As an attorney concentrating in business organization, I take a central role advising my business clients on the appropriate entity to form. Most of my clients approach me already armed with the knowledge that an organized business entity will generally shield them from personal liability for the acts or omissions of the business. However, relations between multiple owners, tax considerations and treatment of assets are just a few of the factors that will dictate which choice of entity is truly suitable for your business. By and large, there is no uniform “right” choice. A careful review of the details, strategies and goals of each business needs to be made before the proper entity is chosen.
Corporations and limited liability companies (LLC’s) are the most commonly utilized business entities. Since most small to medium sized businesses are better structured as either a corporation or LLC, this article highlights some basic similarities and differences between these entities. I have attempted to provide an overview of these key elements below. But, keep in mind that the information below, by itself, will not allow you to make a proper, informed choice of entity. This should always be done with the coordinated assistance of your attorney and accountant.
Most large companies are C corporations. All publicly traded corporations are C corporations. The “C” designation comes from Subchapter C of the Internal Revenue Code, which governs corporate taxation. There are a variety of reasons C corporations are more aptly suited to large businesses. Multiple classes of stock, unlimited number of and types of shareholders, a fiscal year vs. calendar tax year and retention of corporate earnings are just a few of the key differences of a C corporation. Generally, this structure is desirable for businesses who seek to raise capital publicly or whose class of investors vary.
Most importantly, C corporations are subject to double taxation. This means that all of the income of the C corporation is taxed once at the corporate level, then those same revenues are taxed again at the shareholder level when profits are distributed via dividends. In smaller C corporations, the double tax can sometimes be avoided by eliminating net income each year by making payments to shareholder-employees. Shareholders must report any dividend earnings as capital gains on their personal tax returns.
A corporation starts out as a C corporation for tax purposes. All corporations are automatically recognized as C corporations, unless the shareholder’s elect “S” corporation tax treatment, which is discussed below. The taxable income of the C corporations (after deductions for salary, business expenses and depreciation on furniture and equipment) is taxable to the corporation itself. The C corporation would only be taxed on income “effectively connected with the United States”, beginning at a corporate tax rate of 15% for the first $50,000 of corporate taxable income each year.
If the corporation is classified as a “personal service corporation”, (PSC), is will pay a 35% flat rate from dollar one of net profit. This is a generally undesirable entity type. PSCs are C corporations whose shareholders are engaged in the performance of personal services in the fields of accounting, actuarial science, architecture, consulting, engineering, health and veterinary services, law, and the performing arts. The lowest 15% tax rate is only available to a corporation rendering personal services if a person who is not employed by the corporation owns at least 6% of the issued stock of the corporation. Otherwise the top personal tax rate would apply to the taxable income from personal services in that corporation. A PSC is a C corporation by definition. Thus, a timely made S-election, as discussed below, would negate classification of your corporation as a PSC and avoid the 35% flat tax rate.
There are some unique tax advantages gained with the use of the C corporation. Some of the key advantages most beneficial to small businesses are the ability to deduct all of the premiums paid on health insurance for owners who are employed, along with their spouses and dependents. In addition, a C corporation may adopt a MERP (Medical, Dental and Drug Expense Reimbursement Plan) at any time during a fiscal year, which can be made effective retroactive to the beginning of the fiscal year and can purchase disability insurance for one or more of its executives or other employees. A C corporation can also deduct the premiums of disability insurance without the cost being taxable to the executive or employee. Finally, a C corporation can deduct contributions to qualified retirement plans.
In terms of ownership, shareholders own the corporation by virtue of owning stock (or shares) in the corporation. Corporations issue stock certificates to its shareholders to indicate ownership percentage in the corporation. C corporations are permitted to have different classes of stock, such as common and preferred stock, offering dissimilar distribution and voting rights among shareholders. Shares may be freely transferred or redeemed without affecting the corporation. Under Illinois law, as every other State, shareholders of corporations generally enjoy a complete liability shield from the acts or omissions of the corporation itself. The shareholders elect a board of directors, who then manage the business and affairs of the corporation. Illinois law requires that a President, Secretary and Treasurer be appointed as officers of the corporation, although sole-shareholder corporations are permitted.
