Taxes are unavoidable - as an entrepreneur, you are going to have to pay tax in one form or another, regardless of your business structure. However, your business's tax burden could affect whether you choose to form a corporation or a limited liability company. Each structure has its own fiscal and legal benefits, but they are liable for different taxes and have different rules governing them. As taxes are an inevitable part of running a business, it is a good idea to have a basic understanding of the differences between how corporations and a limited liability companies are taxed. C-Corporations
C-Corporations
C-Corporations are your standard, run-of-the-mill corporate structure. When you file your articles of incorporation, the entity that you form will be, by default, a C-Corp. And standard corporations are a great legal structure - they separate your personal finances from the business's debts, help protect you from lawsuits, and allow you to sell shares to raise investment capital. Payments to corporate officers are also considered wages, which means their personal social security and medicare withholdings are subject to the FICA tax rate of 7.65% Opens a new window - the self-employment rate for these withholdings Opens a new window, on the other hand, is set at 15.3%. Corporations are, however, subject to double taxation. When you form your corporation, you are creating a separate, legal entity, which is capable of earning income. As of writing, the federal government, along with 47 states and the District of Columbia, collect tax on corporate income. Then, on top of that tax, you have to pay personal income taxes on any wages you earn from running this business. There are some federal tax deductions that are only made available to corporations, but taken alone those are usually not enough to make it worth paying taxes twice. Happily, there are some ways for smaller corporations to avoid double taxation - one of the most popular methods is to elect S-Corp status.
S-Corporations
An S-Corp is a standard corporation that chooses to be taxed according to Subchapter S of the first chapter of the Internal Revenue Code. Essentially, this election allows the corporation to be taxed as a pass-through structure - annual income flows through the corporation, directly to the shareholders, who then go on to pay their income tax. The corporation and its shareholders avoid the issue of double taxation as the entity is basically taxed like a partnership, and they are able to avail of the FICA tax rate. There are, however, a few drawbacks to the S-Corp election. Only smaller corporations are eligible, meaning the corporation cannot have more than 100 shareholders, and can only have one class of stock. Standard corporations must also elect to receive S-Corp status by the 15th day of the third month of the tax year, or they will be treated as a C-Corp. Some states also collect tax on S-Corp income - California, for example, charges a 1.5% tax on net income.
Limited Liability Companies
Limited Liability Companies haven't been around as long as corporations, but now outpace corporate formation by nearly two-to-one, largely thanks to the way the structure is taxed. A Limited Liability Company is, by default, a pass-through structure which means no extra paperwork or elections are necessary. If the LLC has one member, the total income earned by the business flows through it and to that member who will then report it as income on Schedule C of their tax return. If there are multiple members, then the LLC is taxed as a partnership. After the LLC determines its income, losses, deductions, and credits, each member receives a K-1 report, which informs them what portion of those gains and losses are theirs. The members then use that information to fill out their normal 1040. Members of limited liability companies, however, are subject to the self-employment social security and medicare tax withholding of 15.6%, rather than the FICA rate that corporate directors/executives pay on their compensation. Because of this, some LLCs choose to be taxed as S-Corporations, allowing them to retain the flexibility of an LLC and the pass-through tax structure, without the members of the LLC having to pay nearly double in self-employment tax.
Of course, every business has different needs, and the structure that works well for one may be a poor fit for another. If you aren't 100% sure about what structure would best suit you, contact a professional and then decide on what works best.
