Among the many decisions you need to make when launching a business is selecting a business structure. If you do nothing, your business, by default, is structured as either a general partnership (multiple owners) or sole proprietorship (solo owner). These may be the simplest entities to form, but they offer one major drawback: There’s no separation between the business and business owner.
If your partnership or sole proprietorship business is sued or can’t pay its bills, your personal assets can be on the hook. That is why both the Limited Liability Company (LLC) and C corporation, or just corporation, are popular business structures, as they minimize the owner’s personal liability. Yet, they have vastly different approaches to taxation.
Here we’ll break down the five key differences between how an LLC and corporation are taxed. While these pointers can be a great starting point, you should consult a tax advisor if you have any questions about how these differences apply to your particular situation.
1. Pass-through business structure vs. non pass-through entity
By default, an LLC is considered a pass-through entity, similar to a sole proprietorship or partnership. This means that the business itself doesn’t pay income taxes on its profits; rather any profits or loss are passed through to the owners (called members) and reported on their personal tax returns.
By contrast, a corporation is considered a separate legal entity and must submit a tax return and pay income taxes on its profits. In some cases, this can lead to “double taxation," where the corporation is taxed on its profits, then when the owners take those profits out, they will need to report the dividend on their personal tax returns. For some small-business owners who are accustomed to taking profits out of the business, double taxation can be costly.
Keep in mind that a corporation can elect a “S corporation tax treatment” to be treated as a pass-through tax entity like an LLC. Additionally, an LLC can even choose to be taxed like a corporation or an S corporation.
2. Ability to leave money in the company
While C corporations are subject to double taxation, they offer more flexibility in terms of income shifting compared with pass-through entities like LLCs and S corporations. When an LLC is taxed as a pass-through entity, its members must pay taxes on their share of the profits, whether or not that money stays in the business or is distributed to their personal account.
By contrast, C corporation owners are taxed only on the actual amount they receive as dividends. By working with a tax advisor, you can allocate your business’s profits in such a way to take advantage of lower income tax brackets. For example, if your business made $90,000 in profits for the year, you could choose to leave $50,000 in the corporation as corporate profit and take $40,000 in salary.
3. Social security and Medicare taxes
LLC members are not considered employees, so their share of the profit is not subject to social security or Medicare tax. However, LLC members who actively work in the business need to pay self-employment taxes on their income (including salary and their share of any profits). However, with a corporation, only the salaries are subject to social security and Medicare taxes. Any profit distribution isn’t subject to these taxes.
Keep in mind that an LLC can opt to be taxed as a corporation. In this case, only the member’s salary is subject to social security and Medicare and not the profit distribution.
4. Ability to deduct a loss
LLC members who actively work in the business are able to deduct the business’s operating losses on their personal tax return to offset other income. C corporation shareholders are not able to deduct these losses but S corporation shareholders can.
5. Employee benefits
In terms of perks and benefits, there are some key differences between an LLC and a corporation. First, certain retirement plans, stock option and employee stock purchase plans are only available for C corporations. In addition, LLC members (as well as S corporation shareholders who own more than 2 percent of the business) need to pay taxes on certain employee benefits like health benefits, employer contributions to HSAs or FSAs, and life insurance benefits. Shareholders of a C corporation do not have to pay taxes on these benefits.
When it comes to choosing a structure, there’s no single right answer that works for every business. You need to think about your financial situation and future plans to determine the optimal structure for your needs.