end. The tax rate is that of a Corporation, lower than that of an individual. This can be used as a tool for asset protection, LLC legal provisions protect the company assets in the event a member is sued. Another key to Corporation’s and taxation is that you can choose a fiscal year when you incorporate, however this can be changed later with some paperwork. This is a month and your tax year ends on the last day of that month. This opens the door to additional flexibility, so that you can shift personal income from one year to another. When you incorporate an S Corporation, you will have a calendar year end so this is not possible. Corporations and LLC’s electing to be taxed as a Corporation can choose a fiscal year end date for increased financial flexibility in regards to taxation. Corporations can write off 100% of medical expenses for employees and their dependents. An LLC that elects to be taxed as a Corporation has the same benefit.

Why would you choose S Corporation taxation on an LLC?
S Corporations are a strong choice for active businesses. Passive income businesses tend to lean toward the flexibility of a Limited Liability Company. The S Corporation will have a calendar year end date in December, just as an individual’s personal tax year end date. This opens the door for shareholders to pay themselves a reasonable salary and still take distributions from the business. Distributions are void of Social Security and Medicare taxes. This is a 15.3% savings on income received as shareholder distributions.

Other LLC Tax Considerations

The limited liability afforded by the LLC formation is a very obvious benefit that it offers. In addition, there can also be tremendous benefits based on the flexibility by which the LLC can be taxed. Members of an LLC can, via the “check box” method, elect to have their LLC taxed as either a C corporation or, by timely filing the 2553 form, as an S corporation. By default an LLC is taxed as a sole proprietorship if it is a single-owner LLC, or as partnership if it has two or more owners. All options should be examined to determine which method provides the greatest tax relief. Regardless of the method of taxation, the legal liability shield remains in place.

Entity Classification Selection (Filing Form 8832)

The IRS has created a form to deal with the manner in which an LLC is to be treated for taxation purposes: the “check the box” form, form 8832. It greatly simplifies the once complicated process of allowing the LLC members to elect how they would like their entity to be treated for tax purposes. Both single and multiple member LLCs may use the form. Though most often times multiple member LLCs wish to be treated as an S corporation or partnership in order to benefit from the pass-through taxation, this should not automatically be assumed as, ideally, members of all tax-classifications of LLCs may be best-served to file form 8832 as an affirmative selection of the manner in which they want their entity to be taxed.

LLC Taxed as a Partnership or S Corporation

LLCs with more than one member are usually classified as a partnership for tax treatment purposes, though it is not mandated. A multiple member LLC can elect to be treated as a C or S corporation, but it would lose the pass-through taxation benefits afforded the partnership tax treatment with C corporation tax treatment, and is limited with respect to how many members it can have and prevents non-citizen/resident alien ownership with the S corporation taxation. Subject to the subchapter K of the Internal Revenue Code governing the taxation of partners and partnerships, electing to have your LLC taxed as a partnership would subject it only to a single Federal Income Tax at the partner level, with each member reporting his share of each item in the LLC’s gain, loss, income, deduction, or credit on his personal tax return.

The restrictions on the equity and capital structure of an S corporation can significantly limit the flexibility in strategic planning for your company, especially for growth, changes in stock types, inter-generational business transfers, etc. Among these restrictions, for example, are the limitation that an S corporation can have no more than 75 shareholders, and that shareholders can only be individuals and estates (some trusts, but not other corporations). Another limitation is that an S corporation can only issue one class of stock, thus limiting one of the LLC’s flexibilities in that it can have varying levels of ownership interest.

Basis of Member Interest in the LLC

Members of LLCs taxed as Partnerships typically obtain basis in their LLC interest from the contributions/payments for their membership interest. Each member or partner has a basis in his partnership interest that is separate from the partnership’s basis in its assets. Partnership interest is treated as an interest in a separate entity comparable to stock in a corporation. A member must know the basis for his interest for a number of tax purposes, including:

  • Computing his gain or loss when he sells or relinquishes the interest
  • Computing his gain or loss on a distribution from the LLC
  • Determining his basis in property distributed by the LLC
  • Determining the maximum amount of partnership losses he may deduct

When Limited Liability Company membership interest is purchased, the purchaser can step up the tax basis of his/her unappreciated LLC assets to reflect the purchase price pursuant to internal revenue code Section 754. There is no similar adjustment provision available for purchasers of “S” or “C” corporate stock.

