Are you operating your business in the most favorable form? Is an LLC better than an S corporation?
Should I incorporate in Pennsylvania? What is the initial step? We can help with answers.
Effective January 1, 2018, other than C corporation businesses are entitled to a business income deduction; C corporations will have a new, flat tax rate of 21%.
C Corporation Overview
A business entity may be taxed as a corporation if it is organized and operates under a state corporation statute or if it meets the requirements for being an association taxable as a corporation or a publicly traded partnership. A basic decision in organizing any business venture is the choice of whether it will be conducted in corporate form or otherwise.
If an entity is taxable as a corporation, it is normally taxed under rules applicable to C corporations. It may, however, qualify for special treatment depending on factors such as the nature of its business and the number and identity of its shareholders. A corporation may receive such treatment if it meets the requirements for being an "S" corporation. If the shareholders of a new corporation elect to have the corporation treated as an S corporation, however, they are not prevented from later deciding to have the corporation become a C corporation (and vice versa).
A C corporation computes its taxable income differently from an individual. For example, it may take a deduction for any dividends received from other corporations. This deduction is not available to individuals. Similarly, special rules may apply to its charitable contributions deduction, organizational expenditures, capital losses, "passive activity" losses, and amount "at risk" in an activity. For instance, a new corporation may elect to deduct a pro rata portion of its organizational expenditures each year over a period of 60 or more months.
Certain deductions are curtailed for corporations, and certain capital gains may be re-characterized as ordinary income. For example, a corporation is limited in its ability to deduct expenses for "disqualified interest," which is interest paid to a related person if the payee is exempt from U.S. tax on such interest. For years after 1993, disqualified interest may also include interest paid to unrelated parties if certain conditions are met.
The rules regarding the tax rates and tax returns of C corporations are different than those for individuals. For example, instead of filing separate corporate returns, a group of affiliated corporations may file a single, consolidated tax return. Furthermore, C corporations are subject to taxes that do not apply to individuals. For instance, a C corporation may be subject to an environmental tax, a personal holding company tax, and an accumulated earnings tax.
S Corporation Overview
While S corporations are corporations for purposes of state law, they are taxed much like partnerships for federal (and, in many cases, state) income tax purposes. There are several major federal income tax advantages of operating as an S corporation instead of as a regular C corporation. These advantages include:
• A single level of tax. The income of an S corporation is generally subject to just one level of tax. In other words, the income generally is taxed only to the corporation's shareholders. In contrast, a C corporation pays tax on its earnings, and its shareholders pay a second tax when corporate earnings are distributed to them in the form of dividends.
• The availability of losses. Shareholders of an S corporation generally may deduct their share of the corporation's net operating loss on their individual tax returns in the year the loss occurs. Losses of a C corporation, however, may offset only the corporation's earnings. This pass-through of an S corporation's losses to its shareholders makes the S corporation form particularly suitable for start-up businesses that are expected to generate losses during their initial stages.
• Income splitting. S corporations can serve as excellent vehicles for splitting income among family members through gifts or sales of stock.
Although operating as an S corporation offers many significant tax benefits, there are also some significant disadvantages associated with electing S status. The primary disadvantages are:
• Stock in an S corporation can only be transferred to eligible shareholders (individuals, estates, and certain trusts; certain pension plans and charitable organizations are also eligible for tax years beginning in 1998) and an S corporation cannot have more than 75 shareholders. These limitations restrict the sources and amount of equity capital.
• Estate planning for shareholders is generally more complicated when an S corporation is involved.
• Tax rates applicable to many individuals are higher than the rates that would apply to a C corporation at the same income level.
• Employee stock ownership plans are not available to S corporations; ESOPs can be used after 1997, but some of their tax advantages are not available to S corporations.
Not all corporations may elect S status. The election is available only to qualifying "small business corporations." A corporation must formally elect to be taxed as an S corporation by filing Form 2553, "Election by a Small Business Corporation," with the IRS.
