Prospective business owners often ask, “which is better – a corporation or an LLC?” Of course, the answer is that it depends on your circumstances and the business you plan on running. In some cases an LLC is best, while in others an S-Corp is favorable, and in others a C-Corp wins.
Here are some of the characteristics of each one to factor in when making your choice:
Limited Liability Companies. LLCs are relatively new in the U.S. as they have only been around since 1977, so there are plenty of situations where the law is unsettled about how LLCs will be treated, as opposed to corporations. Minnesota enacted its Limited Liability statutes in 1992. LLCs are designed to give owners protection from business liabilities, but have more flexibility and less rigorous corporate governance rules than corporations. Owners can elect to have an LLC be taxed as a pass-through entity (like a sole proprietorship or a partnership), or be taxed like an S-Corp or C-Corp. While an LLC can be taxed like a C-Corp, it does not get to take advantage of the fringe benefits available to C-Corps.
S-Corporations. Corporations as a business structure have been around in the U.S. since our country’s founding, and history of corporations goes all the way back to Roman Law. Until Congress allowed for S-Corporations in 1958, entrepreneurs had the choice of organizing as a corporation (getting the liability limitation but being subject to corporate double taxation rules) or acting as a sole proprietorship or partnership (foregoing liability limitation but having pass-through taxation). The S-Corporation was created to allow small businesses to have limited liability through corporate formation, but be able to have pass-through taxation.
S-Corps are limited in the number of shareholders they can have, and trusts or other entities cannot be shareholders. There are limitations on non-U.S. citizen ownership and passive income, as well. S-Corps have the potential of having tax savings over an LLC taxed as a pass-through entity because a shareholder-employee can take a portion of income as salary (subject to the self-employment tax) and a portion as dividends (subject only to ordinary income tax). The IRS is vigilant about scrutinizing S-Corp shareholder returns so it is important not to underpay on the salary portion, and make sure the salary is reasonable and appropriate for the work being done. Fringe benefits are not available to S-Corp shareholders, with exception to those with less than two percent ownership.
C-Corporations. Most people are thinking about C-Corporations when they use the term “corporation.” While large, publicly traded companies are always C-Corps (LLCs and S-Corps cannot be publicly traded), there are some reasons for small businesses to use the C-Corp structure, as well. If you have a reason to want more than one class of stock, like to have voting shares for shareholder-employees and non-voting shares for financial investors not active in the business, then you need to choose a C-Corp over an S-Corp. You are able to offer the full panoply of fringe benefits as a C-Corp and have those benefits be pre-tax business expenses, and you can offer those benefits to your spouse and dependants as well. The value of the benefit does get reported as income to the employee and you have to pay payroll tax on that amount, with limited exceptions, so as a shareholder-employee in a small business you will want to make sure that you are not defeating the purpose of tax savings by being subject to a higher combined income/payroll tax rate than you would be saving in corporate taxes. Where that line is drawn for you depends on your particular situation, so you will want to talk about that with your CPA before you decide.
If you are thinking about starting a small business and want help deciding which business structure would be best for you, call us today to schedule your comprehensive LIFT™ (legal, insurance, financial and tax) Foundation Audit. Normally, this session is $1,250, but if you mention this article and we still have room on our calendar this month, we will waive that fee.
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