Distributions to Members

A member may generally receive distributions of partnership property without recognizing a gain or incurring a loss. The distribution is treated as a non-taxable withdrawal of the member’s investment up to the level of his interest in the membership.

A member does, however, recognize a gain on a current distribution if it exceeds his level of investment or interest in the LLC. A partner may not recognize a loss on a current distribution, though he may recognize a loss on a distribution that consists solely of liquid assets, cash, or unrealized receivables. The loss would be limited to the difference between a member’s basis for his interest and the sum of the distribution. These gains or losses are treated as capital gains or losses for taxation purposes.

Tax Consequences of Capital Contributions

Cash contributions to an LLC are not much different than a cash contribution to a corporation or partnership. No gain or loss is recognized, and the contributor’s basis for the stock or interest he receives is typically deemed to equal the amount of cash he contributes. Contributing property, however, has a significantly different impact. In an LLC, gain or loss in contributed property is deferred until the partnership sells that particular asset or the contributing member sells his or her share in the LLC. The contributing member does not recognize a gain or a loss at the time of contribution, irrespective of the percentage of his ownership allowed by the operating agreement. When the LLC sells the contributed property, the gain or loss that was not recognized initially is now recognized and allocated to the contributing member.

This is in direct contrast is the transfer of appreciated property in a C or S corporation in exchange for stock interest. In this instance the transaction is taxable unless the contributor controls the corporation through ownership of at least 80% of the stock.

In a C corporation, the corporation is taxable on any gain or loss when it disposes of the contributed property, though there would be no tax consequences to the shareholders. In an S Corporation, gain or loss that the corporation recognizes when it disposes of the property passes through to the shareholders in direct proportion to their stock ownership/investment. The gain or loss is not allocated to the contributing shareholder.

These scenarios exemplify why it is critical to understand the type of business in which your company will be engaging and what taxation model best suits your LLC.

Taxation of LLC Income and Loss

Speaking strictly in taxation terms, an LLC, when taxed as a partnership or sole proprietorship is not a separate tax-paying entity in the eyes of the IRS. Each member is separately and individually liable for the taxes on his share of the LLC (profits, losses, deductions, and credits). Each member must report his share of his tax liability, and each tax liability retains the same character it had when earned or incurred by the LLC. The pass through of items to members means that income avoids being double taxed, and losses may offset income that the member may have from other sources.

In direct contrast, a C corporation is a separate entity for even tax purposes and is such, is required to pay its own taxes. Income and profits are taxed at the corporate level when earned, then taxed again when distributed to the various shareholders as dividends. Dividends are always taxable as income, irrespective of the source. Therefore, when distributing corporate profit, it may be advantageous to pay the gain as salary or bonus rather than as a dividend, which is tax-deductible to the corporation.

S corporations are taxed in a somewhat similar fashion as are partnerships. The tax burden on retained earning in an S corporation passes through to the individual shareholders. Each shareholder reports his percentage share of the income on his tax return. However, the income can be re-characterized. For example, if the S corporation earns profits that would be taxed as ordinary income if earned by an individual, the S corporation can pay the earnings as a “distribution to shareholders.” When one received payment in this fashion, they can avoid Social Security and Medicare tax, currently a 15.3% tax savings. One must tread carefully with the LLC as an S corporation because the LLC may be taxed as a C corporation, even if the S corporation election is made, if the requirements are not met and it is operated like a “regular” corporation. For example, if the entity has even one foreign owner it will be deemed to be a C corporation for taxation purposes. Similarly, if excessive passive-type income is generated by corporate assets or if the corporation disposes of assets that had built in gain when the election was made to be treated as an S corporation, the IRS may see fit to tax the LLC as a C corporation.

LLC Termination

Change in ownership of the corporate shares does not terminate a “C” or “S” Corporation for Federal Tax purposes, unless the change involves foreign owners. Because a multi-member LLC can be considered a Partnership, it is subject to the Termination Rule of IRC Section 708(b). An LLC terminates for Federal Income Tax law purposes whenever 50% or more of the interest in capital and profits are sold within a 12 month period. This means that even though the LLC may technically still be in existence under State Law, for tax purposes, it terminates and re-starts. This has the same effect establishing a new entity for accounting purposes, and brings the current LLC tax year to a close.

