Amazon: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
(referral link – help me buy new books!)
A no-nonsense whirlwind tour of the essential difference between LLCs, S-Corps and C-Corps. A great foundation for going to talk to an attorney or accountant or someone who actually knows what they’re doing. I wouldn’t recommend doing any of the work yourself beyond forming an LLC, but then I’m pretty risk adverse.
The notes below are a condensed version of the book above, so that I can quickly and easily access the content without having to dig the book out on my Kindle.
Part 1: A discussion of sole proprietorships and partner ships – it’s most likely than a currently operating business is one of the two. Chapters 1 – 7.
Part 2: LLC vs. S-Corp vs. C-Corp, and ramifications. Chapters 8 – 15.
Part 3: Related topics such as ramifications of becoming an employee of your business as a result of electing corporate tax treatment. Chapters 16 – 17.
From a federal standpoint, any business started by a single person is automatically a sole proprietorship, unless the owner decides to take some action, such as incorporating, in order to become a different type of entity.
State, county or city may have extra requirements, such as licenses.
An Employer Identification Number (EIN) is not required, however is convenient. EIN is to a business as a SSN is to an individual. Sole proprieterships can use the owners SSN, but an EIN can protect the SSN from identity theft.
Most states require a “Doing Business As” (DBA) if your name and the business name don’t match.
Sole proprietorships are a “pass-through” entity, meaning owner is responsible for profits and losses. File taxes as normal, profits are taxed as income (added to owners 1040 from calculation on Schedule C), with added self employement tax (calculated on Schedule SE) of 15.3%.
Half of the self employement tax can be deducted as an “above the line” deduction.
Sole proprietorships have “unlimited liability”, that is, owner is personally liable for debts of business.
Partnerships start similarly to sole proprietorships, by multiple people doing business as a unit, but require an EIN and a DBA.
Much more likely for local requirements on a partnership, so check city hall.
Also recommended is a partnership agreement. This is a contract that specifies how expenses are divided, profits allocated, how and when profits allocated, which partners are responsible for which tasks, under what circumstances a partner can sell his or her interest to someone else, how disagreements will be resolved. At least. Anything else that might come up.
Partnerships are taxed like sole proprietorships, only with the inclusion of Form 1065 to calculate the partnerships profit/loss. At the end of Form 1065 is a Schedule K where income is broken down into categories, and each member of partnership fills out a Schedule K-1 for their share of those incomes. These then show up on regular income tax return (Form 1040).
Partnership taxation is based on the concept of “tax basis”. Generally, owners of a partnership are taxed upon their share of the taxable income, regardless of how much is distributed. A partner is not taxed upon distributions from the partnership as long as the distributions don’t exceed the partner’s tax basis.
A partner’s tax basis in a partnership is:
1. Increased by any amount s/he invests in the business
2. Increased by his/her share of the partnership’s taxable income (and decreased by his/her share of the partnership losses)
3. Decreased by the amount of any distributions s/he recieves
4. Increased by his/her share of the debt owed by the partnership.
Partnerships have unlimited liability, and a partner is responsible for the partnerships liabilities in total, even if created by another partner.
Thus far, the term partnership refers to a general partnership. Concept of limited partnership also exists. Limited partners are only liable up to their investment in the partnership, but cannot engage in management or day to day operations. Usually reserved for outside investors.
An LLC has pass-through tax treatment with limited liability protection. It is a state level entity, and requirements will vary state to state. In most states, an LLC is formed by filing a document known as articles of organization with the Secretary of State. Generally, articles must include:
1. LLC’s name and address of it’s principal place of business
2. Names of the owners (members) of the LLC
3. Nature of the LLC’s business
4. The name and address of the LLC’s registered agent (party authorized to accept delivery of legal documents on behalf of LLC)
If you wish to have a physical presence in another state, you will need to “qualify” or “foreign qualify” the LLC with the Secretary of State in those states.
If the LLC will have multiple owners, as per a partnership, should include an operating agreement and have an EIN.
Converting between a sole proprietorship and an LLC, or between a partnership and an LLC is a non-taxable event given how LLCs are taxed.
If the LLC is single-member with no employees, owner should continue to use SSN instead of EIN for taxation.
An LLC is a “disregarded entity”, meaning for federal taxation requirements, it doesn’t exist, and is instead treated as a sole proprietorship or partnership.
An LLC can opt to be taxed as a corporation. This can be done by either forming a corporation and transfering all assets from the LLC to the corporation, or by filling out a form (form 8832 for C-Corp, form 2553 for S-Corp) electing for corporate tax treatment.
LLCs may be taxed differently in different states, and that may affect the viability of forming an LLC.
