What are the potential tax advantages of the LLC, C corp and S corp?
As an accounting professional, you know there are potential tax-related upsides and downsides for every type of business entity. It’s important to communicate those considerations to your clients to help guide them as they decide which legal business structure to form for their company. In addition to your insight, of course, your clients should also consult a knowledgeable business attorney who can share the legal ramifications of the various business entity types.
Let’s take a moment to lay out the tax pros and cons in a way that may make it easier for you to cover all the bases in your conversations with your clients.
LLC (limited liability company)
As a “disregarded entity” for tax purposes, an LLC’s profits and losses flow through to its owners’ (known as “members”) personal tax returns. Note that from a legal standpoint, an LLC is considered a separate entity from its members, so it provides some liability protection to its owners. Generally, LLC members’ personal assets are not at risk if the company gets sued or cannot pay its debts.
Tax advantages of the LLC structure:
- Owners choose how to distribute profits. LLC members may choose how their business will divide the company’s profits and losses among its owners. This allows for members to consider not only money invested, but also time and work invested when distributing profits.
- S corporation election option for qualifying LLCs. LLC members may elect to have their LLC treated as an S corporation for tax purposes. More on that later!
Tax disadvantages of the LLC structure:
- Bigger self-employment taxes burden. All of an LLC’s business profits are subject to Social Security and Medicare taxes. This may create an unfavorable financial situation for LLC owners as they must pay self-employment taxes on their distributive share of the LLC’s profits, even if they invest that money back into the business rather than taking a distribution of those profits.
A corporation or "C corporation" is a separate legal and tax-paying entity. Its profits, losses and liabilities are tied to the business, not its owners (shareholders). It comes with more complex compliance formalities than the LLC structure, but it also offers the highest level of liability protection for owners of the business.
Tax advantages of the C corporation:
- Corporate income tax rate may be favorable. A C corp’s profits get taxed at the corporate income tax rate. In some circumstances, that might work in the business owners’ favor. Depending on where the business is incorporated and shareholders’ personal tax situation, they might find the corporate income tax rates will cost them less than if they were set up as an LLC and had to pay the individual income tax rate (and self-employment tax) on all of their company.
- Possibly more tax deduction opportunities. As a C corp, the business may be eligible for more tax deductions than if it were operated as an LLC, partnership or sole proprietorship.
- S corporation option for qualifying C corporations. Eligible C corps may be taxed as an S corporation. I'll explain more about that below. The primary advantage of the S corp election for C corps is that it can enable them to avoid the sting of "double taxation." This leads me to the potential tax disadvantages of the C corporation...
Tax disadvantages of the C corporation:
- A double tax hit. A C corporation’s profits are taxed when they are earned. Then, any of the profits paid as dividend income to shareholders (which is not tax-deductible to the corporation) is taxed again on the shareholder’s individual tax returns.
The S corporation isn't a legal entity in itself but rather an option for a qualifying LLC or corporation. The IRS explains what criteria an LLC or corporation must meet to get S corp tax treatment.
Tax advantages of the S corporation:
- Lessens the self-employment tax burden on LLC members. The primary advantage that LLC members gain by electing S corp status is that only income paid to LLC members on the payroll is subject to self-employment taxes. Profits paid as distributions are not subject to Social Security and Medicare taxes. Therefore, an LLC’s members may find that the S corp election will lower their personal tax burden.
- Enables C corporations to avoid double taxation. As an S corporation, a corporation's profits and losses flow through to shareholders' personal tax returns and are taxed (according to the shares of ownership) at the applicable individual tax rates. The corporate entity does not pay income tax. Shareholders who are employees of the C corporation only pay self-employment tax on the wages or salary that the corporation pays them. Dividend income paid to shareholders is not subject to self-employment tax; those monies are taxed as either ordinary income (at the individual income tax rates) or qualified dividends (at the capital gain tax rates).
Tax disadvantages of the S corporation:
- May limit a corporation’s growth potential. S corps may not have more than 100 shareholders, so corporations that want to maximize their growth potential may find the S corp option limiting.
- Reasonable compensation is key for LLC members working as LLC employees. An LLC must pay its owners fair compensation for the work they perform. If it pays its members unreasonably low wages and doles out the majority of money as distributions, it could raise red flags with the IRS and other tax authorities. It might appear that the LLC members are gaming the system to avoid paying their fair share of self-employment taxes.
Your role in helping clients make an informed choice
As a financial and tax professional, your expertise will be immensely helpful to clients as they make the all-important decision about which business entity to choose. Remember to only offer advice that you’re legally authorized to provide — and direct them to a trusted attorney for guidance about the legal ramifications of each business entity type.