Tax savings is one of the advantages of doing business as an LLC or corporation. If you’re operating as a sole proprietor or independent contractor, you may discover significant tax benefits by forming a business entity.
Of all the choices you have, which one is better for taxes: an LLC or C Corp?
Spoiler alert: it’s somewhat of a trick question. You’ll soon learn why.
How Could An LLC Be Better For Taxes?
Limited Liability Company’s (LLCs) are a very popular type of business structure. Not only do they help limit personal liability, they offer significant flexibility when it comes to how the business will be taxed.
There’s no specific “LLC income tax” in the Internal Revenue Code. Instead, LLCs can be taxed as disregarded entities (similar to sole proprietorships), S corps, C corps or partnerships.
An LLC has members; and an LLC can be a single member or multi-member LLC. The number of members will affect the taxation options available.
By default, single member LLCs are automatically treated as a “disregarded entity” by the IRS unless the members choose (and notify the IRS) otherwise.
What does that mean? Unless the business owner chooses otherwise, the single-member LLC will be treated like a sole proprietorship. In this “pass through taxation,” the income (or losses) of the business will flow through to the personal income tax returns of the members. Members are responsible for taxes, including self-employment tax. (Self-employment taxes refer to Social Security and Medicare taxes normally split by employee and employer.)
In this scenario, the LLC owner will use Form 1040, Schedule C to report business income and expenses and include it with their personal tax return. If you’ve filed taxes as a sole proprietor or independent contractor before, the Schedule C form will be familiar to you because it’s the same tax form you used as a sole prop.
Multi-member LLCs are treated as a partnership by default unless they elect to be treated as a corporation or disregarded entity for tax purposes. If taxed as a partnership or disregarded entity, business income and expenses flow through to the member’s tax returns. Partnerships use Form 1065 to report income and expenses, which are split based on the owner’s proportional ownership.
LLC’s can also choose to be taxed as a corporation by filing IRS Form 8832 with the IRS. Multi-member LLCs also have the choice of being treated as a partnership for tax purposes. They also file IRS Form 8832 to make this election.
If the LLC wants to be taxed as an S Corp, it will file IRS Form 8832 and subsequently file another form, Form 2553 to elect to be taxed as an S Corp.
While you can file Form 8832 anytime, there are deadlines for it to take effect so be sure to talk with your tax advisor as soon as possible if you don’t want to choose something other than the default.
How Could A C Corporation Be Better For Taxes?
If an LLC chooses to be taxed as a corporation but does not take the extra step of electing to be taxed as an S Corp, it will be taxed as a C corp. That’s the default.
A C corporation is not a pass-through entity. There is a corporate tax, and the corporation must file a tax return and pay taxes on its income. If it also distributes profits to shareholders in the form of dividends, the individual shareholders pay taxes on the income they receive as dividends on their personal taxes. This results in what’s known as “double taxation.”
Why would a business owner ever choose this option? Business owners may decide to be taxed as a corporation if they don’t want all profits to flow through to their personal tax returns.
If they work in the business, for example, they can get paid a salary. The corporation can deduct employee’s salaries, and payroll taxes will be split between the employer and employee. C corporations can also offer numerous benefits that are not taxable to the employee, such as health, dental and vision insurance, group life and disability insurance and even fringe benefits like a company car.
Who Pays More Taxes S Corp Or LLC?
Remember the trick question we mentioned earlier? This is a perfect example of it.
If you’ve seen the movie My Cousin Vinny, you may remember the scene where Marissa Tomeii’s character is being grilled about her “general automotive knowledge.” She’s answered a question she refuses to answer even after she is pressed by the prosecuting attorney.
“I can’t answer that question,” she tells the judge. “It’s a trick question.”
This is like that trick question, and by now you probably know why.
There is no single way an LLC can be taxed, so whether an S corp or LLC pays more taxes depends on how the LLC chooses to be taxed.
If it chooses, the LLC can be taxed as an S corp and pay the same amount of taxes it would pay as a corporation that elects S corp tax status. (All other things being equal of course.)
Some LLC members choose to be taxed as an S corporation, because it may allow them to reduce payroll taxes. In this scenario, the owner (member) pays herself a salary subject to payroll taxes, and also pays herself distributions, which are not subject to payroll taxes. This can reduce the amount of payroll taxes paid. Sole proprietorships don’t have this option, and with C corporations the employer and employee split payroll taxes.
Why An LLC May Not Be Beneficial For Taxes
There’s no reason why an LLC has to be a “bad” choice for tax purposes; after all, the members may choose various ways to be taxed, depending on the number of members.
However, unless the LLC has chosen to be taxed as a regular corporation, all profits will be taxable to members immediately, even if they leave that money in the business bank account.
If you’ve decided to form an LLC, you’ll want to talk to a tax professional to choose the best way to be taxed, and to make sure you notify the IRS of your choice in a timely fashion.
Why Choose An LLC Over A Corporation?
Both entity types offer owners limited liability protection. That means that if the business is sued, their personal assets are likely safe from creditors.
Remember, an LLC can choose to be taxed as a corporation so that may not be a reason to choose the LLC over a corporation.
Instead, business owners often find forming an LLC to be easier, faster and cheaper than forming and maintaining a corporation.
State filing fees may be lower, and LLCs avoid many of the corporate formalities that corporations must follow, such as holding annual meetings and keeping minutes, adopting bylaws, etc.
Is There A Downside To An LLC?
An LLC isn’t right for every business. If your goal is to build a business to get acquired, or if you want to attract investors, a C Corp may be a better choice.
LLC’s don’t issue stock; instead they issue management certificates that describe each member’s ownership. With an LLC, members must approve new members or changes in ownership. That makes it more difficult to bring on new members.
LLCs are more expensive to create and maintain than a sole proprietorship, but almost certainly cheaper than a C corporation.
What Is The Biggest Advantage A Corporation Has Over A LLC?
C corporations are often the preferred legal entity for businesses that want to get venture capital, find investors or go public. Because a C corporation can have unlimited classes of stock, it’s easier to raise money.
In addition, a corporation can retain earnings (up to certain limits) and can pay for fringe benefits that aren’t taxable to the employee.