LLC Tax Classifications

There are four main ways that an LLC can be taxed in the United States:

  • As a sole proprietorship
  • As a partnership
  • As a C corporation
  • As an S corporation

This article provides information and examples of the four ways that the limited liability company is taxed. The article ends with a summary of why one might choose one method of taxation over another.

LLC Taxed as a Sole Proprietorship or Partnership

By default if an LLC has one member (“owner”) it will be taxed as a sole proprietorship. Likewise, if it has two or more members it will be automatically taxed as a partnership unless you elect otherwise. When taxed as a sole proprietorship or partnership, income and deductions flow through to the members of the company. Such flow-through taxation is the preferential tax treatment for real estate investors according to many tax advisors because taxes will be minimized. This is because the real estate tax deductions and other tax benefits flow through to the owners of the LLC. Plus, there will be no federal income tax on the company itself.

It is important to note that how an LLC is taxed and how it protects you legally are separate issues. An LLC taxed as a sole proprietorship or partnership can still offer substantial legal protection. Whereas, sole proprietorships and partnerships themselves, (such businesses that are not corporations or LLC’s) offer little, if any, liability protection to business owners.

Here is an example. John is a real estate investor. He establishes one LLC for each property, or group of properties. Therefore, when there is a lawsuit stemming from one property, the lawsuit does not attach properties in John’s other LLCs. Additionally, when John is sued personally, such as a car crash where John is sued for more than his insurance limits, there are asset protection provisions in the statutes such that assets inside John’s company are protected from being taken from him.

John also enjoys tax benefits offered by his legal entities. The real estate depreciation deduction on John’s properties flows through to his personal tax returns, reducing his personal income taxes. John does not have to pay Social Security (12.4%) or Medicare (2.9%) on his rental income, saving him 15.3% in taxes. John can use his company to participate in 1031 tax deferred exchanges where the profit produced on the sale of one property can be rolled into one or more other properties without paying income taxes. So, the tax benefits remain intact and John enjoys the added benefits of lawsuit protection stemming from liability on his properties.

John also enjoys asset protection. His properties are owned by properly structured limited liability companies. The statutes provide that when John is sued personally, the assets inside the companies are protected from being taken from a member of the companies. So, when legal liability strikes his personal life, the properties he worked so hard to acquire can be protected from seizure.

LLC Taxed as a “C” Corporation

An LLC can be taxed as a “C” corporation by filling out the IRS form 8832, titled the “Entity Classification Election,” and electing corporation taxation status. The election says, “A domestic eligible entity electing to be classified as an association taxable as a corporation.” The LLC will then be taxed as a C Corporation separately from the owners. Profit remaining in the LLC after the end of its tax year will be taxed at corporate tax rates, which, incidentally, are often lower than personal tax rates. This is often chosen when a client desires asset protection and financial privacy. Since the company is taxed separately from the individual, the income need not appear on one’s personal tax returns, giving the members additional privacy. Plus, there are provisions in LLC law that protect company assets from being taken when a member is sued.

Additionally, with C corp. taxation you can choose a fiscal year rather than a calendar year. When you choose a month on which to end your tax year, the tax year will end on the last day of the month you have chosen. For example, if you choose March as your tax year end, the tax year will end on March 31 of each year. Many professionals suggest choosing a calendar quarter, which corresponds with quarterly filings; March, June or September, for example. The benefit of choosing a fiscal rather than a calendar year is that this allows you to move money from one tax year to another.

For example, Ben ordered an LLC to be formed. He elected C corporation taxation status on the 8832 form and chose a March tax year end. He had a customer who placed a sizable order in June that resulted in profit of $100,000 more than his business usually earns. Next year, he does not expect the additional $100,000 in income. He does not want to bump himself into a higher tax bracket this year by paying himself the entire amount as a salary or bonus in one calendar year.

So, Ben writes a check to himself out of the corporate checkbook $50,000 before December of that year and adds that amount to his personal income taxes. The $50,000 salary he has paid himself is taxable income to him and is a tax-deductible expense to the corporation. The remaining $50,000 of extra profit remains in the company.