An S corporation's taxable income must be computed in order to determine the items of income or loss to pass through to the shareholders. An S corporation's taxable income generally is computed in the same manner as that of a partnership. Thus, items of income, gain, loss, deduction and credit, the separate treatment of which could affect the tax liability of a shareholder, must be passed through separately to each shareholder. The tax character of these items is determined at the corporate level, and they retain their character when passed through to the shareholders.
An S corporation that was once a C corporation may be subject to one or more of three separate taxes (e.g., the "built-in gains" BIG tax). This rule is an exception to the general rule that S corporations are not subject to tax.
Items of income, gain, loss or deduction that pass through to a shareholder are reflected in the basis in his or her stock (and, in some cases, in debt - if any - that the corporation owes to the shareholder) and, where the corporation has earnings and profits, its "accumulated adjustments account." These adjustments are made to prevent income that is taxed to the shareholder (when earned by the corporation) from being taxed again at the shareholder level when later distributed.
Once an S election is made, it applies for all succeeding years unless the election is terminated. An election can be terminated either intentionally or unintentionally. The election may terminate by revocation, by the corporation's ceasing to satisfy the eligibility requirements for S status, or by the corporation's failing a passive investment income test. For example, the election terminates if the S corporation's stock is acquired by a nonqualified shareholder (e.g., a corporation) or if the number of shareholders exceeds the maximum permitted. The election terminates on the day the eligibility requirement is violated.
LLC - Limited Liability Company
The LLC is the newest of the forms of business entity, and as a result there are a few unanswered questions concerning its use. All states now have enacted LLC statutes which provide that members of an entity incorporating under that state statute will not be personally liable for the debts of the entity. The entity will be treated as a proprietorship or a partnership for federal, and generally state, tax purposes unless the entity elects taxation as a corporation.
The biggest advantage of an LLC is its flexibility. LLCs are hybrid entities which combine the flow-through attributes of partnerships with the corporate characteristic of limited liability. Therefore, like a corporation, the LLC offers limited liability to its members. Members of an LLC are only at risk to the extent of their investment and cannot be held responsible for actions of the LLC. The maximum amount a member can lose is the value of his investment in the LLC. His personal assets are protected.
Like general partners in a partnership, LLC members may participate in the management of the LLC. However, unlike limited partners, participation in management will not cause the member to lose his limited liability protection.
Unlike a C corporation, an LLC is not subject to two levels of tax. Income or loss from the LLC flows from the LLC to the members and is recorded on the members' individual returns. The LLC operating agreement can provide for an allocation of most items of income and deduction in any manner in which the members see fit. The multi-member LLC is, however, required to file a partnership return.
LLCs are similar to S corporations in that they provide limited liability but are not subject to tax at the corporate level. However, unlike S corporations, an LLC is not subject to any limitation on the number and type of members it may have. In addition, the one class of stock restrictions and the complex regulations governing S corporation status do not apply to LLCs, thereby allowing flexibility in planning distributions and special allocations. The LLC operating agreement can provide for special allocation of most items of income and deduction.
An LLC is created by filing articles of organization with the state in which it is being formed. Thus, certain filing fees will be incurred. Although an operating agreement is not required, it is an important document for setting forth the members' understanding of the procedures and formula for distributing profits and losses, as well as various other operational concerns.
If created in Pennsylvania, an LLC legal advertising notice must be placed in a general circulation newspaper as well as in a legal newspaper. As is the case with any separate legal entity, if owners do not treat it as a separate entity, the veil of limited liability may be pierced by the courts. This means no commingling of personal funds. Maintain a separate bank account, also. While LLC's are not required to maintain minutes and conduct regular meetings, it remains a good idea to do so.
Tax law reform ushered in beginning 2018 included a Qualified Business Income credit for businesses other than C corporations. The workings of the credit suggest that pass through organizations such as LLC's being taxed as partnership review their operating agreements to be sure they are gaining optimal advantage.