You’ve decided that you want to form a company. Great! Maybe you want to form a simple C corporation, but you’ve heard something about “double taxation,” and you certainly don’t want to pay taxes twice. You’ve also heard people, in passing, mention S corporations, but you probably didn’t want to dig around in subchapter S of the Internal Revenue Code (“IRC”) to find out the benefits of an S corporation. I’m sure you’ve also heard of a Limited Liability Company (“LLC”), and some of the benefits of the LLC structure. So, which do you chose, and more importantly, why?
The C Corporation
The C Corp. is the entity that people typically think of when first investigating entity formation. The C Corp. has a lot of advantages, and some major drawbacks.
The primary advantage of a C Corp. is limited liability. This means, if the corporation is sued and there is a judgement against the corporation, as a shareholder, your personal assets are not on the line. There is a caveat to that statement: In certain cases, courts can “pierce the corporate veil” if the elements are met. This typically involves a fact pattern where the shareholder is perpetrating some type of fraud through the corporation, using the limited liability characteristic to shield the shareholder’s assets from liability while engaging in the fraud.
Many other advantages deal with taxation, an often neglected aspect of the considerations when forming a company. Shareholders only have to report income when they receive dividends, or non-dividend distributions in excess of the bases in their shares. That means, shareholders are insulated from taxation on corporate profits until those profits leave the “corporate box.”
An important aspect of a C Corp. is the fact that the highest corporate tax rate, 35%, is lower than the highest personal tax rate, 39.6% (or 43.4% if the taxpayer is subject to the 3.8% tax associated with the Affordable Care Act). This is a great characteristic for a person who wants to continually reinvest profit of the corporation back into the corporation. For someone who is looking to fund the growth of the company through reinvestment, a C Corp. structure could save nearly 10% in taxes, allowing more money to flow back to the corporation.
As mentioned, there are drawbacks to the C Corp. structure, the foremost being the dreaded “double taxation.” For example, let’s assume Corporation A has $100 in revenue and is taxed at 35%. After paying taxes, the corporation is left with $65 of profit. If the corporation has a single shareholder and distributes the $65 to the shareholder, depending on the shareholder’s income tax bracket, the shareholder could have to pay up to $15.47 in taxes on the dividend. In total, the tax paid on the corporation’s $100 revenue is $50.47. That is over a 50% tax rate when distributions are given to the shareholder.
Obviously, a potential tax rate higher than 50% is off-putting to many, especially small business owners.
Lastly, but importantly, especially for a corporation that may acquire many capital assets, there is no preferential long-term capital gain rates. Simply, everything is taxed at the corporation’s tax rate, whether it’s an ordinary or capital asset. The disparity between a long-term capital gains rate and the corporate tax rate could be as much as 20%. This exacerbates the effects of double-taxation.
The S Corporation
An S Corp. is, in many respects, like a C Corp. In fact, an S Corp. is a C Corp. that has filed an election under subchapter S of the IRC. Unlike a C Corp. though, an S Corp. is not subject to federal taxation (with a few exceptions beyond the scope of this article). Additionally, S Corps. come with more restrictions.
Only “small business corporations” can file for S Corp. status. In order to be taxable as an S Corp. the corporation must follow these requirements:
1) The corporation cannot have more than 100 shareholders;
2) The corporation must be a “domestic” corporation;
3) The corporation may only allow individuals to be shareholders (no partnerships or corporations);
4) All shareholders must either be US citizens or US “residents” under the income tax laws; and
5) The corporation may have only one class of stock.
In lieu of double taxation, the IRC allows for S Corp. shareholders to directly report their pro-rata shares of income at their personal income tax rates. An S Corp. is referred to as a “pass-through entity” for tax purposes. This is because income passes through the corporate structure and is then taxed to the individual shareholder. Further, unlike the C Corp. that gets no benefit from long-term capital gains, because the S Corp. is a pass through entity, shareholders can take advantage of long-term capital gains rates.
For example, if the S Corp. has $100 in revenue and a single shareholder, the only tax due on that $100 is determined by the shareholder’s tax bracket. Therefore, assuming the shareholder is in the 35% tax bracket, only $35 dollars is paid in taxes, leaving $65. Moreover, if that $100 in revenue was due to long term capital gains, the shareholder, depending on tax bracket, will only pay a maximum of 23.8% in taxes.
Another benefit of the S Corp. is the ease of formation. Unlike the LLC to be discussed, the formation of an S Corp. requires filing the requisite forms with the state and IRS and paying the associated filing fees.
An additional consideration is whether your company might attract investors. As outlined above, an S Corp. can only have individuals as shareholders and shareholders must be U.S citizens or residents. Many investors come in the form of limited liability companies or limited liability partnerships. In order to have investors who are not individuals or U.S. citizens or residents would necessitate a conversion from S Corp. to C Corp. This can have additional tax ramifications due to the conversion.
Lastly, many investors will want preferred stock, which will allow the investors to recoup their investment before common stock shareholders receive dividends in addition to other benefits. As mentioned above, an S Corp. may only issue one class of stock. Therefore, while an S Corp. may be a great entity choice for certain small businesses, it can create issues down the line if the long term future of the company has not been fully explored.
The Limited Liability Company
The LLC is similar to the S Corp. in that it is a pass-through entity. However, unlike an S Corp., which is a corporation, an LLC may be treated like a partnership. I say “may” because under the “check the box” rules of formation, a person may literally check a box to determine whether the LLC will be treated as a partnership or a corporation.
It is also important to understand that forming an LLC can be more expensive than forming either a C or an S Corp. This is due to the fact that there is a publication requirement for LLCs in New York which, when including filing fees, can be several hundred dollars more than the fees associated with a corporation.
An LLC with a single member will be, for tax purposes, treated as a disregarded entity. That means the IRS will treat the LLC as though it does not exist, and instead will treat the entity as a sole proprietorship. LLCs with more than one member are treated as a partnership for tax purposes, unless the members choose to treat the LLC as a corporation for tax purposes.
As with the other types of entities discussed above, the major benefit of an LLC is limited liability. However, like the S Corp. and unlike the C Corp., the LLC avoids double taxation. Further, an LLC allows an owner to offer a share of the company’s profit without giving up any ownership interest. This advantage is similar to a C Corp’s ability to have preferred stock, which may restrict certain ownership interests in the corporation. A profit interest in an LLC is similar to an equity interest in that it entitles the holder to a certain percentage of the LLC’s profits. However, unlike an equity interest, a profit interest holder has no right to anything if the partnership were to liquidate after the profit interest holder receives his or her interest.
Finally, because LLCs are essentially contractual relationships, they offer much greater flexibility regarding distributions and taxation than either a C Corp. or an S Corp. For example, an LLC may distribute an appreciated piece of property (not cash) to a member and neither the member nor the LLC will recognize gain on the disposition, assuming there is not a deemed distribution due to liabilities in excess of the member’s basis. In both C and S Corps. a distribution of appreciated property will result in a taxable event.
These considerations merely scratch the surface when determining the appropriate entity for a business venture. Discussing entity selection with an attorney who specializes in corporate formation and taxation will help you come to an informed choice that will suit your particular business purposes as well as helping to minimize possible tax issues, planning for mergers and acquisitions and attracting potential investors.