Before March of the next year, he pays himself the remaining $50,000 of excess profit by writing another check from the corporate checkbook. This is also tax deducible to the company Thus, he clams the $50,000 on the following year’s personal tax returns. If he had claimed the entire $100,000 of extra income on his personal income tax returns in one tax year it would have bumped him up to a higher personal tax bracket.

So, Ben used his entity taxed as a C corporation to move part of the money from one personal tax year to another. He has made the same amount of money. But he has used the offset tax year between himself and his company to pay less of that money in taxes by keeping himself in a lower personal income tax bracket. He has saved himself thousands of dollars in income tax.

Finally, when an entity taxed as a C corporation the company can write off 100% of medical insurance and related medical expenses for all employees and their dependants. Medical insurance, insurance deductions, prescriptions, aspirin, bandages can all be deducted through the C corporation.

As an example, Nick and Betty Johnson have a son with diabetes. The disease has resulted in substantial medical expense for the family. Personally, the IRS only lets you deduct medical costs if they are more than 7.5 percent of your adjusted gross income. So, first chunk of medical expenses are not deductible. Medical expenses must reach a great threshold before deductibility kicks in on one’s individual tax return. Then there are great limitations on the deductibility of those expenses. That is, there are substantial limitations as to what can and cannot be deducted.

Knowing this, Nick and Betty elected C corporation status for their business and have adopted a corporate medical plan. Now, all medical expenses for all family members are deductible, starting with the first dollar. In addition to other tax benefits, the Johnson’s save several thousand dollars each year on the medical deductions alone with their C corporation.

LLC Taxed as an “S” Corporation

An LLC can be taxed as an “S” corporation when, after choosing the corporation election on the 8832 form, the IRS tax form 2553 “Election by a Small Business Corporation” is subsequently filed with the IRS. All owners of a limited liability company taxed as an S corporation must be US citizens or resident aliens. With rare exception the tax year-end must be December.

The S corporation election is considered by many to be favorable for active businesses (as opposed to passive investment businesses) when the owner wants to spend all or most of the profit generated by the business. This is because, in addition to a “reasonable” salary that is paid to the owner of the company, the shareholders can receive income in the form of “distributions” to shareholders. Distributions to shareholders are free from Social Security (12.4%) or Medicare (2.9%) taxation. So by paying oneself a small but reasonable salary and paying the rest of the corporate profits as a distribution to shareholders, one can save 15.3% in taxes. That is an extra $1530 that the owner can keep in his or her pocket for every $10,000 paid in this fashion.

Bill has a lawn care business with several employees. He has formed a company and elected the S status by filing an IRS form 2553. His business earns him $100,000 per year. He pays half of the $100,000 as a salary and the other half as a distribution to himself as a shareholder of the company. So, he pays himself what the IRS would consider to be a reasonable salary, let’s say $50,000 per year. He pays himself $2083 on the 15th and the 30th of each month. He pulls out his corporate checkbook and writes a check payable to himself. On the memo section of the check he writes the word “Salary.” He or a payroll service he hires calculates and deducts the required taxes and he writes the check to himself for the rest.

Then he pays the remaining $50,000 to himself as a distribution to shareholders. As income allows he writes checks from his corporate checkbook to himself throughout the year. He pays this to himself several time a month as income allows. He writes “distribution” on the memo section of the check. He does not have to pay the 15.3% self employment tax on this income (which consist of the 12.4% Social Security and the 2.9% Medicare tax). So he saves $50,000 X 15.3% = $ 7650 in taxes by choosing the S election.

So, there are four ways that an LLC is taxed. Here are the common reasons why one would choose each type of taxation:

  • As a sole proprietorship – when the business has one owner.
    • To own real estate rental property
    • For a business that has passive investment income such as stocks, bonds and mutual funds.
  • As a partnership – when the business has two or more owners.
    • To own real estate rental property
    • For a business has passive investment income such as stocks, bonds and mutual funds.
  • As a C corporation
    • For financial privacy to keep business income from appearing on one’s personal tax returns.
    • For an individual or family with high medical expenses
  • As an S corporation
    • To operate an active business.
    • To save the 15.3% self employment tax (consisting of Social Security and Medicare) on distributions to the shareholders.

