Use a Corporation to Keep More of What You Earn and Shield Yourself from Personal Liability

Most business owners today are operating as limited liability companies (LLCs). The LLC offers less formality and hassle than traditional corporate entities, but generally affords protection from pesonal liability unlike a sole proprietorship. However, what about the traditional types of corporations? Is it wise for you to consider an S or C corporation? Or should you stay with an LLC? 

They All Offer Protection from Liability

S corporations by law are a unique entity, separate and apart from those who own it. This limits the financial liability for which you (the owner, or "shareholder") are responsible. Nevertheless, liability protection is limited - S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.

C corporations are also an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs. C corporations are more complex than other business entities because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally suggested for established, larger companies with multiple employees. For businesses in that position, corporations offer the ability to sell ownership shares or "go public" through an initial public offering (IPO).

Limited Liability Corporations (LLCs) are a hybrid type of legal structure that provides the limited liability benefits of an S and C corporation, but with tax efficiencies and less formal requirements of a partnership. The “shareholders” (owners) of an LLC are referred to as “members.” Depending on the state, the members may consist of a single individual (one owner), two or more individuals, and even corporations or other LLCs can be members.

The Tax Consequences of Each Type Corporation are Different

This is where it gets interesting – and a bit complicated. Therefore, this is where it’s vital you seek a tax professional who can help you navigate the tax consequences of forming an S or C or LLC. For example, unlike shareholders in a corporation, LLCs are not taxed as a separate business entity, but instead all profits and losses are “passed through” the business to each member (owner) of the LLC. If you are a member of the LLC, then you will report profits and losses on your personal federal tax returns, just like the owners of a partnership or a sole proprietor would.

With an S corporation, the profits and losses pass through to your personal tax return. The federal government and most states do not tax the S corporation itself; only the shareholders are taxed. Notice that this allows an S corporation to retain earnings and avoid tax liability. However, any shareholder who works for the S corporation must be paid reasonable compensation. In basic terms, this means shareholder must be paid fair market value, or the IRS can reclassify corporate earnings as "wages."

A corporation may be taxed as a C corporation for many years and then convert to an S corporation, and you can convert an S to a C corporation by voluntarily revoking the S election. You may want to convert to a C corporation because of changes in the tax laws or to provide the corporation with more flexibility as the business grows. And converting to a C corporation offers greater ability to raise capital if the corporation decides to go public. It may also allow the business to offer a wider range of tax-deductible fringe benefits.

Income from a C corporation is taxed twice. The corporation pays tax on its net income. Then, shareholders also pay tax on distributions. Income from an S corporation is taxed once at the shareholder level.

What Corporation is Best for You?

The only way for you to answer this question is to get the advice of a tax professional who will – in plain language – give you sound advice after carefully considering your business and your business goals.

However, in my opinion an S corporation provides the most benefit for small and medium sized businesses. Usually, C corporations are not the best choice for small businesses. The main reason is the double tax on income and on proceeds of sale. Besides, if you incur losses, you want to claim them personally, favoring an S corporation. Whatever you do, get some advice, and pay attention to the tax rules.

Now this advice may not be right for you, but what I advise many of my clients who are members (owners) of an LLC, is to combine the benefits of an LLC with an S corporation by requesting S Corp status for your LLC. This is relatively easy to do by completing and filing Form 2553. The LLC remains a limited liability company from a legal standpoint, but for tax purposes it's treated as an S corporation. 

If you have a tax question or tax problem, I would love to talk with you. Call me free at (800) 659 0525.

Be the first to comment!
Post a Comment