The Bylaws of the corporation are its governing document. The bylaws govern the business and affairs of the corporation (both C and S corporations) and specify mattes such as the number and powers and duties of the board of directors, shareholder voting rights, dissolution of the corporation, annual and special meetings, and other rules of the corporation. Typically, the relationship governing the owners (shareholders) in a small or closely held corporation is governed by a stock purchase or stock restriction agreement or similar document. This instrument can provide for shareholder purchase and sale rights, restrictions on the sale or transfer of shares and corporation purchase rights, among other matters. In all jurisdictions, corporations must have a set of bylaws that govern the corporation, or the corporation will be subject to the default provisions set forth under state statute.
Keep in mind, the relationship between the owners (shareholders) of the corporation can also be governed by a separate instrument, such as a stock purchase or stock restriction agreement, shareholder’s agreement or similar document. This document generally controls share transfers and purchases of additional stock and company and/or shareholder stock purchase rights.
C corporations are best suited for active businesses with a likelihood to appreciate and strong potential to offer shares publicly. C corporations generally retain their earnings in the beginning stages of growth and do not distribute corporate earnings to shareholders in an effort to appreciate.
An S corporation is a corporation, just like a C corporation. Its shareholders enjoy the same general shield from personal liability for the corporations’ acts or omissions.
The major difference lies in the tax treatment of the S corporation. As stated, C corporations are subject to taxation at the corporate level and the shareholders are then subject to taxation on that same stream of revenue when distributed in the form of dividends. By contrast, S corporations avoid double taxation since only the individual shareholders are taxed. S corporation status is achieved by electing such tax treatment after organization (IRS Form 2553). Net profit or loss after expenses for S corporations, including salaries paid to employees and shareholder-employees, is reported on federal Form 1120S and “passed through” to shareholders’ personal tax return via Schedule K-1, where it is subject only to ordinary income taxes. Additionally, pass-through losses are limited to the taxpayer’s basis in the stock of the S corporation.
All wages are subject to self-employment (payroll) taxes. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The S corporation will pay the employer’s share of FICA taxes (7.65%), and the employee will pay the other share of FICA taxes (also 7.65%). Between the S corporation and the shareholder, wages are subject to approximately a combined 15.3% payroll tax, plus the shareholder’s income tax rate. So all things considered, the shareholder-employee should pay only a minimal salary to themselves in order to decrease the amount of taxes paid on corporations’ profit stream. IRS rules do require that reasonable salaries must be paid to shareholder-employees (the failure to do so is considered by many to trigger an internal audit). But, all other earnings avoid self-employment taxes and are subject to either ordinary income or capital gains. This means the payroll taxes would have to be paid on reasonable salaries (wages) of employee-shareholders only, and not the S corporation’s distributions.
When do you need to pay wages? According to the IRS, reasonable compensation is determined by what the shareholder-employee did for the S corporation. The IRS will look at the source of the S corporation’s gross receipts: 1) services of shareholder, 2) services of non-shareholder employees, or 3) capital and equipment. If the gross receipts and profits come from items 2 and 3, then no compensation needs to be paid to the shareholder-employee. However, if most of the gross receipts and profits are associated with the shareholders personal services, then most of the profit distribution should be allocated as compensation. (Of course, you should ask an accountant for more details).
Even if income is not distributed to the shareholders and left as operating capital, it will still be taxable to the individual shareholders. This is because all income is passed through to the shareholders automatically. Shareholders in a C corporation are only liable for taxes on dividends they actually receive (but, undistributed income of the corporation is not subject to self-employment taxes).
Some disadvantages of the S Election status are that deductions for health insurance, disability insurance, automobile, and medical, drug and dental plan reimbursements would be taxable to the S corporation stockholders for whom they are paid.
Among other key differences, S corporations are less flexible than C corporations and LLC’s. Only a limited number of shareholders, usually only individuals, and no foreign shareholders are allowed. In this sense, S corporations are typically more suitable for small and closely held businesses who do not seek to raise large amounts of capital publicly. As with a C corporation, shareholders own the corporation by virtue of their stock in the corporation. However, there can only be one class of stock with respect to distribution rights, unlike a C corporation.
S corporations are generally suitable for active businesses with little debt, no high risk assets and low chance for substantial appreciation since all corporate earnings are typically distributed to the shareholders.
Limited Liability Company (LLC)
An LLC, or limited liability company, offers the same personal liability shield to each of its owners that a corporation offers. But, it provides significant flexibility in terms of the treatment of capital contributions and allocation of profits and losses to its owners. Specifically, an LLC can distribute profits in the manner its members see fit. For example, assume you and your partner own an LLC to which you contributed $80,000 in capital and your partner only contributed $20,000. If your partner performs 80% of work, the owners could still decide to split the profits 50/50. However, if you and your partner were shareholders in an S corporation, you would be required to distribute 80% to you and 20% to your partner by law. This can be an inequitable way to structure your business if you have any partners.
