One of the common questions from new business owners is, “should I form a limited liability company (LLC) or a corporation?” Although there are non-tax (e.g., legal) issues that should be considered, in this article we address entity selection from a tax perspective. After LLC’s became common, the IRS decided to let taxpayers choose how they wanted their entity to be taxed. Essentially, when you create a new legal entity, you decide how you want that entity to be treated for tax purposes and tell the IRS by filing Form 8832.  This election can be made up to three months after the new entity is created.  So for purposes of this column, the question is less “do I want an LLC or a corporation” and more “how do I want my entity to be taxed, regardless of which entity I choose?”

Corporations and LLCs can choose between the following three alternatives for tax treatment:

C-corporation treatment:  A corporation (a/k/a C-corporation) pays its own tax, using a set of tax rules and rates specific to corporations.  Any distributions to shareholders of the corporation are considered dividends and are taxable to the recipient.  This causes a “double tax”, once at the corporate level when the income is earned and again at the individual shareholder level when the dividend is paid out by the company.  Many closely-held businesses try to avoid this situation, and elect S-corporation tax treatment for the entity (see below).  [Note that what is referred to as an S-corporation is simply a corporation that has told the IRS they want to be taxed under sub-chapter “S” of a particular section of the Internal Revenue Code, hence they are referred to as S-corporations and corporations that have not made this election are referred to as C-corporations.] There are restrictions on the ownership and activities of S-corporations, so S-corporation tax treatment is not always an option, especially for larger companies and companies involved in certain industries. As compared to individual taxpayers, the marginal tax rates for corporations are generally higher and the brackets are more compressed (i.e. higher rates at lower income levels).  Additionally, there is no capital gains tax treatment for corporate income; all income is treated as ordinary income, which can be a severe disadvantage for entities taxed as corporations. However, the first $50,000 of net income is taxed at 15%, which means owners of new companies showing smaller profits often pay a lower tax rate on that income when taxed as a C-corporation than they would if the business was taxed as an S-corporation or an LLC (which by default is taxed as a partnership, but more on that below).

S-corporation treatment:  S-corporation tax treatment has traditionally been the most popular choice (by far) for closely-held businesses. An S-corporation does not pay tax separately from its shareholders.  Rather, any profit or loss “flows through” to the individual shareholders. The S-corporation will file its own “informational” tax return, but the responsibility for paying the tax rests on the shareholders themselves. The S-corporation delivers the shareholders a Form K-1 showing them how much profit or loss to declare on their own tax return.  There are limits on who can be shareholders of S-corporations (generally only individual U.S. citizens or permanent residents), the entity can only have one class of stock, and can have no more than 100 shareholders at one time. In addition, there are restrictions on the amount of passive income (e.g., dividends, rents, interest) that an S-corporation can receive. Closely-held business owners often prefer S-corporation treatment because: (1) they avoid corporate double-taxation; (2) they pay themselves a low salary (which minimizes payroll taxes like social security tax, unemployment tax, etc.); (3) they take the remainder of the profits out of the business as distributions (which are not subject to payroll taxes); and (4) they avoid self-employment tax (which is levied against all of the income of a sole proprietor). Sounds like a perfect scenario, right? Of course the IRS is wise to this structure and has been targeting S-corporations that pay owners an unreasonably low salary in an attempt to transfer the profits of the business to themselves while avoiding payroll and self-employment taxes.

Partnership treatment:  Partnership tax treatment is chosen less frequently due primarily to a lack of understanding, but it is gaining in popularity. Remember, tax treatment election (C-corporation, S-corporation, or partnership) is separate and apart from legal entity selection (e.g., do I want to be a corporation or an LLC). Selecting partnership tax treatment in and of itself will not destroy the liability protection afforded to corporations and LLC’s. Like S-corporation tax treatment, partnership treatment means the entity itself pays no tax, but passes profit/loss to the individual owners of the entity.  Unlike S-corporations, partnership treatment comes with none of the restrictions on ownership, classes of stock, etc. that apply to S-corporations. Entities electing partnership tax treatment have considerable flexibility in structuring profit and loss sharing between owners. For instance, say there is a “silent partner” that puts capital into the business, does not participate in operations, and wants his/her capital contribution returned from profits before any other owners receive distributions. This can be done under partnership tax treatment, but would be prohibited as an S-corporation because it results in different owners having different rights (i.e., the entity has more than one class of “stock”). Operating this way as an S-corporation would cause the entity to lose its S-corporation election, reverting it back to C-corporation tax treatment. This is likely to have very ugly tax consequences for the owners of the business. So you may be wondering why anyone would choose S-corporation treatment when you can achieve the same benefits as an LLC electing partnership treatment and avoid the restrictions on S-corporations. The answer is that while the IRS has long ago decided that distributions from S-corporations to owners actively involved in the business are not subject to self-employment taxes, they have technically never decided the issue with respect to distributions to owners of LLC’s that have elected partnership tax treatment. Because of this, some owners choose the limitations on S-corporations over what they perceive as uncertainty in the IRS’s position with respect to LLC’s electing partnership tax treatment.

Choosing the correct entity and tax treatment is an individualized decision and should be done only after discussing your specific situation with your lawyer and tax advisor.