As an attorney concentrating in business organization, I take a central role advising my business clients on the appropriate entity to form. Most of my clients approach me already LLC services armed with the knowledge that an organized business entity will generally shield them from personal liability for the acts or omissions of the business. However, relations between multiple owners, tax considerations and treatment of assets are just a few of the factors that will dictate which choice of entity is truly suitable for your business. By and large, there is no uniform “right” choice. A careful review of the details, strategies and goals of each business needs to be made before the proper entity is chosen.
Corporations and limited liability companies (LLC’s) are the most commonly utilized business entities. Since most small to medium sized businesses are better structured as either a corporation or LLC, this article highlights some basic similarities and differences between these entities. I have attempted to provide an overview of these key elements below. But, keep in mind that the information below, by itself, will not allow you to make a proper, informed choice of entity. This should always be done with the coordinated assistance of your attorney and accountant.
Most large companies are C corporations. All publicly traded corporations are C corporations. The “C” designation comes from Subchapter C of the Internal Revenue Code, which governs corporate taxation. There are a variety of reasons C corporations are more aptly suited to large businesses. Multiple classes of stock, unlimited number of and types of shareholders, a fiscal year vs. calendar tax year and retention of corporate earnings are just a few of the key differences of a C corporation. Generally, this structure is desirable for businesses who seek to raise capital publicly or whose class of investors vary.
Most importantly, C corporations are subject to double taxation. This means that all of the income of the C corporation is taxed once at the corporate level, then those same revenues are taxed again at the shareholder level when profits are distributed via dividends. In smaller C corporations, the double tax can sometimes be avoided by eliminating net income each year by making payments to shareholder-employees. Shareholders must report any dividend earnings as capital gains on their personal tax returns.
A corporation starts out as a C corporation for tax purposes. All corporations are automatically recognized as C corporations, unless the shareholder’s elect “S” corporation tax treatment, which is discussed below. The taxable income of the C corporations (after deductions for salary, business expenses and depreciation on furniture and equipment) is taxable to the corporation itself. The C corporation would only be taxed on income “effectively connected with the United States”, beginning at a corporate tax rate of 15% for the first $50,000 of corporate taxable income each year.
If the corporation is classified as a “personal service corporation”, (PSC), is will pay a 35% flat rate from dollar one of net profit. This is a generally undesirable entity type. PSCs are C corporations whose shareholders are engaged in the performance of personal services in the fields of accounting, actuarial science, architecture, consulting, engineering, health and veterinary services, law, and the performing arts. The lowest 15% tax rate is only available to a corporation rendering personal services if a person who is not employed by the corporation owns at least 6% of the issued stock of the corporation. Otherwise the top personal tax rate would apply to the taxable income from personal services in that corporation. A PSC is a C corporation by definition. Thus, a timely made S-election, as discussed below, would negate classification of your corporation as a PSC and avoid the 35% flat tax rate.
There are some unique tax advantages gained with the use of the C corporation. Some of the key advantages most beneficial to small businesses are the ability to deduct all of the premiums paid on health insurance for owners who are employed, along with their spouses and dependents. In addition, a C corporation may adopt a MERP (Medical, Dental and Drug Expense Reimbursement Plan) at any time during a fiscal year, which can be made effective retroactive to the beginning of the fiscal year and can purchase disability insurance for one or more of its executives or other employees. A C corporation can also deduct the premiums of disability insurance without the cost being taxable to the executive or employee. Finally, a C corporation can deduct contributions to qualified retirement plans.