Incorporating and Tax Advantages

Now that we have mentioned some of the chief characteristics of tax benefits and differences between the incorporated entities, we can bring this back around to selecting the type of business to incorporate.

LLC’s can be taxed as any entity, sole proprietorships, partnerships, corporations and S corporations. Very flexible, so if taxation is your biggest factor when incorporating, this may be something you want to investigate further, all of the options are here.

Corporations are taxed on its income as well as the shareholders. This may seem like a disadvantage, however shareholders can be any legal entity or person, foreign and domestic and the number is unlimited.

S Corporations are taxed as sole proprietorships or partnerships and allow for Corporation allowed deductions, however lack the flexibility of ownership. Owners of an S Corporation must be a legal resident or legal alien and there can be no more than 75 shareholders. S Corporation’s fiscal year end date is December 31, so the business and your personal tax year ends on the same day.

Before you incorporate, you should examine your true focus. Incorporating for tax advantages opens the door to a myriad of scenarios. Choosing what is right for you is important. Here are some general guidelines:

  • Pass Through Taxation: When a business has a single owner and by entity type is granted pass through taxation. This is a consideration when there is a passive income situation, such as holding accounts, stocks, mutual funds and bonds. Owning real estate is another passive investment consideration where business deductions and employee plans aren’t important in the planned tax scenario before you decide to incorporate a business. This is how an LLC is taxed, by default, as well as sole proprietorships and partnerships.
  • Corporate Taxation: When an active business spends all or most of its income, this is recommended when health plans and contributions are a primary consideration. Asset protection is increased when a shareholder can keep profits in the company that do not appear on personal tax returns or financial statements.
  • S Corporation Taxation: When operating an active business and reducing shareholder tax responsibility on a portion of his/her income by 15.3%.

Understanding how your business form benefits you now and when you are growing is important. Incorporating and forming an LLC have different advantages for businesses in different stages. Know how your business structure will serve you as you now and years after you incorporate. We will cover some advantages and how the LLC can change its status to support phases of your business after incorporating.

Understanding the advantages of the entities and the growth of your business is essential when you decide what form of business to incorporate

We’ll examine income taxation and compare how the Corporation and the LLC offer different advantages. For starters, General For Profit Corporations are taxed as a separate entity. Pass through tax entities, such as the Limited Liability Company, do not pay taxes themselves, the owners of the entity have the liability on their personal income tax return. For example, if a Corporation has $50,000 of profit in the business bank account, that sum is taxed at corporate rates. If an LLC has the same amount of profit in the company, the owners are responsible for the tax liability on their personal returns, whether they distribute the money to themselves, or not.

Disadvantages of Corporate Taxation

If the business has little or no need to accumulate money, then corporate tax treatment may not be the best scenario. A Corporation will pay Taxes on any profits that remain in the business. So the situation here presents two levels of taxation:

  • Personal Income Tax: Shareholders and employees will pay income taxes on all salary and distributions on their personal income tax returns.
  • Corporate Income Tax: As a separate entity, the Corporation will pay taxes on any profit remaining in the business.

Advantages of Corporate Taxation

Now we can get into income splitting and how the corporate taxation can be a huge asset to grow your business. When you need to accumulate money in the business for future expenses, such as inventory or office equipment, a corporate tax scenario will allow you to do this with some savings on the overall bite the IRS will take. Lets take an example where there is $100,000 remaining profit in the business. If the entity was not incorporated or subject to pass through taxation, that amount would be the responsibility of the business owners on their personal income tax returns and taxed at a rate of their tax bracket. If funds were to be left in the business for future expenses, the owners could distribute half of the profit to themselves and leave the other $50,000 in the company which would be taxed at %15, the corporate tax rate. This saves the owners money at the end of the year. Remember that if this were an LLC the entire $100,000 would be taxed on the owner’s personal return, whether the money was distributed or not.

LLC Taxation Advantages

Previously we discussed in this guide that an LLC can choose its tax status with the IRS. You can incorporate as a Limited Liability Company and have the advantageous pass through taxation when you are taking all of the profits out of the business and when that isn’t an advantage any longer, you can elect corporate tax status. This will put the company into a position where income splitting is possible for a different phase of your business.