Choosing a for profit business entity
Corporation vs. LLC

A majority of for profit small businesses wishing to create an entity choose between limited liability company ("LLC") and a corporation. In choosing a corporation an election can be made with the IRS as to whether the entity should taxed under Subchapter S or Subchapter C of the the IRS code (the so called "S" and "C" corporations)

Most people end up choosing to be an LLC because the IRS allows such entities to elect to be taxed however they want (as a partnership or as either an S or a C corporation).

In most cases choosing to be an actual corporation (as opposed to an LLC) is desirable only there are to be numerous owners or they they want to attract additional investors in the future.

The tax issues are complicated a CPA or other tax professional should be consulted.

LLC is a relatively new business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC, unless they have signed a personal guarantee.

Owners of an LLC are called members. Members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. An S corporation may have up to 100 shareholders that must be U.S. citizens, residents, and certain trusts.

AN LLC CAN ELECT TO BE TAXED AS A CORPORATION IF IT SO DESIRES. For tax purposes, by default, the IRS treats a single member LLC as a "disregarded entity" meaning that the LLC files no tax return and all tax reporting is done on the member"s individual tax return (IRS Form 1040, Schedule C).

By default the IRS treats multi-member LLCs as partnerships meaning that the LLC must file the relevant informational return (Form 1065) but no taxes are paid directly by the LLC (all tax related information is reported on the tax returns of the individual members in accordance with their respective ownership percentage).

BUT - an LLCs can to make an election with the IRS to be taxed as a corporation using the "check the box" form if the members perceive that to be to there advantage (the remainder of this letter assumes that this election will not been made)

By default corporation are taxed under Subchapter C. C corporations are subject to double taxation, that is, a tax is paid by the corporation and then the individual stockholders are taxed on the profits distributed to them. In some situations this is counterintuitively advantageous.

S corporations and LLCs are similar in that they are both "pass-though" entities for tax purposes; the incomes of these companies are passed through to their owners and reported on the owners" personal income tax returns, thereby eliminating the double taxation incurred by the owners of a standard C Corporation.

Usually an LLC presents a better choice for small business owners, mainly because the LLC is a low-cost, simpler alternative to the corporation. Typically, the LLC"s advantages over the S Corporation include:

• LLC is more flexible in terms of structuring different types of ownership interests, where the S Corporation is limited by a single-class-of-stock requirement;


• LLCs need not publicly disclose rights of their owners, unlike the corporations that must spell out the provisions for any preemptive rights of shareholders in their Articles of Incorporation, a public document.


• LLC is simpler to operate because it is not subject to the formalities by which an S Corporation must abide. Specifically, corporations are required to keep formal minutes, have meetings, and record resolutions. LLC can be member-managed, meaning that the owners run the company; or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC.


• LLC may have tax advantages over the S Corporation relating to the contribution and distribution of property, especially the distribution of appreciated property.


• All your business losses, profits, and expenses in LLC flow through the company to the individual members. As a member of LLC you avoid the double taxation of paying both corporate tax and individual tax. Generally, this is a tax advantage, but circumstances can favor a corporate tax structure.


• LLC may decide on the method for distributing income to its owners, while a corporation is required to distribute based on ownership percentages. Let"s say, for example, you and your partner own an LLC. You contributed $7,000 and your partner only contributed $3,000 but he performs significant amount of work. The two of you decide that, in the interest of fairness, you will share the profits 50/50. As an LLC you could do that. As an S Corporation, however, you would take 70% of the profits, while your partner would only be entitled to 30%.

Note that dividing profits and losses in a way that is not proportionate to the owners" percentage interests in the business is called a special allocation. The IRS pays careful attention to special allocations to be sure business owners are not trying to hide potential tax dollars, by allocating all business losses to the owner in the highest income tax bracket.

Tax considerations can be the driving force behind special allocation. For example, the members of an LLC may each contribute an equal amount of capital and agree to share profits equally but to allocate all losses to a single member. This will yield tax savings if the member to whom losses are allocated is in a higher tax bracket than the others. But special allocation can also arise in rather simple arrangements that are not designed with taxes in mind. For example, a two-member LLC makes special allocations if one member contributes capital, the other contributes future services, and they agree to split profits equally because the members" profit shares are not proportionate to their capital contributions.

A concern with special allocations is that they could permit some members to enjoy the tax benefits associated with the ownership of an interest in an LLC without bearing the economic consequences. In order to prevent this, the IRS has authority to reallocate an LLC"s profits and losses between the members.

Major factor that differentiates an LLC from an S Corporation that can be seen as a disadvantage is the employments tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, is subject to "self-employment tax" of 15.3% (combined social security tax rate of 12.4% and Medicare tax rate of 2.9%). The entire net income of the business is subject to self-employment tax. In an S Corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax.

For example, let"s say you manage your web-site, and decide that reasonable salary for a manager is $40,000 and you pay yourself accordingly. If your total earnings for the year is $90,000: $40,000 paid in salary and the remaining $50,000 paid as distribution from the S Corporation, then your total employment tax is $7,650. If you are the owner of an LLC, you will have to pay employment tax on the entire $90,000, equaling $13,770. As an S Corporation you realize savings of $6,120 in employment tax.

Still, while the potential employment tax savings may make the S Corporation an attractive structure for your business, bear in mind that you would have to deal with all the paperwork associated with payroll tax.

It is very important to remember that as LLC your filing status for tax purposes is determined by the elections made with the IRS.. An LLC can elect to be taxed as corporation and then make an election to be taxed under Subchapter S. Doing this would allow the LLC to take advantage of possible reductions in self-employment taxes.

Another disadvantage of an LLC is inability to provide fringe benefits to its employees. C corporations may offer certain fringe benefits to employees, such as health insurance, that are tax-deductible to the company and also tax-free to the employee. This option is not available to an LLC unless LLC elects to be taxed as C Corporation.

Regardless of what business entity is choosen, it is highly recommended that a CPA or other qualified tax professional be consulted for advice and/or assistance.