The LLC is taxed as a partnership as profits and losses are “passed through” to the members and there is no entity level income tax. The LLC avoids double taxation then just like the S corporation. (Again, some states do impose replacement taxes on the income of LLC’s). The LLC income is reported on Form 1065 and then distributed to owners via Schedule K-1. The owners then report this income on their individual returns (1040) on schedule E. If the LLC has only one owner, the IRS will automatically treat the LLC as if it were a sole proprietorship (a “disregarded entity”). A disregarded entity does not file a tax return and the owner reports the income through schedule C of his or her individual return. If the LLC has multiple owners, the IRS will automatically treat the LLC as if it were a partnership. However, an LLC is known as a “check the box” entity, meaning it may elect to be taxed as a corporation or as a partnership.
In terms of self-employment taxes, there is a lot of confusion when it comes to LLC members. In general, the difference of whether you are treated as a general partner compared to a limited partner is significant for determining self-employment tax liability since an LLC is taxed as a partnership. If a member of an LLC is treated as a limited partner, there is no self-employment tax on the member’s share of LLC income (except for any “guaranteed payments”). If a member is considered a general partner, he or she must pay self-employment taxes on all LLC income. However, under the 1997 Proposed IRS Treasury Regulations Section 1.1402(a)-2, if an LLC member is personally liable for debts, does have the power to bind the LLC to a contract or does provide more than 500 hours of service per year to the LLC, the member will be taxed as a general partner and will have self-employment tax obligations on his or her LLC income allocations. Otherwise the member will be taxed as limited partner and will not have self-employment tax obligations on his or her LLC income allocations.
Also, it is possible that the LLC will have two classes of interests, one of which is treated as a general partnership interest and one of which is treated as a limited partner interest. If a partner or a member owns interests of both classes, then the member will be able to allocate his or her income allocations between the two classes and will be required to pay self-employment taxes on the general partner portion, but not on the limited partner portion. The 1997 Proposed Regulations have never officially been adopted by the IRS, but they have been relied on by many professionals and taxpayers. Also, IRS representatives have now stated they can be relied upon.
All profits and losses distributed to the members and any “salaries” (generally considered any guaranteed payments) paid to them are considered self-employment income and are subject to self-employment taxes. Owners of the LLC are considered to be self-employed and must pay a self-employment tax equal to 15.3%. Remember, in an S corporation, only the salaries, and not the distributions to shareholder employees, are subject to employment taxes. Thus, the S corporation provides significant employment tax savings to its shareholders in contrast to the LLC.
LLCs provide limited liability protection in most instances if properly established and maintained, but usually few or no tax benefits versus a sole proprietorship or general partnership exist. One significant benefit of LLC’s over corporations is the ability of the members to limit a transfer of a membership interest to transferring an economic interest only. This means future members can be restricted to receiving distributions (and paying taxes on those distributions) but with no accompanying voting or management rights. When a shareholder of a corporation transfers his or her stock, all attributes of ownership including voting rights accompany the transfer, unless the stock is non-voting stock.
The LLC’s owners are called members and each Member owns a percentage of the LLC by virtue of owning a Membership Interest in the company. Similar to C corporations, LLC’s may create differing classes of membership interests. Members can include corporations and other LLCs, providing ultimate flexibility in ownership structure with this entity. An LLC is usually member-managed, where the business and affairs of the LLC are managed by the members themselves, or can be a manager-managed LLC where either a member-manager or an outside manager is appointed instead. Most small business LLCs are usually member-managed. Illinois allows single-member LLCs, like most if not all other states. Illinois also allows professional service providers, such as attorneys and doctors, to form LLC’s for conducting their business, unlike many other states.
The Operating Agreement is the governing document of the LLC. It is similar to corporate bylaws and controls basically the same aspects. However, most jurisdictions specify the contents that are required to be included in bylaws and operating agreements and there are, of course, differing provisions. Also, the relationship between the members of an LLC is stated in the operating agreement, whereas corporations typically use a separate instrument for certain shareholder rights, such as stock transfers and corporation buy-out rights.
Real estate investments and businesses that own other assets that generally expose its owners to risk of liability are generally appropriate for LLC’s. Of course, if you have one or more partners and want to be flexible with how the business distributes profits (and losses) to the owners, then the LLC is likely the best choice.