There are many complexities involved in launching a new business. One of the initial conundrums you will need to unravel is figuring out what is the difference between a Corp and an LLC?
The majority of movers and shakers need to pick between establishing a corporation (aka INC) or an LLC (limited liability company). This can be a tough decision in its own right, largely because it’s difficult to understand what the differences are and which will benefit you more.
So here’s a look at the factors that differentiate the two, and the other options that are available.
On a superficial level, working out what separates an LLC from an INC is straightforward.
An LLC is typically either owned by one person or a small group of co-founders.
Meanwhile, an INC effectively belongs to the people who hold shares in it, which means that the management is accountable to the shareholders.
One reason that making your business an LLC is worthwhile is that, as the name suggests, the owners are considered as separate entities to the organization itself, from a legal standpoint. Any debts it accrues will not fall to you to repay should it encounter legal issues, for example.
That said, an INC pretty much offers the same liability protections that an LLC does, especially for INCs owned by one person or spouses (even though it’s not in the name! I know!). This information comes from my long time attorney, by the way.
In the end they both will protect you similarly…I am told.
One of the common issues discussed when deciding between an INC or LLC is the amount of paperwork hassle you have to undertake.
Generally speaking, it’s true that LLCs have less paperwork, particularly in the sense that it doesn’t have to hold “annual meetings” of the directors and take meeting minutes. It also does not have to issue “stock certificates” to its members.
It’s also true that a single member LLC doesn’t have to do payroll, or even file a tax return (because all profit is taken on the individual owner’s “schedule c”). Now, that would be beneficial, except for the fact that, as you will see below, it comes at a relatively high financial cost.
So if you make your LLC an S corp to save on taxes, you will have to, in fact, do payroll and file a tax return for the entity. But again, that still does leave the LLC/S sorp with less paper work hassles overall.
Tax savings used to be the most important deciding factor between INCs and LLCs. Oddly, since now both C corps and LLCs can be classified as S corps for tax purposes, they are pretty much the same. But let’s take a closer look…
Just as independent contractor taxes are applied on the basis that this is personal income, the same status is relevant if you generate income from an LLC as a sole owner. In plain english, a single-member LLC does not have to do a tax return. The net income goes right on your personal return on the “Schedule C.”
Multi-owner LLCs will be taxed as partnerships, which means the entity does have to file a tax return. The net income still passes through directly to the members personal return, only it’s in the form of a K1.
In both of these cases, being the profit of the LLC is passed directly onto the members, the entity itself pays no taxes. This is a so-called “pass-through entity.”
Furthermore, in both cases (specifically of LLCs) those profits that are passed through are subject to “self employment tax” (of an extra 15%) on the personal return. In the same way that 1099 income would be. This is very important to note…more on this below!
NOTE: K1s are the tax document a company owner will get at the end of the year to represent the income they received from the company. It’s similar to the W2 that an “employee” receives or a 1099 that a freelancer would get.
Corporations, on the other hand, are taxed as if they were an entity in their own right, with revenues gained through sales considered the equivalent of income earned by an individuals.
A C corporation earns money, has expenses it deducts, then pays federal and often state tax in the net income. It does not “pass-through” to the shareholders. That said, you can make an INC a pass-through entity by giving it an S corp election (see below).
A tax on profits and dividends will also apply. If you are a shareholder, the dividends in particular will be taxed twice (which is why people often avoid C corps) since they are not deductible.
This encourages owners to inject cash back into the business, rather than extracting it as it grows (to avoid this double taxation). What this means is that the C corp does not have to pass on the profits if it doesn’t want to. It can just keep them and reinvest them back into the company.
Now don’t think you are out of the tax woods yet! Your state will want to get its hands on some tax as well, most likely.
There are actually two types of state tax you may run into. You have tax on “net profits,” which you would commonly refer to as “income tax.” Income tax will only be paid by a C corp (or a non pass-through entity).
That said, some states also have a “privilege tax” (which can also often be called a “franchise tax” or “minimum business tax”).
Privilege tax is just that. A tax for the privilege of doing business in that state. This tax is often based on the gross revenue of the company, with a minimum amount imposed.
NOTE: The privilege tax percentage may be the same for both LLCs and INCs, but often it’s different…yah! I have found that the privilege taxes imposed on LLCs are often higher than that of INCs.
To confuse matters a bit more, most states also require you to file an “annual report” where you update them on any changes (or lack of) that have happened with your entity. With this report you usually pay a fee.
In some states, the annual report fee is one-in-the same as the privilege tax. In others you may have no privilege tax, but you have an annual fee. While in others, you have just a privilege tax and no annual fee! Aye yai yai!
