How you structure your business can have a significant impact on how much you pay in taxes, what you have to do in order to maintain your personal liability protection, and how much time you spend doing compliance-related activities. In the interest of giving you an idea of what may be the best option for you, we at Hartmann Law wanted to break down some of the biggest differences between three of the most popular business formation structures.
It is important to begin with the understanding that an LLC is a legal entity only, and is not recognized by the IRS as a taxpaying business structure. After setting up, the owners of an LLC must choose between a C corporation, S corporation, Partnership, or Proprietorship.
The reason for the popularity of LLCs (which stands for limited liability company) experience is because LLCs protect the owner’s personal assets from business lawsuits, is significantly easier to manager from an administrative perspective than S-corps or C-corps, and still provides the flexibility to change as the business evolves. For example, it is common for LLCs to be converted to an S corporation status after the company becomes profitable, or C corporation when the company is preparing to pursue investment.
One of the largest drawbacks to proprietorships and partnerships is that profits are subject to both federal income tax and Social Security tax (otherwise referred to as FICA). FICA tax is 15.3% of income up to $128,400 and 2.9% of income past that threshold. This can often be higher than a businesses income taxes.
Benefits of an LLC
- A simple way of protecting personal assets
- Easy to form, minimal guidelines or restrictions for how it is operated
- Unlimited owners
- There is flexibility in how the business wants to be taxed
Disadvantages of an LLC
- LLCs cannot go public
- There is not global recognition, so other countries that the LLC does business in may tax it as a corporation
- Proprietorships and Partnerships are subject to both federal income tax and FICA taxes
S corporations (or S-corp for short) are pass-through tax entities. They file an informational federal return (Form 1120S), but do not pay corporate taxes on income. Instead, the profits or losses of the corporation are “passed-through” to the shareholders, who are then able to claim on their personal tax returns. This means that any tax due is paid at the individual level by the business owners.
Benefits of an S-corp
- S-corps provide limited liability protection for owners’ personal assets
- Profits are taxed at a personal tax rate versus a corporate tax rate. This often means a lower tax rate and an ability to claim deductions, credits, and losses on personal filings
- The overall tax bill can be reduced by the owners receiving a “reasonable” salary, and then dividends for the rest of the profits (dividends are not subject to self-employment taxes)
- The owner salaries can be deducted prior to calculating the amount shareholders pay taxes on
Disadvantages of an S-corp
- All shareholders must be U.S. citizens or residents and fit certain parameters, which can make selling or transferring shares harder
- Strict qualifications around who can be a shareholder, and how shares can be structured
- Profits must be allocated based solely on percentage of ownership. There is no flexibility in allocation
- Corporate formalities such as having a board, conducting board meetings at least once a year, and keeping minutes at all board meetings
- Limited to 100 shareholders or less
- All stock must be commonshares, which means that in the case of a sale, creditor actions, liquidation, or restructuring event such as bankruptcy, all business owners get paid last
In contrast to LLC’s and S-corps who are pass-through entities, C corporations pay corporate taxes at both the federal and state level. Right now that means a flat 21% federal tax, and a variable state tax based on which state you are in. At the same time, any disbursements that are made out of a C-corp are usually in the form of salaries or dividends to shareholders. This is where C-corps get their reputation for double taxation – since the company is paying federal and state taxes, and then the individual is charged payroll taxes, while the shareholder is paying long-term capital gains taxes on any dividends received. This means that C-corps may be better for businesses who think they will quickly scale past 100 employees, or who will want to show net profits, and be able to retain them within the business.
Benefits of a C-corp
- Great if planning to potentially go public one day, since the company can issue shares to founders, employees, and investors
- There are no restrictions on the number of investors
- Owners or investors can get preferred stock, which have priority and preference over commonstock shares
- The corporate structure is recognized internationally
- If potentially taking on investment in the future, C-corps are preferred by investors
Disadvantages of a C-corp
- Double taxed – the business pays federal and state corporate taxes, and shareholders pay long-term capital gains taxes
- Significantly less management flexibility
- Administrative rules that must be followed or else personal protections for owners and shareholders is waived
- Must have a board of directors, with stricter governing rules
- High cost and complexity to set up
What else do you need to know?
S Corps and C corps need to have a board of directors elected by the shareholders, and must hold an annual meeting, with minutes. Corporations have as few as one director, as in Massachusetts or Delaware, for example, but the exact amount varies based on the rules in that state. A failure to meet these requirements can result in potentially no longer maintaining limited liability for company shareholders.
This “Board of Directors” seems like a big deal. Tell me more about it
The board of directors, as elected by the shareholders, is responsible for overseeing the company and setting corporate policy. The directors are the ones who authorize stock issuance, declare stock dividends, and set executive salaries. The board also makes decisions around financial items that can have a potentially large impact on the business such as business loans and real estate purchases. The officers, elected by the board, tend to more of the day-to-day operational decisions. Some states require that directors meet in person, but most allow board meetings to be held over the phone.
The reason the board of directors requirement is a very important aspect of the rules governing C-corps, is because the board of directors has the power to fire and replace the founders or executive team if they do not believe they are doing a good job. Since LLCs do not require a board, and S-corps allow the board to be composed entirely of internal members such as the founders, the C-corp has a much higher likelihood of adverse action against an executive if there is a confrontation or poor performance.
Who can be on the board?
In smaller companies, the board of directors and officers are often the same people. The CEO of the company is often also the chairman of the board and the other top executives may also serve. If there is a major shareholder or investor who is not an employee of the company, they may want to either be on the board or have someone represent them. As a private company, there is no obligation to have outside directors. With that said, it may sometimes be a good idea to diversify the board with outside perspectives to make sure there are no blind spots, and to identify problems or growth opportunities that the executive team or internal board members may miss.
At Hartmann Law, we enjoy considering all of the factors that can create the best possible business structure and outcomes given the goals that you as a business owner have. Through planning ahead, the results of the business structure can have a significant impact on the company’s bottom line. To discuss creating or transitioning a business structure, or to see how we can help with compliance for your S corporation or C corporation, give us a call at (816) 599-6638 or visit us at https://hlawkc.com/.