When forming a business, buying out a business partner, or litigating a partnership dispute, it is important to understand the different kinds of business entities and their tax implications. The following article summarizes the different types of legal entities that are commonly used and the advantages and tax filing requirements of each.
I. Corporations vs. LLCs
Traditional corporations, also known as C corps, are simply corporations which have not filed an S corp election with the IRS. They pay corporate income taxes and pay their shareholders through dividends. Their shareholders then pay taxes on those dividends. This results in double taxation, which can be avoided through an S corp election (if there are less than 100 shareholders) or other entity structures.
A C corp is primarily useful for start-ups that rely on venture capital to scale quickly without making a profit in the initial years. In such cases, Delaware corporations are preferred by venture capitalists. The corporation can issue convertible notes or SAFEs to early investors before a meaningful valuation can be fixed. Direct shares are issued in later financing rounds once it's more practical to establish a valuation.
LLCs and S corps are pass-through entities which pay no income tax. Cash distributions ("draw") are not taxed either. Instead, the owners are taxed on their share of profits, as allocated on IRS Form K-1. This avoids the double taxation of a C corp. To avoid a massive tax payment each April, the owners pay quarterly estimated taxes to the federal, state, and city governments.
Corporations in New York City must pay NYC Business Corporation Tax of 4.425%-8.85%. Owners of other business pay NYC Unincorporated Business Tax of 4%. The federal and state income tax rates paid by LLCs and S corps are the same, except as specified below. An LLC can elect to be treated as a S corp for tax purposes, but not vice versa. Because of the lower NYC tax rate, flexibility, and reduced corporate formalities (reducing the risk of corporate veil-piercing), an LLC is generally preferable to an S corp.
II. Taxation of LLCs
By default, an LLC with one owner is a "disregarded entity" for tax purposes. Its income and expenses are reported on a Schedule C of the personal tax return (Form 1040) of its owner. This is identical for tax purposes to a sole proprietorship, where the business and the owner are treated as one and the same, but the LLC provides its owner the benefit of limited liability.
By default, an LLC with multiple members will be taxed as a partnership and file a partnership tax return. This is an informational return unaccompanied by payment. It will issue K-1s to its members each year, reflecting their share of profit (or loss) and cash distributions. An LLP or LP is also taxed as a partnership.
III. Taxation of S Corps
LLCs and S corps are both pass-through entities that file information returns and issue K-1s to their owners. However, an LLC (unless it files an S Corp election) is unable to pay and deduct salaries paid to its members. It distributes only cash/draw. A corporation (or LLC that files an S corp election) may pay and deduct salaries paid to its members. This has three potential benefits.
One benefit is this allows tax withholding through payroll, which can simplify and smooth out tax payments. A second is that payroll taxes (employer and employee side of FICA) are only assessed against the salary and not draw. However, the salary cannot be artificially low, and FICA is only assessed against the first $147,000 of earnings anyway. The third potential benefit is that 20% of Qualified Business Income is deductible under the Tax Cut and Jobs Act of 2017, which is set to expire in 2025 unless extended. For Specified Service Trades and Businesses (including lawyers), business income is only treated as QBI up a threshold ($170,050 for singles and $340,100 for couples in 2022), after which there is a phase-out of the QBI deduction. The precise amount of the QBI deduction can depend on the entity's W-2 wages, so wages paid to owners may increase the QBI deduction.
IV. Taxation of Other Business Entities
B corps are corporations that may earn a profit but have a public benefit purpose. They will be taxes like a traditional corporation unless they file an election to be taxed as an S corp.
501(c)(3) corporations are corporations that have requested and received tax exemption from the IRS. While they do not pay income taxes or issue dividends, they are required to file informational returns, pay payroll taxes, and withhold income taxes from employees.
PLLCs and PCs are simply LLCs and corporations whose members are licensed to perform professional services. Their taxation is no different from other LLCs and corporations.
V. Formation and Governing Documents
An LLC is formed by filing articles of organization with the Secretary of State. This is a short form simply confirming the existence of the entity and designating the Secretary of State as its agent to accept service of process of any court papers. The rights and obligations of an LLC’s members are set forth in an operating agreement, which can be flexibly structured and can be comparatively complex. Even a single-member LLC is technically required to have an operating agreement, but that is effectively an agreement of the sole member to do whatever he, she, or it (entities can also be members) may please, with possible provisions for succession. Members hold membership interest in the LLC, but do not receive share certificates.
A corporation is formed by filing articles of incorporation with the Secretary of State. This too is a short form simply confirming the existence of the entity and designating the Secretary of State as its agent to accept service of process. The rights and obligations of a corporation’s shareholders are set forth in a shareholders’ agreement, which can be structured somewhat flexibly, but typically requires that the shareholders appoint a board of directors and designate corporate officers like a president, vice president, treasurer, and secretary. Members hold shares in a corporation and new shares can be issued to the extent authorized in the shareholders’ agreement. This can be useful for issuing stock options, convertible notes, SAFEs, or direct equity to new investors.
VI. Payroll Taxes, Workers Compensation, and Disability Insurance
Any company with employees must also pay payroll taxes (FICA) and obtain workers compensation and disability insurance. For employee income up to a cap ($147,000 in 2022), payroll taxes of 7.65% are withheld from the employee and the same 7.65% is matched by the employer. Business owners pay self-employment taxes of 15.3% (both sides of FICA) up to the cap. Workers compensation insurance can cost between 1% of payroll for office workers to 12-20% for construction workers. Employers who misclassify workers as independent contractors to avoid these costs can face substantial liability.
Conclusion
For most new businesses, an LLC is the simpler and more flexible entity structure. For companies that intend to scale to more than 100 owners and do not anticipate profits in the early years, a corporation is more appropriate. Whether to file an S corp election is independent of the choice of entity and is a decision which should be made in consultation with a tax advisor.
About Author
Andrew Muchmore graduated cum laude from the University of Georgia School of Law in 2008. He founded the firm in 2014 following five years as an associate at a construction litigation boutique. Read more.
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