Suffice it to say, you should do some investigation on this. You can check out my post Annual S Corporation Filing Requirements for all 50 States where I lay most of this out!
S Corp (Tax) Status
At some point, it became possible to give your corporation (which by default is a “C” corp) an “S” corp designation. This basically makes the corp a pass-through entity. But an S corp exists only as a taxation option, rather than as a specific type of entity.
Now it’s true that this means all profits are no longer taxed at the corporate level, but passed through to the shareholders. HOWEVER, being that in a corporation the (active) owners are also considered employees, you have to do some amount of payroll for the owners.
The common practice (for single owner entities) is to give yourself half of your profits in the form of “W2 Salary,” and the rest as profits. This is also a very important tax distinction…more on this below.
This can also be useful in preventing the full profits of a business from being taxed if you are only taking a small proportion of this as income.
Interestingly enough, it is possible for LLCs to also request to be classified as an S corp by the IRS. In the case of an LLC that is classified as an S corp, this means the owner is considered to be an employee (just like in a C corp/S corp).
So rather than simply equating the income and expenses of the organization to personal income on their tax returns (i.e. on their “Schedule C”), they must take part of their profits in the form of W2 salary.
Effectively, both LLCs and corporations can be classified as S corps if they wish, although there are some restrictions. An S corp cannot have over 75 shareholders, and every one of them needs to be resident in the US.
The CRITICAL Self-Employment Tax Distinction (for an S Corp) **VERY IMPORTANT**
Ok, this is probably the MOST IMPORTANT thing to know in all of this bologna! Remember how I said that…
1) An LLC passes through all the profits to the members and then has a 15% “self-employment tax” imposed?
Well the reason this is the case is because the fed and state want to get some money for social security, medicare and UI. But being you don’t receive W2 payroll, they don’t collect it though your paycheck. They collect in the form of a self-employment tax.
2) I also said that an S corp considers the owners “employees,” which requires you to pay yourself via a W2 paycheck, which in fact does send the government those employment taxes.
HERE’S THE THING. With an S corp, you only have to pay yourself “reasonable” compensation in the form of W2. Commonly this is considered to be somewhere between 40-60% of your profits (depending on what your CPA advises).
The remainder of your profits come to you from that K1 that I mentioned earlier. BUT for whatever reason, that K1 income is NOT SUBJECT TO SELF-EMPLOYMENT TAX. Thereby by saving you a ton in taxes!
TAX SAVINGS WITH AN S CORP: If you netted 100K from your business, with a straight LLC you would pay 15K in employment taxes, while with an S corp (INC or LLC) you would pay only 11K (roughy speaking with 50% payroll).
Here is a tax calculator I made illustrating what I just wrote above (in the green box).
Now, if you are interested in getting your hands on this calculator, or are thinking about setting up an entity for yourself…..
I present my course on this topic! This free version allows you to download the calculator, and walks you through setting up an entity on IncFile*!
Ok, back to the post…
Some other semi-important random points about the entities
- LLCs can have INC/C corps, INC/S corps, LLC/S corps, LLCs and people as members.
- S corps can only have individuals (or a living trust) as a shareholder.
- S corp can change back to C corp, but once you do that you have to wait 10 years if you want to switch again.
- Per my CPA: Except for medical write-offs, S corps are usually more tax favorable.
- Per my CPA: Statistically S corps get audited the least of all entities.
- If you have losses on a C corp, no one gets the benefit, as it does not pass through. Losses are passed through to the owners for S corps and straight LLCs.
- Customers are required to send Single Member LLCs and Partnership LLCs a 1099. But they don’t have to send a 1099 to a INC/C corp, INC/S corp or an LLC/S corp. For those entities, you are on the honor system in terms of reporting your income to the IRS.
Which is right for you?
For small businesses, becoming an LLC (with an S corp election) could be the best option. Particularly if the organization is very small and is aiming to minimize the complexity of its tax affairs, while still protecting the owners from unwanted legal ramifications.
But again, you should double check the state based taxes for LLCs before going that route. I honestly feel that all-in-all the INC/S corp is the best way to go for individual owners or spouses. That’s what I do.
Growing firms with several owners who are looking at the option of becoming a corporation, but do not want to commit to being a fully fledged C corp, should consider the advantages of S corp status. You can even go back to being a C corp if you need to.
In short, there are positive and negative aspects of each approach, and you need to balance whether the innate malleability of LLC status is better than the credibility and anonymity that comes with incorporating…or perhaps pick S corp classification as the middle ground.