LLCs are usually formed for their limited liability, but it’s not perfect. Here are some situations where you are still liable for the actions of the LLC:
1. Signing personally for business debt
2. Liability resulting from tort of the LLC owner (where “tort” refers to wrongful acts other than breach of contract)
A C-corp is similar to an LLC, and differs only in how it is taxed. Accountaints, doctors, engineers, lawyers and social workers are usually not allowed to form a regular C-corp, though this varies from state to state.
A C-corp itself is subject to income tax, as opposed to the owner/partners of an LLC. The taxation rate is unaffected by how many owners (shareholders) there are.
Taxation rates for a C-corp can vary year to year. For 2012, here are the rates:
|$0 – $50,000||15%|
|$50,001 – $75,000||25%|
|$75,001 – $100,000||34%|
|$100,001 – $335,000||39%|
|$335,001 – $10,000,000||34%|
|$10,000,001 – $15,000,000||35%|
|$15,000,001 – $18,333,333||38%|
When a corporation makes a distribution to it’s owners, the payment is known as a divident, and is taxable to the recipient. That is, corporate profits are taxed twice.
To get around the double taxation, the corporation can pay the owners a salary or end of year bonus that will leave the corporation with zero income. This will be taxed on the owners at their income tax rates, as per an LLC.
Double taxation can be leveraged to save money, by paying a portion of income as salary rather than all of it. This can cause both the employees and the corporation to be in lower tax brackets, and save money. However, be aware of the 15% accumulated earnings tax charged on top of income tax on income that accumulates (not distributed) beyond the corporations reasonable needs. Keeping accumulation under $250,000 is a good rule of thumb.
Corporate losses are also not passed to the owners as an LLCs are. Instead, C-corp losses can be used to offset taxable income from the two prior years, or up to twenty years in the future.
Form 1120 is filed for a C-corps tax return. The second page (Schedule C) is only applicable if the corporation owns shares in other businesses. The third page (Schedule J) is where any tax credits are applied. The fourth page (Schedule K) is a mixed bag of questions, such as the number and nature of shareholders, whether the necessary forms have been filed, etc. The last pages (Schedules L, M-1 and M-2) are only required if the corporation has assets greater than $250,000 at the end of the year or total receipts of $250,000 or more for the year.
For liability, coprorations are distinct entities that can own things, rent things, sue or be sued.
In order for a corporation to keep it’s classification, a few legal requirements need to be met. For example, whenever a major decision is made, it must be recorded in a document known as a “resolution”. Also, most states require an annual meeting of the directors and shareholders of the corporation, and a record of everything that was discussed.
As in an LLC, it’s possible for the owners of a corporation to be liable as a result of any torts they personally commit.
The term “piercing the corporate veil” refers to breaking the separation between the owners of a corporation and the corporation itself.
Some factors that may lead to a court piercing the corporate veil:
- Intermingling of funds between corporate accounts and personal accounts
- Disregard for corporate formatlities
- Undercapitalization of the corporation (corp. lacks capital to satisfy obligations)
- Absence of corporate financial records
- Anything else a court believes would mean that the corp. is just a formality and not materially distinct from it’s owners.
S-corporations are similar to C-corporations, and differ only in taxation and a few rules of ownership:
- Must be a domestic corporation
- No more than 100 shareholders/members
- Shareholders can only be individuals, estates or tax-exempt organizations. No corporations or partnerships.
- No non-resident alient shareholders
- Can only have one class of stock
- Cannot be a bank or insurance company
- All shareholders must consent to the election
An S-corp, like a partnership, is a pass-through entity. Taxes are filed on Form 1120S. Unlike a partnership, S-corps are not subject to the self employment tax, however each owner who also works as an employee must be paid a “reasonable” salary, which will be subject to Social Security and Medicare taxes to be paid half by the employee, and half by the corporation. This means the benefits from not having a self-employment tax only kick in once the S-corp is making enough money to pay it’s owners a reasonable salary.
Each state has it’s own rules regarding S-corp taxation, so check with the state the S-corp is incorporated in.
Being an Employee of Your Business
Being an employee of your corporation has rammifications.
As a business with employees, you will have to register as an employer in your state to pay unemployement tax.
You will also have federal and possible state level reporting requirements, such as needing to file:
- Form 940 annually to report the Federal Unemployment Tax Act (FUTA) tax for wages paid,
- Form 941 quarterly to report Social Security, Medicare and withheld income taxes on wages paid,
- Form W-2 annually to report wages paid, taxes withheld and other related information.
Also need to make monthly payments of the employers share of Social Security and Medicare taxes on wages, plus amount withheld for employee’s share of taxes as well as income tax.
Another drawback to corporate taxation is the limitation imposed on the amount allowed to be contributed to a business retirement plan. For example, a sole proprieter can contribute to a SEP IRA for 2012 the lesser of $50,000 or 25% of the net earnings from self employment, but as an employee the most you can contribute is the lesser of $50,000 or 25% of your salary.